In an earlier post (The Fed Does Not Create Money), I explained why the Federal Reserve banks do not create money.
In this post, I will return to the definition of money and explain who creates money and the process by which claims used as money get produced.
Money consists of any economic good, or any claim on such a good, that serves as a general medium of Indirect Exchange and that acts as a final means of payment.
We no longer use economic goods, e.g., gold, as a form of money. Nowadays, all money comes in the form of monetary claims.
Nowadays, nearly all monetary claims appear in two dollar-denominated forms.
- Ex Nihilo claims created out of nothing.
- Currency claims against the government.
Creator of Money
We have to start a discussion of how money gets created by explaining who actually creates money.
Usage Defines Meaning
Like so many words in our language, money is defined by its usage. A hammer is only a hammer because it is used to “hammer” things. The football is only a football because people use it in a game we call “football.” A fork only becomes a fork when used for eating.
Market Uses Dollars as Money
The very same thing applies to money. A commodity (or claims against that commodity) only becomes money when market participants accept it as a medium of indirect exchange. The market has determined to use dollars as money, but not all dollars are the same. The market uses dollars created by banks as money. The market cannot, however, use dollars created by the Federal Reserve as money. The dollars created by the Federal Reserve serve only to transfer claims from one bank to another in a process that I will describe in another post.
Producers of Dollar Denominated Claims
Because of their government charters, only banks have the authority to produce dollar-denominated claims that the market can use as money. Here’s where the money dollars get created.
Creating New Dollars
Creating new dollars is so simple it almost seems unnecessary to explain. Banks simply make an entry in their ledger for deposit liabilities. (Today, these entries are in a computerized ledger, but it’s just as simple. They create them ex nihilo (out of nothing.)
It is essential to know that banks do not actually create dollars. They create claims on dollars. Where do the dollars exist? Or do they? The topic for another blog.
From sound economic theory, we learn that distribution plays an essential role in the production process, which holds valid with the production of dollars.
In addition to creating money, banks also distribute (in addition to dollar claims it creates) dollar claims in the form of Federal Reserve notes and some coins.
Thus, banks produce all dollar claims that comprise our current monetary system.
Claims on what? Makes up the topic of another blog post in the future.
Why do banks produce these dollar claims that we use as money?
We should not forget that market participants decide what they will use as money. Declarations by governments do not, by themselves, make a commodity or a claim money. Even fiat “money” must have the acceptance of the market to make it money.
Only banks (through ex nihilo creation and distribution) produce dollar-denominated claims that the market can use as money.
Banks produce the “money dollars” to pay for earning assets.