How does new value created by industry and economy become cash?

December 28, 2007 9:47 PM

(Possibly Advanced) Economics Filter: How does new value created by industry and economy become money?

This question is NOT: "How are freshly-minted dollars sent into circulation?"

It IS: When the industry of a country (we'll use the US here) produces more valuable good and services than there is physical currency to satisfy demand, how does that country's mint get the currency into the hands of those who are entitled to it?

I'm sorry that I'm having a hard time wording this question well. Here's where my confusion comes from:

The US constantly produces more currency. Much of that replaces currency that is removed from circulation due to wear or obsoletion, but in aggregate, I'm assuming that there are more $100 bills in circulation today than there were in, say, 2002. It's granted that the Federal Reserve banks send currency to your local bank so that you can withdraw cash, but that money was already in your hands in another form. Your employer/customer had it stored until you were to be payed, so it didn't come directly from the Treasury.

So how do NEW dollars...ones that are generated by the economy, not yet backed by currency, and then demanded in currency...get distributed?

posted by SlyBevel to work & money (32 comments total)

Someone else will answer in much greater detail and sophistication, but the gist is this: paper currency is almost irrelevant; it's a tiny fraction of the true measure of the economy's money supply. The only point of paper currency is allowing transactions to happen outside the financial system. The vast majority of the economy is lubricated by money that's transferred by check or by debt (credit cards and loans).

So here's what happens, the Treasury prints some money. The Federal Reserve bank buys it at a small percentage of face value-about as much as it cost the Treasury to print it. Let's pretend it's 5%. So the Treasury prints $100, the Fed pays the Treasury $5 for it, then turns around and uses the $100 to buy Treasury bonds. Now, the physical currency may never return from the Fed to the government-the government doesn't really need to physically have it in order it to spend it. They can keep track of it electronically. Now, the government owes the Fed $100, but the Fed still has the $100 bill. The Treasury puts the borrowed $100 on its ledger to work, buying goods and services for the government, and anyone who receives a payment from the government can convert it into actual money by taking their check to their bank and cashing it. So retail banks (the kind you can walk into and open an account with) are the place where imaginary money (accounts) get converted into real-ish money (dollar bills). What happens when the bank runs out of bills? It simply calls the Fed up and asks for more. In exchange for which, the Fed's account at the bank gets bigger. So, say the Fed's checking account at Citibank is $1000, and Citibank needs $100 cash to meet its needs this month. Citibank orders $100 in newly printed money from the Fed, and the Fed's new balance with Citi is $1100. The $100 bill delivered to Citibank is the $100 bill we started this paragraph with, printed by the Treasury, purchased by the Fed, and backed by the asset of a Treasury bond (IE, you can count on the $100 bill to be worth something because you can theoretically give it back to the Fed, and get the Treasury bond that backs it, which is backed by the full faith and credit of the government).

Here's more on how cash money gets into the economy, and what makes up the money supply, of which actual currency is only a tiny fraction.
posted by evariste at 10:37 PM on December 28, 2007

I'm not an expert, but I'm intrigued by the question, and I'm hoping I can throw out a few things that can help, based on my hazy recollections of university intro to economics.

I think something that'll help clarify this is a lot is going to be a distinction between "cash" and "money". Cash is, I think, more or less what you're thinking of: bills and coins.

Money is something way *way* more abstract.

It's easy to imagine that if someone writes you a cheque for $500, their bank does something like move $500 in cash to your bank. But of course that doesn't happen. Lots of "money" never sees the light of day as cash in that sort of way, existing only as signals being passed around. That's a simple level of abstraction - lots of "money" exists only as signatures on cheques or bits passing around between computers.

More confusing - banks don't actually keep all the money you deposit, even in virtual form. When you put your money into the bank, the bank is allowed to lend out a rather large fraction of it to other people. Of your $500, $400 might be lent out to others. You still have $500 of "money" in the bank. But the recipient of your loan now has another $400 of "money". That, I think, is called the Money Multiplier. It gets even worse than that - the $400 that the recipient keeps is kept in their bank account, to be lent to others, multiplying even further. (See an explanation here)
All those bank acounts are all "money", even though there may never be bills, and even though your $500 magically has transformed into over two grand by being lent and re-lent.

Those levels of abstraction are called, I believe, M0 and M1 by economists. But the abstraction (and multiplication) goes further still - with quantities called M2 and M3. I can't explain those - maybe someone else here can.

I think it might be fair to say that while *wealth* is created be "the production of valuable goods and services", *money* is created by banking activity. The money supply can increase or decrease lot independently of the productivity of the economy, just by people making loans to each other.

I'm hoping someone who knows the topic better than I do can correct/amend some of this, and hope too there's enough accurate info to get the ball rolling.
posted by ManInSuit at 10:40 PM on December 28, 2007

I grant that cash is a minimal part of the lumbering beast we call the economy.

Really, the question doesn't need to be cash-specific to get answered. The tangible end-result of cash just makes it easier for me to ask the question, and hopefully understand the answer.

The root of the question is: When, on net balance, more value is created in an economy than there was before (say, over the period of one year), how does that new value get translated to money, whether electronic in a bank account, or $100 bills in someone's pocket?

Obviously, we move money around a lot from buyer to seller, customer to service provider, and so on. But that seems to be a closed system, where only dollars that someone already holds can be transferred, and does not allow the creation of new dollars.

So when the economy grows, where do the new dollars come from?
posted by SlyBevel at 10:49 PM on December 28, 2007

Er, sorry, I guess I might have just spent a lot of words not quite answering your question. New activity in the economy can be entirely funded by imaginary money and old currency. You don't need to print new currency to keep the economy moving. Taking out the bla-blah that you already said you understand (physical currency distribution, etc), the money supply is much larger than the actual amount of physical dollars. So, the growth of the economy is in no way constrained by how many dollar bills are out there. I can have a million dollars in my checking account, but that doesn't mean that the bank has a million dollars sitting in the vault waiting for me. It might have $50,000 sitting around to handle petty cash needs, but the rest is out there in the economy as assets backed by loans.

How would the economy cope with it if there was new economic activity but no new currency printed to account for it? Well, no one would produce anything if no one was buying it, so existing currency is being used to buy the new production. The producer uses the currency to buy what he needs to create the production. Net effect? The same money exists, but simply moves faster throughout the economy because it needs to get used in more places. n other words, the velocity of money increases.

So what happens if we take the restraint of not being able to print new currency off? We print new currency, the Treasury sells it to the Fed, the Fed delivers it to a bank and the Fed's bank account gets fatter, and the bank hands out the cash to depositors. Now the physical money doesn't have to move as fast to keep up with the economy, so the velocity of money can remain stable. Now let's add in the imaginary types of money that make up our modern money supply, and you don't even need to print physical money to increase the amount of money that's out there. Physical money just becomes something you need to have just enough of so that people can keep using vending machines and laundromats, and feeding parking meters, and paying cash for their hot dogs from the guy at the beach, paying cabbies and tip bellhops, and so forth. According to Wikipedia, the velocity of money in the US has been increasing by 1% a year, which means that each unit of physical money gets more of a workout than ever before, each and every year. Even though the government prints lots of new money every year. You'd think this meant that the government wasn't printing enough new money to account for economic growth, inflation, and population increase, but in fact, the greater money supply is increasing plenty fast enough to keep things moving, and more and more establishments that were previously cash-only are joining the rest of the economy. For instance, just in the last decade, the vast majority of fast food joints started taking credit cards. Furthermore, reaching a little further back, the innovation of debit cards allowed a lot more people to eschew carrying cash around on a day-to-day basis.
posted by evariste at 10:56 PM on December 28, 2007

Evariste's answer is right in principle but wrong in detail. "Money" isn't equal to "currency". The Fed does put currency into circulation, but that's not how it increases the money supply.

Most money is just bookkeeping, and while it's true that the primary way that the Fed injects money is by buying T-bills, it does it with digital money, not with physical currency. (They also occasionally buy certain kinds of commercial paper from major banks.)

When you and I buy things, we have to have the money with which to do it. The Fed is unique in that it doesn't have to. When it buys T-bills, it uses money that it conjures out of thin air.

And it is important that it do so. To massively oversimplify something that is very complicated, if there isn't enough money for the amount of economic activity which is taking place, then you get liquidity problems, leading to deflation. Deflation is very bad. Too much of that gets you a depression, and something like that did happen worldwide in the 1930's. (Deflation was only one of several major things which brought about the Great Depression, but it was definitely a contributor.)

On the other hand, if you have too much money, you get high inflation. That's bad, too. So for the last 20 years or so, the Fed has seen its primary task as trying to control the money supply so as to have low, steady inflation, on the order of 2% per year. Why not zero? Because that's really hard to achieve without risking falling into deflation, and because the economy seems to be tuned for about 2% inflation. Low deflation is a lot more dangerous economically than low inflation.

(That was Greenspan's big change. Before that, the Fed had seen its primary task as trying to tune the unemployment rate, to keep it at about 5%. Greenspan decided to let the unemployment rate take care of itself as long as it didn't get absurd, and instead to concentrate on inflation. For a few years the unemployment rate rattled a bit, but now it's settled in at a pretty consistent 3%, which used to be thought to be unsustainably low without causing inflation.)

But "physical currency" as such isn't really all that important. It's a small fraction of the total money supply, and it's the total which is important. When physical currency is released, it's in exchange for digital money from banks, leading to a net no-change.

When they buy T-bills, then effectively what they're doing is to give that money to the Federal Government to spend because they're using new digital money to cover part of the budget deficit. The government uses this new out-of-thin-air money to purchase real goods on the market, or to pay real salaries of its employees, or to pay interest on the national debt, most of which goes to real holders of T-bills.
posted by Steven C. Den Beste at 11:05 PM on December 28, 2007

Evariste posted again while I was composing my post. I was referring to his first post, not his second.
posted by Steven C. Den Beste at 11:06 PM on December 28, 2007

Here’s a way to think about what Evariste is saying:

Imagine you lived in a super-simple economy - you and one other person on a dessert island. Say you made pies, and the other person made hats. Say each cost $5 dollars.

You could buy a hat from the other guy for a single five-dollar bill. Then he could buy a pie from you for five dollars. Then you could buy another hat, and he could buy another pie.

What if you made and sold 10 hats and 10 pies last year, and 100 hats and 100 pies this year? Would you need to print more money? No. You could move that same old five-dollar bill back and forth 10 times one year (lower velocity, same money supply) or 100 times (higher velocity, same money supply).


(All this still misses out on the craziness of what “money” means when banking and fractional reserves allow money to multiply through loans. But maybe it helps explain how productivity and trade can increase without requiring an increase in the money supply…)
posted by ManInSuit at 11:10 PM on December 28, 2007

(I meant desert island. But given all the pies, maybe dessert island is okay, too...)
posted by ManInSuit at 11:12 PM on December 28, 2007

Ok, SCDB is definitely on the right track here.

Please tell me more about the Treasury/Fed creating money out of thin air. How often does this happen? How much at at time? Is there any oversight of how/when/how much it's done?

Also: Please help me understand the process by which that money makes it out of the banks, and into the hands of value creators. This is the part of my question that I don't understand well enough to ask...Producers within our economy add value to things every day, and they manage to get paid...but how? No matter what media money takes, if the system is closed, and producers add value, then dollars become scarce and begin to deflate, right?

The banks are the initial phase of the distribution system...what's the rest of the system moving new money (physical or not)?
posted by SlyBevel at 11:15 PM on December 28, 2007

SlyBevel, I think the concept you're looking for might be fractional reserve banking.
posted by evariste at 11:22 PM on December 28, 2007

Fractional reserve banking is a fascinating concept, and I'm glad that you've pointed it out to me.

I'm not sure yet, but I think that it doesn't completely explain how new dollars make their way from creation to widespread use.

So, more please. :)
posted by SlyBevel at 11:27 PM on December 28, 2007

The system is not closed; stop thinking of it that way. Fiat money is made up. When they want more, they make it up. (In literal terms, they print notes and issue them into the money supply. More than that is the question you didn't want answered!)
posted by bonaldi at 11:30 PM on December 28, 2007

Bonaldi: I know it's not closed, but I don't understand the part of it that isn't, which is why I'm asking for help.

You gave me a useful search term though, and I found Fiat Currency.

We're still left in the banks at that part of the system, so it's been covered in general here already, but it'll be great for further reading.
posted by SlyBevel at 11:34 PM on December 28, 2007

> if the system is closed, and producers add value, then dollars
> become scarce and begin to deflate, right?

No necessarily. For a simple counter-example - look at my "desert island" example, above. Even when all currencly is paper (no "virtual" cash) and there's no fractional reserve banking, you can have a 1000% growth in GNP without requiring any more money. All you need is an increased velocity of the money you have.

In the first year, there are only 10 hats and 10 pies: $100 of "value" in the economy. In the second, we add $1000 of value, and of revenue. But we can do all that with a single five-dollar bill, if it moves around fast enough.
posted by ManInSuit at 11:34 PM on December 28, 2007

ManInSuit: Your desert island analogue is interesting, and it does make sense.

Does that concept, along with fractional reserve banking completely (or nearly so) explain how new dollars make their way from creation to widespread use? As complex as that is in practice, I expected more complexity.
posted by SlyBevel at 11:40 PM on December 28, 2007

explain how new dollars make their way from creation to widespread use?
Can you rephrase this in a way that doesn't sound like "how do new dollars make their way into circulation"? I don't see the distinction between the two questions
posted by bonaldi at 11:44 PM on December 28, 2007

Can you rephrase this in a way that doesn't sound like "how do new dollars make their way into circulation"?

Sure!

To recap-

Step One: Treasury/Fed makes up money, which they send, electronically, into the system via commercial banks (right?). Step Two: I don't understand step two, where the crisp electrobucks move from banks to real people. Step Three: Real people now have the formerly-new dollars and are circulating them.

I feel like the Chief Economist of the Underpants Gnomes here.
posted by SlyBevel at 11:51 PM on December 28, 2007

Slybevel - I think that the desert island analogue explains how money and cash are pretty separate from wealth and value. It does that, I think, without even requiring the more complicated stuff like fractional reserve banking.

That distinction, between "wealth" and "money" is really important to your question.

When we say, for example, that a rich person's wealth is a couple of million dollars, it's easy to imagine he has 2 million dollars of money. But really we're using the money as a measure of the value of everything he owns. If, to use a super-simple example, he has a house worth 1.5 million dollars, and 0.5 million dollars in cash - he has 2 million dollars of wealth, but only 500k of "money". It's easy to confuse the two, but they are different. (In the case of the house - the $1.5m is what economists call the "unit of account" function of money- using it as a measuring unit like inches or pounds. In the case of the cash, it's being used as a "store of value". See: http://en.wikipedia.org/wiki/Money#Economic_characteristics)

In principle, you could have a society with a thousand billionaires in it, but only a million dollars of "money". An in principle, you could double the productivity and wealth of that society, without requiring that the amount of money increase at all.
posted by ManInSuit at 11:53 PM on December 28, 2007

Ok, I guess I'm not really sure I understand just what you don't understand, but I'll keep trying :-)

I know it's not closed, but I don't understand the part of it that isn't, which is why I'm asking for help.

Let's forget about money. There's no money. Poof, it's gone. OK? No more money. Let's also abolish trade. Now let's examine this society of ours. It's every man for himself.

Now, let's say people notice that one guy is really frigging good at making spears. He's the spear master. His spear is the nicest one anyone has. Let's say another fellow is a really good hunter, who manages to get more kills than everyone else even though he's got an inferior spear. He kills way more animals than he can eat. Being a cunning type of guy, he comes up with an idea, and floats it past the spear guy, whose spear he has long envied: give me your nice spear, and I'll give you a buffalo carcass so you don't have to hunt for food for you and the wife while you make yourself a replacement. Boom. That's trade. That's an economy. But there's no money, even though there's new value and new production! But how? Nobody injected anything into the system from the top down! The Fed didn't do anything! There was no bank involved! How can this be? Easy: it's what people do. People invent stuff, people figure out they're good at some things and specialize in them, and trade the fruit of their labors for the fruit of others' labors. That's called the principle of comparative advantage, named that by an economist named Ricardo.

Now let's say the guy who makes spears doesn't need a buffalo carcass. He has plenty of food. What he really would like is someone to fix his shoes. But the guy who fixes shoes doesn't need a spear. He needs a buffalo carcass. But the guy who has an extra buffalo carcass doesn't need his shoes fixed. You can set up a three-way barter, but it's getting ridiculously complicated. It gets worse the more people specialize in more areas. So let's invent a way that we can continue to lubricate the economy: tokens that represent barter. Instead of handing you a dead buffalo, I'll give you something portable and shiny and rare, made of gold. You can use it to buy stuff you need from other people. They can use it in turn to buy stuff from you. The money didn't change anything: you still hunt, he still makes spears, she still fixes shoes. But it made everyone's life much easier.

Now let's stop using money, and instead let's start making notes in a book about who owes what to whom. Now we're back to modern society. At no point was the origin and distribution of money that important. Money was just a tool to help people trade each other's labor. If it didn't work because the government sucked at getting money into the economy, we would abandon it and go back to barter, or forward, to notes in a ledger. Where does new money come from to pay producers? They receive it from their customers! Who themselves get it by borrowing, or by working a little harder, or by selling some assets, or by changing their spending (instead of buying toothpaste A, I'll now buy toothpaste X, new and improved!). There doesn't need to be a formal system for getting new money to new producers. The money comes to them in a decentralized and distributed fashion, and the people who get the money are themselves in charge of obtaining it. The cash is nothing more than a physical version of notes in a ledger. It's a token and a tool. If you need more of it, you make more. It shows up where it needs to be, on demand, like magic, by the spontaneous actions of all of society at once. The physical creation, transportation, and disposition of currency is the least important aspect of the process. We could get rid of it entirely and nothing would change. Make sense?

Your question, if I've begun to understand it, is sort of like "where do the new points in a basketball game come from, and how do they get distributed to the scoreboard?" Money is just a score. You make it up to represent what you did. There's really nothing to it.
posted by evariste at 11:55 PM on December 28, 2007 [2 favorites]

Sly - so, to your intial question:

The need for new paper currency has, I'm pretty sure, very little to do (as the question implies) with the creation of new wealh ("Useful goods and services" as you put it).

It has everything to do, I think, with how much money people (and banks) are lending to each other, and how much of that mostly-digital-and-otherwise-imagnary money people actually feel the need to take out of the ATM and fold into their wallets.
posted by ManInSuit at 11:57 PM on December 28, 2007

Step Two: I don't understand step two, where the crisp electrobucks move from banks to real people.

Borrowing. The purpose of a bank is to lend money. I have an idea for a business or I want to buy a house, I need more money than I have to finance it, so I go to the bank and borrow money. Through fractional reserve banking, the money I borrow doesn't need to really exist, but I can still spend it all the same. The money puts people to work creating the things I'm buying with it, who themselves feed back into the system, and some of whom might again borrow money to create yet more new economic activity.
posted by evariste at 11:59 PM on December 28, 2007

Please tell me more about the Treasury/Fed creating money out of thin air. How often does this happen? How much at at time? Is there any oversight of how/when/how much it's done?

That's one of the decisions made by the board of governors when they meet. Most attention in news reports is paid to the Fed Funds rate, which is another tool they use to tune the economy by indirectly controlling interest rates, but when the governors meet part of what they discuss is how much new money to inject into the economy for the next couple of months. The actual process is pretty gradual, because of a lot of it happened all at once it could cause the rest of the economy to ring afterwards. The governors decide "how much" and the rest of it is handled by paper pushers in the Fed.

"Is there any oversight?" Not by Congress or the President, if that's what you think. The government used to have more control over it, and that was another thing that contributed to a lot of booms and busts that happened in the 19th century. Pumping up the money supply leads to increased economic activity in the short run but inflation longer term, so there was an incentive for incumbents to do it in order to win elections. Part of the reason the Fed was created, and given pretty much complete control, was because it was realized that politicians couldn't be trusted with it.

So the only real oversight is in selection of the members of the board of governors. When vacancies arise, the President nominates and the Senate approves. They serve for a 14 year term, and if they do well they can be renominated. (Greenspan was nominated by Reagan and nominated again by Clinton, and decided to retire before the end of his second term.)

I recommend that you read this article.
posted by Steven C. Den Beste at 12:03 AM on December 29, 2007

Evariste - I like your example.

Sly -

So look at Evariste's buffalo-shoe-spear world. And say imagine each of them is worth one token. Can you see how, say, a total circulations of 10 tokens might be enough, even if spear production, buffalo-killing, and shoe-repair all got a lot more efficient?

Buffaloes, spears, and shoes are all wealth. The gold coins are money. The notes in the book are money. If people run out of coins, and start writing out IOUS, those IOUs are money, too, I'm pretty sure, by the measures economists use. Wealth and money = differnet things.

Now none of this touches, I don't think, even remotely, on the kinds of concerns about inflation, deflation, interest rates, and all the macroeconomic stuff that the Fed worries about. But maybe it's a bit of a help.

(I may be saying the same things in different ways here. Maybe that's useful, maybe not. I'm going to bed now. Hope the rest of you have fun with this. I have...)
posted by ManInSuit at 12:09 AM on December 29, 2007

Step One: Treasury/Fed makes up money, which they send, electronically, into the system via commercial banks (right?).

That's not really how they do it, mostly. The primary way they inject money into the economy is by buying T-bills, which they buy on open market exchanges, just like anyone else who buys a T-bill. The only difference is that they magically create the money they use to make the purchase.

So whoever has T-bills to sell gets money from the fed, and now there's more money out there.
posted by Steven C. Den Beste at 12:09 AM on December 29, 2007

I took my Econ 101 final just over a week ago, so the introductory version of these ideas is fresh in my head.

The government doesn't just add money to the economy; it also takes it out when necessary. The Fed looks at various economic indicators and decides whether the amount of money in the economy is too great or too small or just about right. In the short term, excess money in the economy leads to higher inflation, low interest rates and low unemployment rates; too little money in the economy can lead to deflation, higher unemployment, higher interest rates. Like a gardener deciding whether the plants need watering, the Fed looks at such indicators and decides whether to inject money in economy or take some out (or leave it be).

The Fed can increase the amount of money floating around by...
1) Buying T-bills on the open market
2) Lowering the reserve rate, i.e. allow banks to loan out a larger fraction of the money their customers have on deposit
3) Lowering the Discount rate, which is the interest rate at which the Fed itself loans money to banks

The Fed can decrease the amount of money floating around by...
1) Selling T-bills on the open market
2) Raising the reserve rate
3) Increasing the discount rate

Completely aside from what the Fed can do, Congress can affect the supply of money by increasing or decreasing government spending.
posted by jon1270 at 4:26 AM on December 29, 2007

The short answer is that the government makes up some new money and then spends it. Have you seen the example of money creation in the USA on Wikipedia? Steps 1 through 4, in particular, answer your question.
posted by ssg at 8:18 AM on December 29, 2007

Step Two: I don't understand step two, where the crisp electrobucks move from banks to real people.

As indicated above, the banks only take some of the money in greenbacks. The vast majority is left in electrobucks form. What happens is this: The bank has electrobucks. It notes it needs more currency to meet it needs. It orders more currency, but only a fraction of the electrobucks held by the bank. Most of it never gets converted to currency. If the economy grows, more non-currency money is created and there is more money to be spent by actors in the economy. The Treasury prints more money to cover only the amount needed to be spent in currency transactions. The rest is left as electrobucks in the accounts of banks, in loans made to businesses and people, and in assets owned by banks such as bonds.
posted by Ironmouth at 8:38 AM on December 29, 2007

Money As Debt.
posted by Student of Man at 10:57 AM on December 29, 2007

Thanks, everyone. This has been a lot of fun.

I can't say that I have a crystal clear understanding of the answers to my question now, but I probably understand it as well now as I can until I take some Econ classes.

I tried to make sure that everyone who contributed substantially got at least one best answer.

Now I've got some reading up to do!

Thanks again!
posted by SlyBevel at 1:25 PM on December 29, 2007

Money isn't just distributed to those who create value ("It looks like you used $50 of materials to make this $85 widget, here's $35 from the mint").

Wealth equals something people want. If you create wealth (something people want), you can trade it for other wealth (something you want). Money is just a way to facilitate the trading of stuff people want.
posted by reeddavid at 1:52 PM on December 29, 2007

It was a great question, SlyBevel. I enjoyed reading all the answers (particularly ManInSuit and Steven C Den Beste), as well as bloviating on the topic myself.
posted by evariste at 6:02 PM on December 29, 2007

IAAE. IANYE. (I am an economist. I am not your economist.)

Evariste has given great answers which answer the question (and ManInSuit too) ... Given that, and at the risk of a slight derail: The answers show how important the financial system is to the whole economy. If any other sector goes belly up - who cares outside the system? If the financial sector stops working then it could affect everyone else as it is the system everyone uses to keep score.
posted by TrashyRambo at 8:23 PM on December 29, 2007