.
MONEY
WHAT IT IS
HOW IT WORKS
This
article traces money flows
within the The
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
Money The
monetary
base is the definitive money of
the
nation. It exists in two forms (1) notes and coins issued by the
Fed, and
(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
Fed.
This is known as monetizing
the debt. Conversely when
the Fed sells securities, that amount of base money vanishes. Although base money is not a claim on any Fed assets, it is carried as a liability on the Fed's balance sheet, backed by the financial assets it has purchased. Normally, the 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. In
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
normal levels. Bank
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
base money
on demand. Since bank deposits can be easily transferred by check
or
electronic means, they serve as a medium of exchange, and therefore as
money. A
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
equal
transfer of Fed funds between the respective banks. When one
writes a
personal check to make a purchase, the bank's account at the Fed is
debited to
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
same
bank on which it is drawn, only a transfer of deposits within the bank
is
involved. Bank reserves
comprise a small fraction of
the monetary base, but they play a key role. The Fed adds or
drains
reserves as required to balance the supply and demand at its target Fed
funds
rate. Aggregate reserves increase when the Fed buys Treasury
securities
from the public and decrease when it sells Treasury securities.
The public
also affects aggregate reserves when it deposits or withdraws cash from
banks,
causing the Fed to rebalance reserves to compensate for changes in
aggregate
vault cash. 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
does
not concern itself with individual banks needing reserves. Banks
short of
reserves have to borrow them in the money market or in the Fed funds
market
from those long on reserves. They can also borrow from the
Fed, but
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
commercial banks,
but not the deposits of other banks, the Although cash
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
purchases.
The largest volume of transactions by far involves the transfer of bank
deposits, i.e. bank money. M1 reflects
the demand for liquidity
(immediate spending power) by the private sector. The demand
increases
with inflation and varies with economic conditions. For example,
during
recessions both firms and households spend less, so they usually move
some of
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
the
increasing immigrant population in the Treasury Operations The Treasury
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
accounts,
TT&L accounts are bank money but are not a part of M1 because they
are
owned by the government. The Treasury
writes checks against its
account at the Fed. That injects base money into the
banking
system, which increases aggregate banking system
reserves. However it simultaneously transfers funds from its TT&L accounts
to
replenish its Fed
account, which reduces banking system reserves. By targeting a
constant
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
rate. For
all practical purposes, the Treasury pays
its bills out of its
commercial bank accounts. The Treasury
has no use for funds in its TT&L accounts in excess of its
near-term
payment
obligations. On average it matches inflows against outflows by
selling
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. |
