Three Types of Money
There are three* types of money in the economy. As members of the public, we only have access to two of them – physical money and commercial bank money.
1. Physical money
Physical money, meaning cash and coins, is created by the US Treasury. The Federal Reserve then pays the Treasury the cost of printing the bills (rather than its face value), so that the Treasury makes no profit from printing money. With coins it is different. The Federal Reserve pays the Treasury face value for the coins it mints.
2. Central bank reserves
Central bank reserves are a type of electronic money, created by the Federal Reserve and used by banks to make payments between themselves. In some respects they are like an electronic version of cash. However, members of the public and normal businesses cannot access central bank reserves, as they are only available to those institutions which have accounts at the Federal Reserve, i.e. banks and the Treasury, and now certain other financial institutions as well. Central bank reserves are not counted as part of the money supply for the economy, due to the fact that they are not used by the general public.
3. Commercial bank money
The third type of money accounts for much of the money in circulation. However, unlike central bank reserves and cash, it is not created by the Federal Reserve, the Treasury, or any other part of the government. Instead, commercial bank money is created by private, commercial banks (and to a lesser extent credit unions), usually in the process of making loans. While this money is usually electronic in form, it does not have to be. Before computers, banks could still ‘create money’ by simply adding deposits to their balance sheets.
Commercial bank money is referred to by various names, including: bank deposits, sight deposits, demand deposits, time deposits, term deposits, bank liabilities and bank credit.
* With the rise of the shadow banking sector there is also “shadow money,” but for simplicity’s sake we won’t discuss here.