How does new value created by industry and economy become cash?

I took my Econ 101 final just over a week ago, so the introductory version of these ideas is fresh in my head. The government doesn't just add money to the economy; it also takes it out when necessary. The Fed looks at various economic indicators and decides whether the amount of money in the economy is too great or too small or just about right. In the short term, excess money in the economy leads to higher inflation, low interest rates and low unemployment rates; too little money in the economy can lead to deflation, higher unemployment, higher interest rates. Like a gardener deciding whether the plants need watering, the Fed looks at such indicators and decides whether to inject money in economy or take some out (or leave it be). The Fed can increase the amount of money floating around by... 1) Buying T-bills on the open market 2) Lowering the reserve rate, i.e. allow banks to loan out a larger fraction of the money their customers have on deposit 3) Lowering the Discount rate, which is the interest rate at which the Fed itself loans money to banks The Fed can decrease the amount of money floating around by... 1) Selling T-bills on the open market 2) Raising the reserve rate 3) Increasing the discount rate Completely aside from what the Fed can do, Congress can affect the supply of money by increasing or decreasing government spending.

Slybevel - I think that the desert island analogue explains how money and cash are pretty separate from wealth and value. It does that, I think, without even requiring the more complicated stuff like fractional reserve banking. That distinction, between "wealth" and "money" is really important to your question. When we say, for example, that a rich person's wealth is a couple of million dollars, it's easy to imagine he has 2 million dollars of money. But really we're using the money as a measure of the value of everything he owns. If, to use a super-simple example, he has a house worth 1.5 million dollars, and 0.5 million dollars in cash - he has 2 million dollars of wealth, but only 500k of "money". It's easy to confuse the two, but they are different. (In the case of the house - the $1.5m is what economists call the "unit of account" function of money- using it as a measuring unit like inches or pounds. In the case of the cash, it's being used as a "store of value". See: http://en.wikipedia.org/wiki/Money#Economic_characteristics) In principle, you could have a society with a thousand billionaires in it, but only a million dollars of "money". An in principle, you could double the productivity and wealth of that society, without requiring that the amount of money increase at all.

Ok, I guess I'm not really sure I understand just what you don't understand, but I'll keep trying :-) I know it's not closed, but I don't understand the part of it that isn't, which is why I'm asking for help. Let's forget about money. There's no money. Poof, it's gone. OK? No more money. Let's also abolish trade. Now let's examine this society of ours. It's every man for himself. Now, let's say people notice that one guy is really frigging good at making spears. He's the spear master. His spear is the nicest one anyone has. Let's say another fellow is a really good hunter, who manages to get more kills than everyone else even though he's got an inferior spear. He kills way more animals than he can eat. Being a cunning type of guy, he comes up with an idea, and floats it past the spear guy, whose spear he has long envied: give me your nice spear, and I'll give you a buffalo carcass so you don't have to hunt for food for you and the wife while you make yourself a replacement. Boom. That's trade. That's an economy. But there's no money, even though there's new value and new production! But how? Nobody injected anything into the system from the top down! The Fed didn't do anything! There was no bank involved! How can this be? Easy: it's what people do. People invent stuff, people figure out they're good at some things and specialize in them, and trade the fruit of their labors for the fruit of others' labors. That's called the http://en.wikipedia.org/wiki/Comparative_advantage named that by an economist named Ricardo. Now let's say the guy who makes spears doesn't need a buffalo carcass. He has plenty of food. What he really would like is someone to fix his shoes. But the guy who fixes shoes doesn't need a spear. He needs a buffalo carcass. But the guy who has an extra buffalo carcass doesn't need his shoes fixed. You can set up a three-way barter, but it's getting ridiculously complicated. It gets worse the more people specialize in more areas. So let's invent a way that we can continue to lubricate the economy: tokens that represent barter. Instead of handing you a dead buffalo, I'll give you something portable and shiny and rare, made of gold. You can use it to buy stuff you need from other people. They can use it in turn to buy stuff from you. The money didn't change anything: you still hunt, he still makes spears, she still fixes shoes. But it made everyone's life much easier. Now let's stop using money, and instead let's start making notes in a book about who owes what to whom. Now we're back to modern society. At no point was the origin and distribution of money that important. Money was just a tool to help people trade each other's labor. If it didn't work because the government sucked at getting money into the economy, we would abandon it and go back to barter, or forward, to notes in a ledger. Where does new money come from to pay producers? They receive it from their customers! Who themselves get it by borrowing, or by working a little harder, or by selling some assets, or by changing their spending (instead of buying toothpaste A, I'll now buy toothpaste X, new and improved!). There doesn't need to be a formal system for getting new money to new producers. The money comes to them in a decentralized and distributed fashion, and the people who get the money are themselves in charge of obtaining it. The cash is nothing more than a physical version of notes in a ledger. It's a token and a tool. If you need more of it, you make more. It shows up where it needs to be, on demand, like magic, by the spontaneous actions of all of society at once. The physical creation, transportation, and disposition of currency is the least important aspect of the process. We could get rid of it entirely and nothing would change. Make sense? Your question, if I've begun to understand it, is sort of like "where do the new points in a basketball game come from, and how do they get distributed to the scoreboard?" Money is just a score. You make it up to represent what you did. There's really nothing to it.

Sly - so, to your intial question: The need for new paper currency has, I'm pretty sure, very little to do (as the question implies) with the creation of new wealh ("Useful goods and services" as you put it). It has everything to do, I think, with how much money people (and banks) are lending to each other, and how much of that mostly-digital-and-otherwise-imagnary money people actually feel the need to take out of the ATM and fold into their wallets.

Step Two: I don't understand step two, where the crisp electrobucks move from banks to real people. Borrowing. The purpose of a bank is to lend money. I have an idea for a business or I want to buy a house, I need more money than I have to finance it, so I go to the bank and borrow money. Through fractional reserve banking, the money I borrow doesn't need to really exist, but I can still spend it all the same. The money puts people to work creating the things I'm buying with it, who themselves feed back into the system, and some of whom might again borrow money to create yet more new economic activity.

Please tell me more about the Treasury/Fed creating money out of thin air. How often does this happen? How much at at time? Is there any oversight of how/when/how much it's done? That's one of the decisions made by the board of governors when they meet. Most attention in news reports is paid to the Fed Funds rate, which is another tool they use to tune the economy by indirectly controlling interest rates, but when the governors meet part of what they discuss is how much new money to inject into the economy for the next couple of months. The actual process is pretty gradual, because of a lot of it happened all at once it could cause the rest of the economy to ring afterwards. The governors decide "how much" and the rest of it is handled by paper pushers in the Fed. "Is there any oversight?" Not by Congress or the President, if that's what you think. The government used to have more control over it, and that was another thing that contributed to a lot of booms and busts that happened in the 19th century. Pumping up the money supply leads to increased economic activity in the short run but inflation longer term, so there was an incentive for incumbents to do it in order to win elections. Part of the reason the Fed was created, and given pretty much complete control, was because it was realized that politicians couldn't be trusted with it. So the only real oversight is in selection of the members of the board of governors. When vacancies arise, the President nominates and the Senate approves. They serve for a 14 year term, and if they do well they can be renominated. (Greenspan was nominated by Reagan and nominated again by Clinton, and decided to retire before the end of his second term.) I recommend that you read http://en.wikipedia.org/wiki/Federal_reserve.

Evariste - I like your example. Sly - So look at Evariste's buffalo-shoe-spear world. And say imagine each of them is worth one token. Can you see how, say, a total circulations of 10 tokens might be enough, even if spear production, buffalo-killing, and shoe-repair all got a lot more efficient? Buffaloes, spears, and shoes are all wealth. The gold coins are money. The notes in the book are money. If people run out of coins, and start writing out IOUS, those IOUs are money, too, I'm pretty sure, by the measures economists use. Wealth and money = differnet things. Now none of this touches, I don't think, even remotely, on the kinds of concerns about inflation, deflation, interest rates, and all the macroeconomic stuff that the Fed worries about. But maybe it's a bit of a help. (I may be saying the same things in different ways here. Maybe that's useful, maybe not. I'm going to bed now. Hope the rest of you have fun with this. I have...)

Step One: Treasury/Fed makes up money, which they send, electronically, into the system via commercial banks (right?). That's not really how they do it, mostly. The primary way they inject money into the economy is by buying T-bills, which they buy on open market exchanges, just like anyone else who buys a T-bill. The only difference is that they magically create the money they use to make the purchase. So whoever has T-bills to sell gets money from the fed, and now there's more money out there.

Thanks, everyone. This has been a lot of fun. I can't say that I have a crystal clear understanding of the answers to my question now, but I probably understand it as well now as I can until I take some Econ classes. I tried to make sure that everyone who contributed substantially got at least one best answer. Now I've got some reading up to do! Thanks again!