Introduction

I have on my schedule the writing of an article about the creation of money. Before starting this note, I watched a couple of videos about money and bonds. These presentations contain numerous errors that call the validity of the entire presentation into question. I want to offer some new information that readers can reformulate as questions to test any one of these presentations.

As I have in many other publications, I want to avoid confusion by offering a precise definition of “money.”

Definition of Money

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.

I compare the understanding of money to the understanding of gravity. Gravity acts the same always and everywhere. To walk down the street, you don’t need to know much about gravity. You can be reasonably sure your next step won’t spring you into space.

On the other hand, learning a bit more about gravity will help you design a F1 car.

For years, F1 designers explained that wider tires would not improve cornering speeds because physics dictated that a car could never corner at a force greater than gravity. Then, someone put a wing on the car. With the use of aerodynamic downforce and wider tires, F1 cars now corner at about 4 times the force of gravity.

“Money”

For the general use of “money,” a person normally does not need to look “under the hood,” but those looking at videos and reading accounts of “money” might need more precise information.

So who decides what to use as “money,” and who creates “money?”

I can provide you with answers far simpler than you might expect.

First, individuals in a defined market choose what to use as “money.” In the U.S. market, people have chosen to use dollars authorized by the government as “money.”

Second, only banks create the new dollars that people can use as” money.” Banks create those dollars in two basic forms: demand liabilities and currency.

Most people understand the creation of demand liabilities regardless of the method by which customers use them: check, debit card, phone scan, etc. The bank simply records the liability in its ledger.

Currency, however, tends to confuse people somewhat. Many think that dollar-denominated currency comes from The Government or The Fed. Remember who delivers the currency to the public. As long as currency resides at The Fed or in the bank vault, people cannot use it as money. Those dollars consist of bank reserves, and, as reserves, people cannot simultaneously use them as “money.”

To avoid common confusion, the act of accepting customer notes (AKA making “loans”) does not create “money.” Banks create “money dollars” in exchange for promises to pay (usually more) dollars in the future. Banks can create “money dollars” for other purposes, such as paying salaries, buying furniture, and purchasing office supplies. Bank regulations, however, restrict what assets banks can own.

Summary

Markets choose what to use as money. The U.S. markets have chosen to use the dollars authorized by the U.S. Government.

Only banks have the authority to create new dollar-denominated “money.” The Fed does not create or hold any dollars used by the market as “money.” Dollars at The Fed act as reserves to “back” dollars at banks. Those dollars, which, by regulation, remain inaccessible to the market, cannot logically also serve as “money.”

Because of its importance, I will have more to write about “money” in the future.