My economics text gave a history of money and the development of creating money through banks. According to the text, originally, trade was done by barter. Then, people found more convenience in exchanging something considered of value, but easy to store and carry – like coins of precious metals, to carry value in trade. Eventually, to keep the exchange medium safe, people began storing the medium with a person – say someone who worked in gold smithing for gold coins – and exchanging the medium through paper IOU’s. The persons holding the medium of value found that the persons could give out more IOU’s than the persons had in the value of the medium the persons had in the persons’ vaults. The persons were expanding the money supply, quite unwittingly. Later, banks came into existence to hold the medium of value and came to print money backed by the medium of value held in a bank’s vault. While the government printed money during the Civil War, by the late nineteenth century in the United States, banks were printing the county’s paper money. However, sometimes there would be “runs” on banks, that is more people turning in paper money for the medium of value behind the money than the bank had in store. Runs on banks lead to bank failures. In 1914, the federal reserve system came into existence, with the Federal Reserve banks being the banks of the federal government. After 1914, only the federal government printed money. At first, the government maintained gold reserves to back the paper money, but by 1971, paper money could not be exchanged for gold by anyone. Since 1971, we have had fiat money – that is money with nothing behind the money.
The Federal Reserve banks are the federal government’s bankers. All money going into or out of the government goes through a Federal Reserve bank. The Federal Reserve banks also serve as bankers to the commercial banks in this country. Much of the reserves required by the reserve rate is on deposit at a Federal Reserve bank, the rest being in vaults within commercial banks. The Federal Reserve distributes all new currency in circulation. When a commercial bank’s reserves fall too low, the bank can borrow from the Federal Reserve (from the discount window at the discount rate). The Federal Reserve System is responsible for the implementation of monetary policy, too.
When there is less money taken in by the federal government than is spent, the difference between the money taken in and the money spent must be financed in some way. The government has two ways of financing the difference, by borrowing or by “printing” money. When the government borrows money, the money is either borrowed from the American public or from foreigners (here I am ignoring intra-government transfers). When the government borrows money, the Treasury Department sells securities to the public. If the market is such that the public does not want to buy the securities, the Federal Reserve buys the Treasury securities and pays the bill by borrowing from itself, which is called “printing” money. The money borrowed is created electronically out of nothing. Note that the federal government gets most of the earnings of the Federal Reserve banks.
The money supply is increased when borrowing from foreigners, since money comes into the economy from outside, but borrowing from the the American public should not affect the money supply, since the money is just returned to the economy. When money is “printed”, the money supply increases, since money enters the economy from outside, that is, money is created out of nothing and put into the economy. The Federal Reserve has other ways of influencing the money supply, like open market operations and quantitative easing, as well as changing the reserve rate. However, permanent growth necessitates injecting money into the monetary system from outside of the system, either from our government or from foreigners.
But, the debt, which is mostly money owed to the general public and money owed as part of intra-governmental bookkeeping, is much more than the money supply.