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Understanding the Modern Monetary System


I read your paper titled 'Understanding the Modern Monetary System'. Could you clarify the following:

1.) If the money supply is increased by just the right amount the economic output has increased then would you get Zero inflation?

Some level of inflation is perfectly normal in a credit based monetary system because we should expect that borrowing will expand as the economy grows and improves. So inflation is not always another form of default. It is generally a healthy part of economic expansion

(Understanding the Modern Monetary System - page 28)

2.) How does the US Treasury sell bonds to the Non-bank public? Do they have an account at a commercial bank? This process does not change the amount of broad money – right?

3.) How does the US Treasury sell bonds to the Commercial banks? Will the bank just create a deposit in the US Treasury’s account?

4.) If the US Treasury issues a bond then re-distributes the inside money that was used to buy that bond. When the time comes for interest to be paid on that bond where does the  US Treasury get the money from? Does it just issue more bonds to get more inside money to pay the interest?

5.) How do commercial banks pay interest on reserves they borrow from each other or the central bank?

6.) How do commercial banks get reserves from the central bank? For Example if a new bank is created with $100 as equity capital (in the form of deposit money) how is some of that converted into reserves which will be needed as the bank makes its first loans and creates deposits.


Hi @Haresh,

Thanks for the good questions.

1) No one really knows the answer to this question. Inflation is a price change and there's lots of reasons why prices change. Controlling the money supply is one variable, but one of many. So it's a component of trying to get inflation right, but not one we can control precisely.

2) The US Tsy mostly sells bonds at auction to Primary Dealers (a group of large banks). Those large banks then on-sell the bonds to other buyers.

3) Dealers finance their bond purchases in the repo market primarily. This clears via the overnight system where the Tsy has an account with the Fed. This account is called the Treasury General Account and it operates a lot like a bank reserve account. This is the account where the govt spends and taxes from.

4) Interest on bonds can come from existing money or from new issuance. Banks pay interest by crediting a deposit account so that money is usually created by someone else who took out a loan which is then redistributed to someone else earning interest.

5/6) Banks use the reserve system just like we use the deposit system among one another. So same basic thing as above except reserve balances are credited with reserve deposits. The Fed currently pays interest on reserves out of its net interest earnings. So, there's a line item on the Fed's balance sheet showing its interest payments out of its interest earned from its other portfolio holdings.

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche


Thank you for taking the time to answer my questions. I have some follow up ones :

Further to Qu.3 is this how the Treasury General Account works:

TSY Taxes person A by $100 : The deposits of person’s A bank account will decrease by $100 and the bank will transfer $100 of its reserves at its FED account to the TSY’s FED account.

TSY spends $100 on person B: TSY will transfer $100 of its reserves to the FED account of the Bank for person B. The bank will then increase the deposits of person’s B by $100


Further to Question 6

I am still unclear as to how a completely new bank would get reserves in the first place?

For example if I have $100 (of deposits money) in Bank A as equity capital ready to be infused into my new bank (lets say  ‘BANK B’). How does ‘Bank B’ get reserves at its FED account.


Hi Haresh,

Yes, that's right. It's just a series of debts and credits. So $100 of deposits flows from Bank A and the Tsy's TGA is credited with $100 in reserves. Then when the govt spends the TGA is debited by $100 and Bank B's deposit account is credited with $100 of reserves which creates a coinciding $100 deposit account at the recipients account.

Reserves are a regulatory asset created only by the Fed. So, if there's a 100% reserve requirement then banks will have to hold $100 for every $100 of deposits that are created. This means the Fed MUST expand its balance sheet and make the reserves available to the banking system. In essence, deposit creation with a reserve requirement FORCES the Fed to provide the reserves it requires.

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche


Just to follow up on a few of your answers that are still a bit unclear to me:

1) You answer above implies that the TGA is a reserve account. I was recently reading an MMT paper from Kelton that states that reserves (HPM, in her words) are destroyed when deposits are made to the TGA (taxes, for example). This implied to me that the TGA was a non-reserve account. I assumed it was more or less like a checking account. Could you please clarify?

2) Following up on point #2 in the original post. I wasn't clear from you answer whether a primary dealer purchases bonds from the Treasury with existing deposits or if they create new deposits (as they do when they lend to the private sector).


Hi @BC,

The TGA is functionally a reserve account. Better to call all these accounts settlement balance accounts. But yes, when reserves transfer from a bank's reserve account to the TGA account then there are reserves removed from the banking system. The balances aren't "destroyed". They just aren't accounted for as "bank reserves" because they're not really reserves for a bank. But if you call them all settlement balances from the Fed then the Fed is just transferring around the balances from bank to treasury back to a bank when the govt spends.

Most bond buying from banks is funded in the repo market. They then onsell the bond to another buyer.

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche

Hi Cullen,

So just to clarify - the Primary Dealer borrows existing deposits in the repo market?


Hi @bc,

When the dealer buys the bonds they can fund the position in numerous ways. A common way is that their own bank extends intra-day credit to fund the bond buy and then the dealer uses in a repo to reverse themselves out of the position by day's end. So the dealer has a repo liability at the end of the day.

All of this clears in the TGA account as new settlement balances for the govt.

It's much cleaner to think of the Tsy as a bank though. Once you see the Tsy as a bank then you can see that reserves pretty much just settle at Tsy as needed just like they do when any bank needs settlement balances. The Tsy is a huge huge bank that uses the Fed system to clear its payments so it needs to have a fairly large amount of balances in certain times. So the Fed makes them available mainly by making them available to other banks who settle other payments via the TGA.

Hope that helps.

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche