Central Banking 101

Look in your wallet and think about your day—how much currency do you carry and use? Four types of money.

Look in your wallet and think about your day—how much currency do you carry and use? Four types of money. The modern financial system relies on four main types of money: Central bank reserves: Special money issued by the Federal Reserve, only held by commercial banks Bank deposits: Created by commercial banks, the primary form of money used by the public Treasuries: Government-issued securities that function as interest-bearing money Fiat currency: Physical cash issued by the government These forms of money are interconnected and freely convertible in a functional financial system. Bank deposits, the most common form for the public, are essentially IOUs from banks, while central bank reserves are IOUs from the Federal Reserve to commercial banks. Treasuries serve as a form of money for large investors, offering a safe store of value with interest.

A commercial bank is a special type of business that holds a license from the government to create money. Money creation process. Commercial banks create money when they make loans or buy assets, contrary to the common misconception that they lend out existing deposits. This process increases the money supply without directly involving the central bank. Shadow banks, which are non-bank financial institutions, also engage in banking-like activities and create money-like instruments. Commercial bank money creation: Make a loan or purchase an asset Create a corresponding deposit in the borrower's account New money enters circulation when the borrower spends the loan Shadow bank money creation: Borrow short-term to invest in longer-term assets Create money-like instruments (e.g., money market fund shares) Increase liquidity in the financial system The ability of banks to create money is limited by profitability considerations and regulations, such as capital requirements and reserve ratios.

Eurodollars are U.S. dollars held outside of the United States. Dollar dominance. The U.S. dollar plays a central role in the global financial system, extending far beyond U.S. borders. This dominance is evident in: International trade: About 50% of global trade is invoiced in dollars Foreign exchange reserves: Approximately 60% of global foreign exchange reserves are held in dollars Offshore dollar market: A vast market for dollar-denominated transactions outside the U.S. The widespread use of the dollar gives the U.S. significant economic and geopolitical power. It allows the U.S. to impose effective sanctions by cutting off access to the dollar financial system. However, this also means that Federal Reserve policies have far-reaching global implications, effectively making it the world's central bank during crises.