article traces money flows
within the U.S.
We deal with two types of money, base
money and bank money,
and focus on how they move
between the public, the banks,
the Fed, and the Treasury.
public comprises firms and households,
which are the producing and consuming sectors of the economy. Banks
comprise the depositories which provide payment services as well
as financial intermediation for the public.
base is the definitive money of
nation. It exists in two forms (1) notes and coins issued by the
(2) deposits of banks at the Fed. Both are referred to here as base money, and are interchangeable on demand. The
Fed has sole
authority for issuing base money. It does so by purchasing Treasury securities for its
own portfolio, and crediting the seller's bank with a deposit at the
This is known as monetizing
the debt. Conversely when
the Fed sells securities, that amount of base money vanishes.
base money is not a
claim on any Fed assets, it is carried as a liability on the Fed's
sheet, backed by the financial assets it has purchased. Normally,
Fed only acquires Treasury securities because of their liquidity and
credit-worthiness. However to deal with the 2008 financial
crisis, the Fed expanded the list of eligible securities significantly.
the past, the Fed issued only non-interest-earning
liabilities. As of October 2008, it has authority to pay interest
on the excess reserves it holds on deposit for banks. That interest
rate is currently set at 0.25%, but will no doubt be increased as the
economy recovers and the interbank lending rate is returned to more
Money and Bank Reserves
Banks issue credit
when they accept deposits and when they create new deposits to fund
loans. A bank checking deposit represents a promise to deliver
on demand. Since bank deposits can be easily transferred by check
electronic means, they serve as a medium of exchange, and therefore as
bank’s reserves comprise its
vault cash plus its deposit at the Fed, known as Fed funds. Any
payment involving the transfer of deposits between banks requires an
transfer of Fed funds between the respective banks. When one
personal check to make a purchase, the bank's account at the Fed is
cover the check. That means a bank must have reserves of base money in order to do
business. In the special case when the check is deposited in the
bank on which it is drawn, only a transfer of deposits within the bank
comprise a small fraction of
the monetary base, but they play a key role. The Fed adds or
reserves as required to balance the supply and demand at its target Fed
rate. Aggregate reserves increase when the Fed buys Treasury
from the public and decrease when it sells Treasury securities.
also affects aggregate reserves when it deposits or withdraws cash from
causing the Fed to rebalance reserves to compensate for changes in
When the Fed
needs to adjust banking system
reserves, it deals with a group of financial institutions known as primary
dealers comprising banks and securities dealers. It
not concern itself with individual banks needing reserves. Banks
reserves have to borrow them in the money market or in the Fed funds
from those long on reserves. They can also borrow from the
only at a penalty rate above the Fed funds target rate.
The Transaction Money Supply
The Fed has
defined a measure of the
transaction money supply and named it M1. It consists
of (1) cash in
circulation, (2) travelers checks, and (3) demand deposits at
but not the deposits of other banks, the US government, and foreign
banks. Note that the money supply comprises only liabilities of the Fed and
the banking system. Reserves are bank assets, and not a part of
the money supply.
is the ultimate form of money,
by dollar volume it plays a minor role in the economy. Cash and
traveler’s checks are used mainly as portable money in retail
The largest volume of transactions by far involves the transfer of bank
deposits, i.e. bank money.
the demand for liquidity
(immediate spending power) by the private sector. The demand
with inflation and varies with economic conditions. For example,
recessions both firms and households spend less, so they usually move
their demand deposits into interest-earning savings vehicles like
T-bills and CDs.
Of the many
factors that influence M1, the
most significant is the demand for Federal Reserve notes which has been
steadily growing. Most of that demand comes from overseas, but
increasing immigrant population in the US is also an important
factor. As more notes are withdrawn from banks, the Fed must buy
Treasury securities from the public to prevent a drain on banking
reserves. This effect is seen most clearly in the steady growth
securities in the Fed's portfolio.
deposits its receipts from
taxes and the sale of its securities in commercial bank accounts, known
as Treasury Tax
and Loan (TT&L) accounts. Like ordinary bank
TT&L accounts are bank money but are not a part of M1 because they
owned by the government.
writes checks against its
account at the Fed. That injects base money into the
system, which increases aggregate banking system
reserves. However it simultaneously transfers funds from its TT&L accounts
replenish its Fed
account, which reduces banking system reserves. By targeting a
balance in its Fed account, it minimizes disturbances in the aggregate
reserves of the banking system, and thereby facilitates the Fed’s
control of the Fed fund
all practical purposes, the Treasury pays
its bills out of its
commercial bank accounts.
has no use for funds in its TT&L accounts in excess of its
obligations. On average it matches inflows against outflows by
or redeeming its securities as required. In effect, the public
pays for those securities with funds received from government deficit
spending itself. Thus, except for short-term transients, neither
budget deficits nor budget surpluses affect the money supply.