From my understanding of the current monetary system when a bank issues a loan it is effectively creating money for the receiver of the loan i.e Mortgage. This increases the M1, M2, M3 numbers of the monetary aggregate.

In the news in the past year or so the US government is attempting to pay for a lot of new spending by issuing a lot of bonds. Stimulus + Infrastructure.

Those bonds need to be sold and I am assuming initially it is a set of primary dealers that are the market makers for the bonds. I am guessing most if not all the primary dealers are banks with the ability to create money.

So when the government issues new bonds does that mean the primary dealers actually issue new money to purchase those bonds that will increase the M1, M2, M3 aggregates?

Also when the Fed performs QE it is effectively swapping those bonds for reserves.

So when the US government issues another 2T of bonds it is effectively increasing the money supply by 2T.

Is my model of understanding correct?


2 Answers 2


A brief answer: you have it a bit wrong. Thinking about Primary Dealers this way is misleading. Although PDs do buy some bonds at auction, their function is mostly to facilitate sales to the public. So think of government bond sales as sales to the public. Then you can see that government selling bonds to the public is actually a monetary contraction (money moving from public to government). This is the opposite of QE which is a monetary expansion. However this is a complex subject as noted by @mick

  • $\begingroup$ "government selling bonds to the public is actually a monetary contraction" - not true. I think you are confusing this with a central bank selling bonds - which does indeed shrink the money supply. $\endgroup$
    – Mick
    Nov 20, 2021 at 15:12
  • 2
    $\begingroup$ I disagree - Treasury and Fed are both the government. $\endgroup$
    – dm63
    Nov 20, 2021 at 17:00
  • $\begingroup$ When the government sell their freshly made bonds to the public, pre-existing money is transferred from the public to the government. No money is created or destroyed in the process. If you think it is then please explain how exactly. $\endgroup$
    – Mick
    Jun 17, 2023 at 7:15
  • $\begingroup$ If Treasury sells bond to the public, the money goes to the Fed in an account called the Treasury General Account. This money comes out of public bank accounts, thereby reducing banks’ reserve accounts at the Fed. I consider that a monetary contraction. If and when the Treasury spends down the TGA again, that would be an expansion. The combined act of selling bonds and spending the proceeds is reserve neutral. $\endgroup$
    – dm63
    Jun 17, 2023 at 10:34
  • $\begingroup$ Now we are in agreement. $\endgroup$
    – Mick
    Jun 17, 2023 at 15:33

No, government bonds are used in an asset swap.

The government, via its spending and taxing activities, has left excess reserves held at the central bank by commercial banks.

The government then proceeds to offer an asset swap to these commercial banks: reserves (central bank liability) in exchange for bonds (Treasury liability).

Primary dealers, usually commercial banks, have reserve accounts with the central bank. Only these dealers can take first issuance of bonds.

A secondary bond-trading market exists where individuals or organisations can buy and sell the bonds in issue from the primary dealers and between themselves. This secondary market is entirely endogenous though, since any purchase of a bond represents a sale from someone else with deposit accounts.

The central bank itself does undergo open market operations to buy and sell issued bonds in the secondary market. When the central bank buys bonds, it is called quantitative easing (QE) because it represents an asset swap the other direction: bonds in exchange for reserves. When the central bank sells bonds on the secondary market it's called quantitative tightening (QT) as it, once again, drains reserves held with them.

Importantly to your question details, commercial banks do not have the authority to create central bank liabilities (reserves). Only the central bank can do that. So commercial banks can't create the money to buy the issued bonds in the first place.

Finally, to re-emphasise, as this fact is so often missed, the reserves that commercial banks use to buy newly issued government bonds from the Treasury are the precise same reserves placed there when the government spent more than it taxed back. The 'left over' reserves are then used to swap for bonds.


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