How US Dollars Are Created

How US Dollars Are Created

Okay. Some of you believe the federal government prints money and hands it out. Most of you think the government stockpiles your tax dollars and spends them, and if it falls short then it borrows money or charges things on a Chinese credit card. Forget all that junk. None of it is true.

The fact is, the federal government creates money in the form of US dollars each time it spends, simply by spending. Let me repeat, US dollars come into existence as a result of federal spending. Further, federal spending is the only way that US dollars come into existence. 

Follow closely -- here's how it happens.

1. Congress allocates spending via legislation. Example: Congress authorizes an $81 billion increase in defense spending.

2. The Treasury pays a bill. Example: The Treasury receives a $2 million bill from United Technologies for a fighter jet engine and directs the Federal Reserve Bank (the central bank) to pay United Technologies $2 million at the First Bank of Hartford.

3. The Fed pays the bill by simply crediting (marking up) the receiving bank's account at the Fed (its "reserve account") by the amount of the payment. This action, this credit to the reserve account creates new US dollars because reserves are dollars. Example: The Fed increases the First Bank of Hartford's reserve account balance by $2 million via a simple accounting transaction. When it does that, it has increased the MB Money Supply (the monetary base) by $2 million and new US dollars have come into existence. The monetary base (MB) includes reserves, cash in bank vaults, and cash in circulation.

4. The receiving bank then credits the receiving entity's deposit account by the amount of the payment. This acknowledges that the receiving entity is entitled to the number of US dollars (reserves) equal to his deposit account balance. Example: The First Bank of Hartford credits United Technologies' deposit account by $2 million, United Technologies now has $2 million it did not have before, and United Technologies marks its bill to the government as "Paid". By crediting United Technologies' deposit account by $2 million, the Bank of Hartford has increased the M1 Money Supply (highly liquid bank deposits plus cash in circulation) by $2 million.

Note 1: Private sector checking and savings deposits are measured in dollars but they are not dollars. They are a record of how much of the bank's reserves the deposit holder is entitled to. The reserves themselves, cash in vaults, and cash in circulation are the dollars. When a depositor gets cash from his bank's ATM, the bank reduces the depositor's deposit balance and hands over cash to the depositor. The bank got the cash from the Fed in exchange for lowering its reserve account balance by the amount of the cash it got.

Note 2: Banks also increase the M1 money supply by marking up deposit balances when they make loans. Such markups of deposit accounts indicate an increase in the number of US dollars to which the depositor is entitled. However, banks cannot create reserves (US dollars). Only the government, via the Fed, can do that. Therefore, bank loans cause deposit increases (the number of dollars the depositor is entitled to) but bank loans do not create US dollars (reserves). Example: If I borrow $1000 from First Citizens Bank, my checking account balance is increased by $1000, and the M1 Money Supply goes up by $1000, but no new reserves (US dollars) are added to the Monetary Base (MB). And yes, the result is that depositors are entitled to more US dollars than there are US dollars in existence

Summary:

Dollars are created by federal spending thusly:
1. Congress authorizes spending.
2. Treasury authorizes the Fed to pay someone.
3. The Fed responds by increasing a bank's reserve account thus creating new US dollars and thereby increasing the MB Money Supply.
4. The bank responds by increasing the payee's deposit account thus increasing the M1 Money Supply.