How Money Works
There are four main players in the money game:
- Businesses and Citizens like you and me (business entities).
- Banks
- The U.S. Treasury
- The Federal Reserve
Each has a role to play.
Introduction
If you look at your U.S. $1 bill, you will see that it says FEDERAL RESERVE NOTE.
This means that the holder of the "note" is owed one dollar by the U.S. Government
(the Treasury, not the Federal Reserve).
The piece of paper is not a dollar, but rather entitles you to the value of a dollar.
In the early 1900's and earlier the value of a dollar was fixed to a certain amount of Gold or Silver.
Today the value of a dollar floats according to exchange rates.
It is not collateralized by chunks of metal (Gold or Silver) but the
ability of the government to pay that debt.
The real value of each dollar fluctuates with the
supply and demand of dollars in the marketplace.
Business entities (or persons)
Business entities use money to buy things from other entities, but that's not the interesting part.
For the purposes of understanding our money, it's more interesting to note the interactions we have with
banks. We need loans and savings accounts.
We get a loan from a banking institution and agree to pay them back with interest.
We also want to put our money into a bank account that pays us interest for letting them hold our money.
As you probably know, the bank charges a higher rate of interest on loans than they give out to account holders.
The difference is their profit. They earn this by providing us a service.
Banks
Banks make their money by loaning out money on deposit in the form of loans to other entities or banks.
By law, they are not allowed to loan out all of the money they hold in their(our) accounts.
When we want to get our money out they need to have some on hand to give us.
Certainly they don't need to have it all just sitting around. Most of it is loaned out.
The amount of money they need to hold back for withdrawals is called the reserve
(a percentage of funds not to be loaned out).
Any money "reserved" does not earn interest. A minimum amount of reserves must be on deposit
with the Federal Reserve System itself.
This minimum rate is determined by the Federal Reserve.
Banks can choose to borrow more money than what is deposited in their(our) accounts in order to make more loans.
They can borrow from other banks or if they are large enough, from the Federal Reserve.
Banks choose to borrow from the Fed based on the discount rate set by the Fed.
You could say that banks do their banking at the Fed.
Most banks are FDIC insured. (FDIC= Federal Deposit Insurance Corporation).
The FDIC is an agency of the Federal Government and guarantees each individual's
deposits for up to $100,000 per person.
The U.S. Treasury
The Treasury runs the finances of the government. They collect taxes, pay obligations, manage the national debt,
and a few other odds and ends.
Branches of the Treasury include the IRS,
the US Mint,
the Bureau of Engraving and Printing (that prints our money and stamps),
and the office of the public debt.
(The org chart for 2005 is at this link).
The Treasury "keeps it's money" in the Federal Reserve Bank. Any taxes or customs collected are put on deposit
there (without interest).
Any money it needs above taxes in order to pay it's debts is borrowed from the Fed (with interest).
As of this writing (2003), the Treasury is over 8 trillion dollars in debt ($8,000,000,000,000)!
(Here's a link to the Treasury Website.)
Federal Reserve
The Federal Reserve (Fed) is the central bank of the
United States. I discuss a summary of Federal Reserve history elsewhere.
The Fed sets the interest rate (discount rate) at which the government (and other large banks) can borrow money.
The Fed sets the "fractional lending" ratios - the minimum reserve rates.
The Fed also controls the money supply another way - by buying and selling government bonds on the open bond market
(like adding or subtracting water to a reservoir in order to raise and lower the water level).
Selling bonds takes away money in exchange for bond notes (that just sit there).
Buying bonds puts money into circulation and removes the bond.
The FOMC (Federal Open Market Committee) decides how much buying and selling of bonds to do.
The Fed is governed by a 7 member board of governors, each of which are appointed by the President of the
United States (and confirmed by the Senate) to 14 year terms.
The board of governors reports to the congress (as prescribed by the
constitution).
The Fed is actually owned by the member banks, not the Treasury.
Shares of this private company were sold to the member banks.
The Fed acts like a bank for banks and the government - otherwise known as a "bank of last resort".
When no one else will loan you money,
The Fed should be able to handle the job if it's in the national interest.
The Fed "makes money" by providing services, and by collecting interest on loans.
Any money left over after expenses is given to the U.S. Treasury.
International Monetary Fund (IMF)
Since the United States is a member of the world community, it makes sense for the U.S. Treasury to have an
account with the IMF. In the same way that banks became members (account holders) of the Federal Reserve,
the Fed became a member of the IMF. The advantages of money safety and flexibility obtained by having a
central bank of the USA can be had on a worldwide scale with the IMF.
When natural disasters or unusual economic events occur in a nation, the IMF is there to provide loans to
help stabilize their economy. Like the Fed, the interest pays for the operating expenses
and any extra goes to the shareholders.
How the money (or cash) supply works
First off, the money supply in general is balanced by the Fed, who tries to match
the value being generated in society with the number of dollars floating around (see my discussion on
Supply and demand for further information).
There are really two different questions: "Where does the money come from to change the level of money supply?"
and "Specifically how does a dollar bill enter circulation?".
How does cash enter circulation?
Step 1: A person wants to get $100 cash (5 $20s) from his bank where he has an account with a balance.
This person assumes the bank will have the cash on hand to fulfill this request.
Step 2: The bank gives him the money in cash as requested.
Step 3: In order to keep the correct ratios of cash to deposits
(as defined by the Fed guidelines or possibly more strict from the head bank branch),
the bank orders $100 in cash to be sent on the next truck from the central bank headquarters.
Step 4: In aggregate, the head bank sums up all the requests for new cash
and subtracts off the "old cash" the banks have collected for recycling
and comes up with a net amount it wants to get from the local Federal Reserve branch.
In this example the amount is $100.
(This is the amount the Reserve branch subtracts from the bank's account - just like for an individual).
Step 5: The local Federal Reserve sums up all the requests for all banks and orders bills
from the US treasury.
Step 6: The treasury asks the mint to print the required number of bills (5 $20s in this case).
Step 7: (Here's where it gets interesting).
The Federal reserve purchases the bills from the US Mint (or the Bureau of Engraving and Printing)
at cost (around 3 cents per bill).
Step 8: Because that "Federal Reserve Note" is an obligation of the Treasury department
going into circulation,
the Fed credits $100 to the account of the US Treasury (to balance the debt of $100 given to the reserve bank).
This is like the US Treasury depositing the money with the Federal Reserve bank (without interest) -
who is then loaning it out (with interest).
Step 9: Those 5 bills are then passed down the line with the necessary accounting taking place
along the way.
The Federal Reserve charges interest on all the money it lends out all year long.
It recieves over $20 Billion in interest payments - most of which it gives back to the US treasury.
Some of the "profit" is used to cover expenses (like printing money itself, employees, buildings, etc.)
and some gets paid out in a dividend (about 1%) back to the member banks.
Where does the money come from (or go to) when the money supply is changed?
If you think about it, anyone can do this little magic trick of creating a supply of money.
Most of us can get a credit card and request a cash advance. Suddenly you have more cash on hand
but you also have a debt balance with the credit card issuing bank. The supply of money just went up.
When you pay that off the supply of money just went down.
The Federal Reserve does this anytime it wants to create or expire some amount of the money supply.
The main methods for doing this is to buy or sell US government treasuries and bonds on the open market.
The Fed can request additional bonds or treasuries from the Treasury at will.
Thus the Fed controls the money supply.
Click here for more about the effects of changing the money supply.
Notes:
Who's obligation?
According to the Federal Reserve Act, Federal Reserve Notes are obligations
of the United States Government.
The government manages it's obligations through the department of the Treasury.
Collateral
The ability of the government to pay it's debts is dependent on it's ability to collect taxes from it's citizens.
Those taxes are dependent on the ability of the citizens to work and create value to others.
In a certain sense you could say we are part time slaves: working for the government part of the year and
working for ourselves the rest of the time.
ATF & Secret Service
The department of the Treasury used to include the ATF
and the Secret Service.
The ATF controls the use, regulation, and taxing of Alcohol, Tobacco, and Firearms, as well as enforces the
laws regarding those things. The ATF was part of the department of the Treasury because that's one of the
things being taxed. The tax management part of the ATF stayed with the Treasury department and the law
enforcement aspects were moved under the Department of Justice as part of the reorganization under the
Homeland Security Act of 2002.
The Secret service not only guards the President, Vice president, and all presidential candidates,
but also guards the Treasury buildings and enforces the counterfeiting/forging laws.
Debt
A debt of 9 Trillion dollars is more than $30,000 per citizen. Each generation would prefer to die
without paying that debt and pass it on to our children.
This sort of thinking just makes the number bigger. Don't get me started...
So who is the creditor for all this debt? Whomever holds U.S. Bonds (savings bonds, Treasury bills, etc.)
Currently a significant portion of this debt is owned by the Chinese government.
This is mutually beneficial (to both governments), but that's another story.
Fed ownership
By member banks buying shares of the Fed (to the tune of 3% of capital and surplus), bank funds were
fairly and legally moved from those banks into the Federal Reserve.
This built in some natural incentives for the system to work: The banks would want their "investment"
to work out and the Fed would be influenced by it's shareholders to help out the banks.
Fed expenses
One of the interesting "expenses" of the Federal Reserve is a 6% dividend to member banks on their stock ownership.
Other than a general financial statement, the Fed does not explain it's expenses.
Congress has been considering forcing the Fed to be audited each year, but has not passed the bill into law yet.
This means that the financial records of the Fed are closed to the public and to the government
(whose debt it manages).
IMF ownership
So who owns the shares of the IMF? Do member banks also own shares?
Is it a "credit union" model where the account holders get a percentage of profits?
Who decides?
So, how does the amount of Treasury bond money get determined? It seems the Treasury has to borrow a
certain amount of money each year based on it's budget (or lack thereof).
It also appears that the Fed has the option to put more or less than that amount on the market according
to money supply and inflation needs.
Who decides and how can both authorities coexist in this matter?
Federal Branch abbreviations
The following letters are associated with each of the Federal Reserve branches.
A = Boston, MA
B = New York, NY
C = Philadelphia, PA
D = Cleveland, OH
E = Richmond, VA
F = Atlanta, GA
G = Chicago, IL
H = St. Louis, MO
I = Minneapolis, MN
J = Kansas City, KS
K = Dallas, TX
L = San Francisco, CA
The letters denote the territory number (A=1, B=2, etc.)
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