The fundamental principles that arise in a fiat monetary system are as follows.

The central bank sets the short-term interest rate based on its policy aspirations.
Government spending is independent of borrowing and the latter best thought of as
coming after spending.
Government spending provides the net financial assets (bank reserves) which
ultimately represent the funds used by the non-government agents to purchase the
debt.
Budget deficits that are not accompanied by corresponding monetary operations
(debt-issuance) put downward pressure on interest rates contrary to the myths that
appear in macroeconomic textbooks about crowding out.
The penalty for not borrowing is that the interest rate will fall to the bottom of the
corridor prevailing in the country which may be zero if the central bank does not
offer a return on reserves.
Government debt-issuance is a monetary policy operation rather than being
intrinsic to fiscal policy, although in a modern monetary paradigm the distinctions
between monetary and fiscal policy as traditionally defined are moot.
National governments have cash operating accounts with their central bank. The
specific arrangements vary by country but the principle remains the same. When
the government spends it debits these accounts and credits various bank accounts
within the commercial banking system. Deposits thus show up in a number of
commercial banks as a reflection of the spending. It may issue a cheque and post it
to someone in the private sector whereupon that person will deposit the cheque at
their bank. It is the same effect as if it had have all been done electronically.

All federal spending happens like this. You will note that:

Governments do not spend by printing money. They spend by creating deposits in

the private banking system. Clearly, some currency is in circulation which is
printed but that is a separate process from the daily spending and taxing flows.
There has been no mention of where they get the credits and debits come from! The
short answer is that the spending comes from no-where but we will have to wait for
another blog soon to fully understand that. Suffice to say that the Federal
government, as the monopoly issuer of its own currency is not revenue-constrained.

This means it does not have to finance its spending unlike a household, which
uses the fiat currency.
Any coincident issuing of government debt (bonds) has nothing to do with
financing the government spending.
All the commercial banks maintain reserve accounts with the central bank within
their system. These accounts permit reserves to be managed and allows the
clearing system to operate smoothly. The rules that operate on these accounts in
different countries vary (that is, some nations have minimum reserves others do not
etc). For financial stability, these reserve accounts always have to have positive
balances at the end of each day, although during the day a particular bank might be
in surplus or deficit, depending on the pattern of the cash inflows and outflows.
There is no reason to assume that these flows will exactly offset themselves for any
particular bank at any particular time.

The central bank conducts operations to manage the liquidity in the banking
system such that short-term interest rates match the official target which defines
the current monetary policy stance. The central bank may: (a) Intervene into the
interbank (overnight) money market to manage the daily supply of and demand for
reserve funds; (b) buy certain financial assets at discounted rates from commercial
banks; and (c) impose penal lending rates on banks who require urgent funds, In
practice, most of the liquidity management is achieved through (a). That being said,
central bank operations function to offset operating factors in the system by
altering the composition of reserves, cash, and securities, and do not alter net
financial assets of the non-government sectors.

Fiscal policy impacts on bank reserves government spending (G) adds to reserves
and taxes (T) drains them. So on any particular day, if G > T (a fiscal deficit) then
reserves are rising overall. Any particular bank might be short of reserves but
overall the sum of the bank reserves are in excess. It is in the commercial banks
interests to try to eliminate any unneeded reserves each night given they usually
earn a non-competitive return. Surplus banks will try to loan their excess reserves
on the Interbank market. Some deficit banks will clearly be interested in these loans
to shore up their position and avoid going to the discount window that the central
bank offeres and which is more expensive.

The upshot, however, is that the competition between the surplus banks to shed
their excess reserves drives the short-term interest rate down. These transactions
net to zero (a equal liability and asset are created each time) and so non-

government banking system cannot by itself (conducting horizontal transactions

between commercial banks that is, borrowing and lending on the interbank
market) eliminate a system-wide excess of reserves that the fiscal deficit created.

What is needed is a vertical transaction that is, an interaction between the

government and non-government sector. So bond sales can drain reserves by
offering the banks an attractive interest-bearing security (government debt) which it
can purchase to eliminate its excess reserves.

However, the vertical transaction just offers portfolio choice for the non-government
sector rather than changing the holding of financial assets.

So the issuance of public debt does not increases the assets that are held by the
non-government sector $-for-$.

Further, mainstream macroeconomics claims that public debt-issuance reduces the

capacity of the private sector to borrow from banks because they use their deposits
to buy the bonds. That is also clearly an incorrect statement.

It is based on the erroneous belief that the banks need deposits and reserves before
they can lend. Mainstream macroeconomics wrongly asserts that banks only lend if
they have prior reserves. The illusion is that a bank is an institution that accepts
deposits to build up reserves and then on-lends them at a margin to make money.
The conceptualisation suggests that if it doesnt have adequate reserves then it
cannot lend. So the presupposition is that by adding to bank reserves, quantitative
easing will help lending.

But this is an incorrect depiction of how banks operate. Bank lending is not reserve
constrained. Banks lend to any credit worthy customer they can find and then
worry about their reserve positions afterwards. If they are short of reserves (their
reserve accounts have to be in positive balance each day and in some countries
central banks require certain ratios to be maintained) then they borrow from each
other in the interbank market or, ultimately, they will borrow from the central bank
through the so-called discount window. They are reluctant to use the latter facility
because it carries a penalty (higher interest cost).

The point is that building bank reserves will not increase the banks capacity to
lend. Loans create deposits which generate reserves.

And this bit expands more on the idea we talked about that the central bank is not
printing money and has little control over the money supply. an idea completely
counter to what everybody believes Bold added by me.

The theory of endogenous money is central to the horizontal analysis in Modern

Monetary Theory (MMT). When we talk about endogenous money we are referring to
the outcomes that are arrived at after market participants respond to their own
market prospects and central bank policy settings and make decisions about the
liquid assets they will hold (deposits) and new liquid assets they will seek (loans).

The essential idea is that the money supply in an entrepreneurial economy is

demand-determined as the demand for credit expands so does the money supply.
As credit is repaid the money supply shrinks. These flows are going on all the time
and the stock measure we choose to call the money supply, say M3 (Currency plus
bank current deposits of the private non-bank sector plus all other bank deposits
from the private non-bank sector) is just an arbitrary reflection of the credit circuit.

Central banks clearly do not determine the volume of deposits held each day. These
arise from decisions by commercial banks to make loans [and - Mayer edit here - by
the decisions of borrowers to have those loans]. The central bank can determine the
price of money by setting the interest rate on bank reserves. Further expanding
the monetary base (bank reserves) as we have argued in recent blogs Building
bank reserves will not expand credit and Building bank reserves is not inflationary
does not lead to an expansion of credit.