The purpose if this post is to gather my understanding of how money works and flows in the modern economy. The focus is US centric, but should apply to a soverign country that has control to create it’s own currency, requires taxes to be paid in that currency, and has an independent central bank.
Money creation occurs through two primary sources. When the government (US Tresury) spends money. More specifically, instructs the central bank (Fed) to debit an account. This adds reserve balances at the Fed. The second type of money creation occurs at banks, outside of the central banks’ balance sheet, when a loan is created. A loan and deposit are created in a single transaction.1
Money destruction occurs when taxes are paid, and loans are paid off. Technically reserves are removed when a Treasury auction occurs, but the bank holds a treasury bill, note, or bond instead. Which can be used as collateral in the Fed overnight lending market to get reserves.
Limits on bank money creation are based on Basel III.2 There are no technical limits on government money creation. The debt ceiling created by legislation is a politically imposed limit. Although the debt is bought with reserves already spent into the economy.
Bank money transfers from one bank to another through the change of reserve ownership. Reserves held at the Fed remain the same. If a bank does not have enough reserves they can loan them from another bank or from the Fed.
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Bank of england paper Michael McLeay, Amar Radia, and Ryland Thomas, “Money Creation in the Modern Economy,” Bank of England Quarterly Bulletin 54, no. 1 (2014): 14–27 ↩︎
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Basel Committee on Banking Supervision, Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems, rev. ed., June 2011 (Basel: Bank for International Settlements, 2011) ↩︎
⇒ This article is also available on gemini.