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MONEY

WHAT IT IS
HOW IT WORKS

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Money as
Third Party Debt

Modern money is third party debt that is widely accepted as a medium of exchange.  In other words, modern money is the negotiable debt of a trusted financial institution like a bank.  The ultimate third party is the Fed, with a unique role as we will see.

Negotiable Debt and the Money Supply

When a bank issues a loan, it creates negotiable debt, the deposit it credited to the borrower, in exchange for generally non-negotiable debt, what the borrower owes the bank.  By issuing negotiable debt, banks automatically increase the money supply.  Conversely, as loans are paid off, the money supply decreases.  When a borrower writes a check against his deposit, if the payee deposits the check in another bank that simply transfers the negotiable debt to the other bank without affecting the total money supply.

Definitive Money versus Credit Money

What we normally refer to as the money supply consists of two types of money, definitive money and bank credit.  Definitive money is money that is not convertible into any other form of money.  The Fed issues all definitive money.  Banks can only issue credit convertible into definitive money.  Most definitive money exists as paper dollars, but also includes the deposits that banks hold at the Fed. 

Definitive Money as the Debt of the Fed

All definitive money is non-interest-earning debt of zero maturity issued by the Fed.  In other words, the Fed is the third party debtor behind all of the cash the public uses.  The Treasury issues interest-earning debt of non-zero maturity in the form of bills, notes, and bonds.  Such securities are not money, because they are not widely accepted as a medium of exchange.  However as the securities mature, they are redeemed for definitive money by the Treasury.  Both of these forms of debt can be readily exchanged with each other. 

The Passive Role of the Fed

The public acquires definitive money through the banking system.  A bank must hold enough definitive money, known as reserves, to meet withdrawals of cash or debits by check.  Checking activity simply transfers reserves from the payer's bank to the payee's bank.  However when cash is withdrawn by a depositor, aggregate reserves are drawn down.  The Fed replenishes those reserves on its own initiative in order to avoid a liquidity crisis in the banking system.  It does so by purchasing Treasury securities from the public.  The proceeds end up as new bank deposits for the sellers and additional reserves for their banks.

When the public deposits its excess cash into banks, the Fed recaptures what would otherwise become excess reserves by selling Treasury securities to the public.  In effect, the public trades Treasury securities for cash and vice versa in order to satisfy its liquidity needs.  This means the amount of definitive money is a function of private sector demand, and is not under the control of the Fed.

Bank Credit versus Demand

Bank credit is also a function of demand, limited only by the capital adequacy requirement imposed by the Fed.  However when a bank issues a loan, it puts its own capital at risk.  It therefore lends only to those it believes to be credit-worthy borrowers.  If it issues too many uncollectable loans, it will become insolvent.  In contrast, the Fed can never become insolvent because it has unlimited power to issue definitive money. 

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