Saturday, May 28, 2011

Banks and Government Create Money

We use money every day without thinking about where in comes from, we’re concerned with what we can do with it. In a previous post we looked at some of the consequences of the passing of the gold standard. In preparation for upcoming discussions, we might take a closer look at the two sources of money.
Banks create money by lending to a borrower, who then deposits the money in The bank. (We can think of the whole banking sector as the bank.)The deposit is a liability for the bank and an asset for the borrower. The loan is a corresponding asset for the bank and a liability for the borrower. Both the bank and the borrower have equal assets and liabilities. As the borrower draws down the bank account, her asset decreases along with the bank’s liability. As the borrower pays off the loan, her liability decreases along with the bank’s asset. This all nets to zero in the banking system, because after the loan is paid off the money created is gone. However, if the loan was put to productive use, the borrower may have real assets and her wealth improved. 
In spending, the government creates money by crediting bank accounts. The Fed marks up the balance of the Treasury’s account at the Fed. (It’s as if the Fed just picked money off the money tree.) The treasury then transfers those reserves to to the recipient’s bank, which then marks up the recipient’s account balance. The recipient has an additional asset with no corresponding liability in the banking system. This is the mechanism by which government spending adds wealth to the private sector.
The process is reversed upon taxation. The tax payer’s account at the bank is decreased and subsequently, the Treasury’s account at the Fed is decreased. Money is created by government spending and destroyed through taxation. If the tax payer paid in cash, it would go to the shredder. 
As explained in an earlier post, when the government spends more than it destroys by taxation, excess reserves build up in the banking system that must be drained by selling Treasury bonds. The government buys back Treasuries on the rare occasions that it runs a surplus. In this way, the government defends its target interest rate, which in turn influences the market for bank loans.
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