The Life Cycle of Money

Hacker News · Feb 28, 2026 · Collected from RSS

Full Article

The Life Cycle of Money | Understanding how deficits inject deposits, trade creates dollar outflows, and reserves recycle back into government debt February 2026 36 min read <h1 data-number="1" id="ontology-of-money"><span class="header-section-number">1</span> Ontology of Money</h1> <h2 data-number="1.1" id="objective"><span class="header-section-number">1.1</span> Objective</h2> <p>Define what money is before explaining how it is created.</p> <h2 data-number="1.2" id="what-is-money"><span class="header-section-number">1.2</span> What Is Money?</h2> <p>Money is fundamentally a claim on the state or a financial intermediary. It is not a thing. It is a relationship recorded on a balance sheet. In modern economies, money exists in three forms:</p> <ol type="1"> <li><p><strong>Base Money (Monetary Base)</strong>: Central bank liabilities. These consist of physical currency in circulation and reserve balances held by banks at the central bank. Base money is the liability of the central bank.</p></li> <li><p><strong>Broad Money (M2, M3)</strong>: Includes base money plus deposits held at commercial banks. These bank deposits are liabilities of the commercial bank, not the central bank.</p></li> <li><p><strong>Credit Money</strong>: Claims on the future output or assets of a private entity (e.g., a corporate bond or a personal IOU).</p></li> </ol> <h2 data-number="1.3" id="distinguishing-money-from-credit-debt-and-capital"><span class="header-section-number">1.3</span> Distinguishing Money from Credit, Debt, and Capital</h2> <p><strong>Money</strong> is a universal medium of exchange and store of value, accepted throughout an economy without question.</p> <p><strong>Credit</strong> is a conditional claim on future payment. When a bank extends a loan, it creates credit (not yet money). That credit becomes money only when it is accepted as payment by third parties and deposits are created in the borrower’s account.</p> <p><strong>Debt</strong> is the obligation to repay. Every monetary unit has a corresponding debt claim somewhere in the system. When the central bank creates reserves, it is simultaneously creating a liability (the reserve balance is a debt owed by the central bank to the bank holding it).</p> <p><strong>Capital</strong> is equity ownership or productive assets. A business owner’s equity is capital, not money. Capital and money are fundamentally different categories.</p> <h2 data-number="1.4" id="the-balance-sheet-nature-of-money"><span class="header-section-number">1.4</span> The Balance Sheet Nature of Money</h2> <p>Money is a liability on one side of a balance sheet and an asset on the other. For example:</p> <ul> <li><strong>Federal Reserve perspective</strong>: Reserve balances are a liability of the Fed; the Treasury securities it holds are an asset.</li> <li><strong>Commercial bank perspective</strong>: Depositors’ accounts are liabilities; loans and securities are assets.</li> <li><strong>Private household perspective</strong>: A bank deposit is an asset (a claim on the bank); a mortgage is a liability.</li> </ul> <h2 data-number="1.5" id="commodity-representative-and-fiat-money"><span class="header-section-number">1.5</span> Commodity, Representative, and Fiat Money</h2> <p><strong>Commodity money</strong> (gold, silver) has intrinsic value independent of its use as money. Historical example: gold coins.</p> <p><strong>Representative money</strong> is a claim on a commodity held in reserve. Historical example: gold-backed currency where you could exchange paper dollars for gold at a fixed rate.</p> <p><strong>Fiat money</strong> is money by legal declaration (fiat). It has no commodity backing and derives its value from:</p> <ul> <li>State acceptance for tax payment</li> <li>Network effects (widespread acceptance)</li> <li>Legal enforceability of contracts denominated in that currency</li> </ul> <p>All modern currencies are fiat currencies. Their stability depends on institutional credibility and the depth of markets denominated in that currency, not physical backing.</p> <h2 data-number="1.6" id="why-this-matters"><span class="header-section-number">1.6</span> Why This Matters</h2> <p>Understanding that money is a legal and institutional creation (not a commodity) is essential to understanding the lifecycle that follows. Money is created by law and destroyed by accounting entries. The quantity of money is not exogenous (fixed by mining or government decree); it is endogenous to the credit cycle, shaped by the decisions of millions of borrowers and lenders.</p> <hr /> <h1 data-number="2" id="legal-authority-and-sovereign-issuance"><span class="header-section-number">2</span> Legal Authority and Sovereign Issuance</h1> <h2 data-number="2.1" id="objective-1"><span class="header-section-number">2.1</span> Objective</h2> <p>Explain how modern states acquire the authority to issue currency.</p> <h2 data-number="2.2" id="the-legal-framework"><span class="header-section-number">2.2</span> The Legal Framework</h2> <p>In the United States, the authority to issue currency is distributed across two institutions:</p> <ol type="1"> <li><strong>The Federal Reserve</strong> issues the monetary base (currency and reserves) under the authority granted by the Federal Reserve Act of 1913 and subsequent legislation.</li> <li><strong>The U.S. Treasury</strong> issues debt securities and directs fiscal spending. The Treasury also mints coins (a negligible share of the money supply).</li> </ol> <p>This division reflects a historical compromise: fiscal authority (spending) rests with elected officials in Congress, while monetary authority (interest rates and reserve creation) rests with an independent central bank.</p> <h2 data-number="2.3" id="the-treasury-general-account-tga"><span class="header-section-number">2.3</span> The Treasury General Account (TGA)</h2> <p>The Treasury General Account is the operating account of the U.S. government. It holds all tax receipts and serves as the source from which government checks are drawn. The TGA is not a demand deposit account at a commercial bank; it is a reserve account at the Federal Reserve itself.</p> <p>When the Treasury spends:</p> <ol type="1"> <li>A check is drawn on the TGA</li> <li>The Federal Reserve debits the TGA and credits the reserve account of the bank receiving the check</li> <li>That bank credits the account of the government contractor or employee</li> <li>Net reserves in the system increase</li> </ol> <h2 data-number="2.4" id="debt-issuance-and-spending"><span class="header-section-number">2.4</span> Debt Issuance and Spending</h2> <p>Contrary to popular belief, governments do not <q>print money</q> to spend. Instead:</p> <ol type="1"> <li><strong>Congress appropriates spending</strong> and the Treasury issues debt (Treasury securities: bills, notes, bonds)</li> <li><strong>Primary dealers and the public purchase these securities</strong>, paying with bank deposits (which are claims on the Federal Reserve’s reserves)</li> <li><strong>The proceeds are deposited in the Treasury General Account</strong></li> <li><strong>The Treasury spends</strong> by instructing its bank (the Fed) to transfer reserves to the accounts of recipients</li> <li><strong>The public receives deposits</strong>, not currency (except for a tiny fraction that withdraw cash)</li> </ol> <p>The Treasury does not <q>borrow from the Fed.</q> Instead, it issues debt to the public and primary dealers. The Federal Reserve is a separate legal entity. However, when the Fed conducts quantitative easing, it purchases Treasury securities from the market, which indirectly finances government spending by absorbing debt that would otherwise require higher interest rates.</p> <h2 data-number="2.5" id="fiscal-and-monetary-authority"><span class="header-section-number">2.5</span> Fiscal and Monetary Authority</h2> <p><strong>Fiscal authority</strong> determines the size and composition of government spending and taxation. This rests with Congress and the Executive Branch.</p> <p><strong>Monetary authority</strong> determines the quantity of reserves in the system and the level of short-term interest rates. This rests with the Federal Reserve.</p> <p>These are institutionally separate for good reason: elected officials are accountable to voters; central bankers are accountable to technical objectives (price stability and full employment in the U.S. mandate) and insulated from political pressure to inflate.</p> <hr /> <h1 data-number="3" id="creation-of-base-money"><span class="header-section-number">3</span> Creation of Base Money</h1> <h2 data-number="3.1" id="objective-2"><span class="header-section-number">3.1</span> Objective</h2> <p>Explain how central bank liabilities enter the system.</p> <h2 data-number="3.2" id="what-are-reserves"><span class="header-section-number">3.2</span> What Are Reserves?</h2> <p>Reserves are liabilities of the central bank held by commercial banks. They are electronic entries in the Federal Reserve’s books. When you see $3 trillion in <q>reserves</q> reported by the Fed, this refers to the deposits that banks hold in accounts at the Federal Reserve. This is exactly analogous to how you hold a deposit at your commercial bank.</p> <p>Reserves are not:</p> <ul> <li>Physical cash in a vault (though the Fed holds physical currency too)</li> <li>Something that <q>backs</q> the money supply</li> <li>Constrained by some fixed quantity</li> </ul> <h2 data-number="3.3" id="how-the-central-bank-creates-reserves"><span class="header-section-number">3.3</span> How the Central Bank Creates Reserves</h2> <p>The Federal Reserve creates reserves by purchasing assets, typically Treasury securities. This is called an <strong>open market operation (OMO)</strong>. Here is the balance sheet entry:</p> <p><strong>Federal Reserve Balance Sheet:</strong></p> <table> <thead> <tr class="header"> <th>Assets</th> <th>Liabilities</th> </tr> </thead> <tbody> <tr class="odd"> <td>Treasury Securitie