Bank Money

Date: 2015-10-07; view: 637.

Base Money

Fiat Money as a Tax Credit

The general acceptance of the U.S. government's fiat money derives from its status as legal tender and from the fact that it is required in payment of federal taxes. Those who have no tax liability have reason to acquire fiat money because it is of value to those who do. Thus fiat money can be viewed as a tax credit, which will be used as a medium of exchange as long as the government widely enforces tax collection.

Fiat money held by the private sector is known as the monetary base, which we will refer to as base money. The Fed issues base money when it buys securities from the public for its own portfolio, mainly Treasury debt. It pays by simply creating a deposit at the Federal Reserve Bank for the seller's own bank. This is known as monetizing the debt.

Banks create deposits, known as bank money, when they issue loans by simply crediting the borrower's account with a new deposit. The total amount of bank money increases when a bank issues a loan. When a loan is paid off, that amount of bank money vanishes.

The value of bank money is based on the promise that it can be converted on demand into base money at par. Current rules require a bank to hold reserves of base money equal to at least 10% of its transaction deposits. Reserves can be held in any combination of vault cash and deposit at the Fed. There is no required reserve for other bank liabilities, such as savings accounts or certificates of deposit.

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