Did you know that there is more than one type of money?

We recently came across a fascinating book by American economist Joseph Wang. The book is titled Central Banking 101 and it is billed as an insider’s account of how central banks work, given that Wang spent five years working for the US Federal Reserve – the USA’s central bank.

While Wang writes from the US perspective, Australia utilizes a very similar central banking system. So, much of what Wang writes relates to our situation as well.

Wang starts out with a very well-written description detailing how, in countries like Australia and the US, which use fiat currencies and central banks, there are really four types of money. These types are technically different, but because they can be easily exchanged with each other, they all can essentially be seen as equal. The four types are shown in this picture:

The first type of money is listed as fiat currency. This is notes and coins. In Australia, these are of course issued by the Australian Government. As with the US, anyone can hold Australian dollars. Even people outside of Australia.

The next type of money is bank deposits. These deposits can come about by account holders presenting their coins and notes to their bank. When they do this, the bank puts the cash in the safe and increases the amount held in the customer’s account.

But passing cash and coins over the counter creates only a very small portion of total bank deposits. Most bank deposits are created by banks themselves when they make loans to customers. That’s right, when you take out a loan, the chances are that the money you borrow was newly created for that purpose. When you take out a loan, your bank creates a deposit in your account. This is an asset from your point of view and a liability from the bank’s point of view. They simultaneously create a debt to them in your name. This is a liability from your point of view and an asset from the bank’s point of view.

Once the money is deposited into your account, you can do one of three things with it. You can simply leave it in your account. This is likely to be something you would only do in the short term, because you have to pay interest on the debt that was also created. There is not much point in creating a loan and then holding the money in your account. You just lose money.

A second option is to withdraw some of the money as cash – notes and coins. This is an example of how the two types of money – bank deposits and cash – are interchangeable. Let’s say you withdraw ten $100 notes. The value of your bank deposit goes down by $1,000, but you have $1,000 in cash. You have swapped the two types of money. The bank does not owe you as much money any more, but you have another kind of asset of equal value.

The third, and far more likely option, is that you electronically transfer your bank deposit into the bank account of some other person. If, for example, your loan is a home loan, you will transfer your bank deposit to the person selling the home. So, the value of your bank deposit goes down and the value of the vendor’s bank deposit goes up. This is the usual way in which loan-financed bank deposits are spent. It is actually how most spending happens in our economy.

Imagine that the vendor uses the same bank that you do. In that case, it is a relatively easy thing for the bank to transfer the deposit from your account to the vendor’s account. They simply reduce the amount in your deposit account and increase the amount in the vendor’s account. It is all done with keystrokes. Technically, remember that your bank deposit is a liability for the bank. When you make a payment, the bank decreases its liability to you and increases it to the recipient. It swaps a debt to you for a debt to someone else.

Things get a bit more interesting if the vendor uses a different bank. In that case, the bank cannot simply transfer your deposit to the vendor’s bank account, because they do not have access to the vendor’s account. Instead, your bank has to transfer some money to your vendor’s bank. To do this, they use the third type of money – reserves held at the Reserve Bank of Australia. Each licenced bank has a reserve account with the RBA. When money needs to transfer from one bank to another, the actual transaction is made using the money in these reserve accounts.  Let’s say you bank with Westpac and you pay $100,000 to a vendor who banks with ANZ. Westpac instructs the RBA to transfer $100,000 of its reserves to the ANZ. Once it receives these reserves, the ANZ will deposit the same amount into the deposit account of the vendor.

The fourth type of money is what Wang calls a Treasury Security. We have these too. They are issued by the Commonwealth Treasury, which is the Government department that Jim Chalmers is currently running. The Commonwealth Treasury also has a reserve account at the RBA. When it issues a bond, the bond is usually sold to someone who uses their reserves with the RBA to finance the purchase. When this happens, Treasury’s reserve account goes up and the account of the bond purchaser goes down.

Then, when Treasury needs to make a payment, it transfers its reserves to the bank in which the recipient of the payment holds a deposit account. Let’s say you work as a Commonwealth public servant and you are paid your net salary of $5,000 a month. Treasury transfers $5,000 of its reserves to your bank (Westpac) and Westpac in turn increases the amount in your deposit account by $5,000.

In reality, there are millions of transfers between banks, and transfers between Treasury and banks, each day. Reserves are not exchanged every time a transaction takes place. There is one overall ‘reserve exchange’ at the end of each trading day. If, at the end of the day, Westpac customers have received as much money from ANZ customers as other Westpac customers have paid to other ANZ customers, reserves don’t move at all.

We hope this helps. We personally find this stuff fascinating, but we understand if you do not share our passion! But if you do share that passion, we recommend getting a hold of Charlie Wang’s book and going on a deep dive of your own.