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In the book "Macroeconomics" by Olivier Blanchard & David R. Johnson, the following appears:

In yet other countries, people who have emigrated to the United States bring home U.S. dollar bills; or tourists pay some transactions in dollars, and the bills stay in the country. This is, for example, the case for Mexico or Thailand.

The fact that foreigners hold such a high proportion of the dollar bills in circulation has two main macroeconomic implications. First, the rest of the world, by being willing to hold U.S. currency, is making in effect an interest-free loan to the United States of $500 billion

By holding US bills of 500 billion, the rest of the world is making the US an interest free loan of $500 billion---could you please explain me how?

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  • $\begingroup$ How can someone that cannot create the US Dollar “lend” US Dollars to the one and only issuer of the US Dollars? $\endgroup$ – aliteralmind May 11 at 12:15
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Think about what a loan is in terms of purchasing power. You give a bank your signature on a loan contract and they give you something that will allow you to buy real stuff (houses, cars, whatever). You enjoy this real stuff for some time. Then at the end you have to give the bank something that will allow them to buy real stuff, only more of it. I'm calling it "something" instead of "dollars" for a reason I will explain below.

In the foreign exchange case, the US gives other countries pieces of paper, which are essentially IOUs. They give the US either real stuff, which is then enjoyed, or they give the US their currency, which is immediately spent on real stuff. The US doesn't hoard their currency. Time passes and at the end they give back the IOU's in exchange for some real stuff. Only instead of giving back more real stuff than was originally given, the US gives back less (because of inflation).

I called dollars "something" in the loan example and "IOUs" in the macro example because dollars take on a different role in each case. In the loan, the dollars represent real purchases that are made immediately. In the macro example, the dollars take the place of the loan contract. They don't buy any real stuff until the end of the transaction.

You can think of it another way by ignoring the dollars. Foreigners give the US electronics and clothes and stuff in exchange for nothing. After a while the US gives them back food and machines or whatever, only what the US gives back is worth less than the electronics and clothes it was given. That's a zero interest (or negative interest) loan.

By the way, it's not just foreigners. Whoever holds currency has given up something valuable (time, materials, land, etc.) in exchange for paper. As long as that paper is under your mattress, you are not consuming and the paper is becoming worth less than it was. You've made a negative interest loan.

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U.S. federal financial liabilities consist of currency, reserves at the Fed, bonds, and bills. Bonds and bills do not pay interest, currency does not. For reserves at the Fed, excess reserves need to pay the market rate of interest, while paying interest on required reserves is optional. (The Fed switched to paying interest on required reserves in 2008; it did not pay interest on required reserves earlier.) By not exchanging currency for Treasury bills/notes, the amount of interest bearing liabilities of the federal government is reduced.

Things are only slightly more complicated if you split the Federal Reserve away from the rest of the government in analysis. The Fed issues more currency, but in turn buys bonds and bills to balance its balance sheet. This generates extra interest income for the Fed. The extra interest is then paid back to the Treasury.

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  • $\begingroup$ Note that reserve accounts at the fed do pay interest now. $\endgroup$ – farnsy Apr 17 '17 at 14:38
  • $\begingroup$ I believed that it was only excess reserves; corrected. $\endgroup$ – Brian Romanchuk Apr 17 '17 at 15:07
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Considering a simplified model, as proposed by Blanchard in the book, central banks deterime M1 by buying or selling bonds, called Open Market Operations. In a contractionary open market operation, bonds will be sold and dollars will be taked out of market. When central banks do this, the bonds they sell pay a determined interest rate. Suppose that an economy is in equilibrium Money supply = Money demand, for a given interest rate; and also there are 5 billions dollars held by foreigners. If those 5 billions were actually at US economy, FED should increase bond interest in order to absorb all those excedent dollars. Finally, due to all those dollars are held out of US, FED is exempted to pay that interest to the local market.

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