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.
ultimate third party is the Fed, with a unique role as we will see.
Negotiable Debt and the Money
When a bank issues a loan, it creates negotiable debt, the
it credited to the borrower, in exchange for generally non-negotiable
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
against his deposit, if the payee deposits the check in another bank
simply transfers the negotiable debt to the other bank without
the total money supply.
Definitive Money versus Credit
What we normally refer to as the money supply
consists of two
types of money, definitive money and bank credit.
money is money that is not convertible into any other form of
The Fed issues all definitive money. Banks can only issue credit
convertible into definitive money. Most definitive money exists
paper dollars, but also includes the deposits that banks hold at the
Definitive Money as the Debt of
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
all of the cash the public uses. The Treasury issues
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
of debt can be readily exchanged with each other.
The Passive Role of the Fed
The public acquires definitive money through the banking
A bank must hold enough definitive money, known as reserves, to
meet withdrawals of cash or debits by check. Checking activity
transfers reserves from the payer's bank to the payee's bank.
when cash is withdrawn by a depositor, aggregate reserves are drawn
The Fed replenishes those reserves on its own initiative in order to
a liquidity crisis in the banking system. It does so by
Treasury securities from the public. The proceeds end up as new
deposits for the sellers and additional reserves for their banks.
When the public deposits its excess cash into banks, the
what would otherwise become excess reserves by selling Treasury
to the public. In effect, the public trades Treasury securities
cash and vice versa in order to satisfy its liquidity needs. This
means the amount of definitive money is a function of private sector
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
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
the Fed can never become insolvent because it has unlimited power to