My mental model is that the Fed lends money into existence (either to banks or to the treasury), which creates a loan (that eventually has to be paid back with interest, though I think they can choose not to collect on loans to the treasury?) (I'm also not sure where the money the Fed uses to pay interest on bank reserves comes from, but since it used to not do that I'll ignore it and pretend I'm asking about the time before that existed).

This is true of the Fed's operations in the repo market, but those are a fairly recent development and it's not true in general.

In general, the Fed doesn't lend money into existence, they create money from scratch and then sell that money in exchange for some other asset (typically Treasuries). A bank sells the Fed $1 worth of Treasuries, and the Fed just adds $1 to that bank's account.

However, because the Fed buys a Treasury note/bond in this process, the (rest of the) government then owes the Fed money - i.e. the Treasury note/bond payments. So when the Fed issues a dollar, they also acquire one dollar's worth of somebody else's debt. Note that that's one dollar's worth of debt at current market prices; the Fed will actually be owed more than one dollar. Also, as current market prices shift and the Fed buys and sells assets the amount of money owed to the Fed will generally not be equal to the amount of dollars outstanding.

This suggests that it is not possible, economy-wide, for private sector net savings to increase unless the government debt increases, and that whenever government debt goes down, private savings must decrease.

Private investment is the main thing missing here. Private savings go into a mix of government debt and private capital investments (i.e. grid infrastructure, data infrastructure, railroads, oil wells, real estate, machinery, etc) - i.e. corporate bond/equity-financed capital expenditure. Thus the concern that too much government debt could (at least in theory) crowd out private investments in industry.

As far as I understood money myself, your intuition is correct. All fiat currency are credit money, so that when you are holding a $, either in cash or bank deposit, you are holding someone else liability. The system is balanced, so that total liabilities are equal to total assets at any time. The net value of the entire monetary system in the economy is zero.

That's right, but that's the private sector as a whole. Some part of the private sectors will increase their debt, while others their savings. Clearly that would generate business cycles/boom and bust, and that's the big discussion of macroeconomics in what is the role of governments in damping/preventing them.

Since the Treasury owns the Fed, the profits made by the Fed are channeled back to the Treasury. The ECB is a bit more complex, but it works in a similar way. When a central bank buys government debt, that debt is the facto neutralized.

It' s super easy to be confused about this topic, as the mechanism is, in my humble opinion, much more complex than it should be.

I also see that you asked your question over 6 years ago, so there's a chance you won't even see this answer.

There are a few very important main concepts to understand here. The questions are simple, the answers are involved.

First: What is money and where does it come from?

Second: What is "moneyness"?

Third: What are bank reserves and how is it they have a very low level of moneyness, and yet are the scaffolding on which the entire global banking system is built?


97% of all money in modern monetary economies are deposits in bank accounts. When we pay each other, numbers in one deposit account go down while numbers in another deposit account go up.

There is a a very widely used payment processing infrastructure that allows this to happen, not only between banks, but between banks in different countries, using different currencies.

So... If you want to model money creation and destruction in a modern monetary economy, by focusing on deposits, you create a model that is 97% good.

And when you do so, you see the central banks (such as the Federal Reserve) create reserves, not deposits, and as such, don't really create "money". They create the scaffolding our global payment system runs on, which is reserves.

So how are deposits created and destroyed?

The main methods of money creation are federal government spending and commercial bank lending.

Federal governments literally spend money into existence and commercial banks literally lend money into existence. Federal government spending and bank lending increases the aggregate level of deposits in the banking system, and for that reason, creates money.

Federal taxes literally destroy money, as does the principal portion of loan payments. Federal government tax collections and commercial bank loan repayments of principal decreases the aggregate level of deposits in the banking system, and for that reason, destroys money.

When federal governments spend money into existence, they do so through their "fiscal agent", their central bank.

Additionally, when federal government spending exceeds federal government tax collections, they are required by law to issue and sell bonds equal to the amount of the difference, the deficit.

So, literally, money is created by federal governments and commercial banks. And almost all the money in circulation was created through commercial bank lending.


Now, moneyness. I forget where I first heard that word, but it's a good word. It refers to the degree to which something is accepted as final payment for something else. Bank deposits have a very high degree of moneyness. You can use them pretty much anywhere for the purchase of anything.

There are also non-money money-like things in every economy that have some characteristics of money, but have a very low level of moneyness.

For all of them, there are rules on how you earn them and how you can spend them.

Examples are airline miles, casino chips, and loyalty programs (for example: buy 10 burritos get a free one).

You can spend them, but the rules on where and for what are very narrow. They have a very low level of moneyness.

Bank reserves, which are created ONLY by central banks, are one such form of highly specialized money with a low level of moneyness. Merchants do not accept reserves as payment. To them, they're not money.

So why do they exist?

They serve two main purposes.

They facilitate interbank payments, and they're a main, perhaps the main, way federal governments obtain money.

I said earlier that merchants can not accept bank reserves as payment, and so to them, they're not money.

There are however a small number of institutions from whom reserves ARE money, and the largest of them are national treasures.

To the US Treasury, reserves are money.

When the US Treasury (or any Treasury of any country) sells bonds to banks, the banks pay with reserves, those reserves go into the Treasuries account the Federal Reserve, and the Treasury can spend them the way you and I spend deposits.

I won't go into the details here, but when someone makes a payment and someone else receives that payment, and they bank at different banks, reserves play a very important role in the clearing and setteling of that payment.

This is the bit about reserves being the "scaffolding" for our payment systems. Reserves are integral to the operation of our payment system.

Sorry for such a long answer, but the mechanism is complex, and short simple answers often, maybe generally, leave out so much that those answers tend to be wrong.

Central banks create reserves, not deposits, and reserves are money only to a small handful of institutions, the federal government treasury being the largest of them.

Deposits, which is the money the rest of us use, is created by federal government spending and commercial bank lending.

And almost all the money in circulation is created by bank lending.

The almost universally known story of central banks controlling the money supply is simply false. The money supply is mostly controlled through the rules of bank lending, and to a lessor degree through the rules of federal government spending and taxation.