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.
kevincarney
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Here’s the rub.…
This is the whole point made by the “invisible hand” idea: Competitive markets “invisibly” have each firm produce until price equals marginal cost, and this minimizes total cost to society. While each firm pursues selfish interests, they advance societal goals by creating huge amounts of value in order to make money.
Classical and neoclassical economic ideas and theories are based on the idea of “competitive markets”. But the modern form of capitalism is not built on a foundation of competitive markets. It’s build on a foundation of “rent extraction”, which is turn is based on the idea of creating anti-competitive “moats” around businesses to protect their revenue and earnings.
In industry after industry, fewer and fewer very large powerful firms are squeezing both suppliers and customers to improve their margins and their profits.
If you want to better understand why in the midst of the greatest plenty we find pockets of extreme poverty, read the book Progress and Poverty, by Henry George, which was published in 1879.
A very terse summary is (and this is something Adam Smith wrote about in 1776), the components of price are wages, profits, and rents.
Wages and profits encourage production. Rent diverts money away from production.
As rents take up a larger and larger share of the price of whatever, less remains for wages and profits.
Henry George goes into more detail.