6. If there are two separate monetary cycles – how does government spending make its way into the real economy?

In a two-stage monetary system the following problem arises: the government uses only central bank money for government spending. But government spending is to be sent to households and companies which do not have an account with the central bank and therefore cannot receive central bank money. They only have accounts at commercial banks, i.e. they can only receive deposit money. 

So how does government spending reach private banking accounts in a two-stage monetary system? It is the bank’s task to solve this problem by translating the central bank money, so to speak, into deposit money. When the government wants to transfer her pension to Ms. Sophie, it sends central bank money to the central bank account of Ms. Sophie´s bank. The bank then keeps the central bank money itself on the asset side of its balance sheet, and in return creates the same amount of deposit money by crediting it to Ms. Sophie´s account (which again means a balance sheet extension for the bank, that does not change the equity). 

However, this necessity to translate one kind of money into the other leads to a double money creation: First, the central bank money supply increases in the course of government spending, and then the amount of deposit money increases as a result of the translation. When people pay taxes, the same thing takes place in reverse. The bank erases the money from the person’s bank account and instead transfers the corresponding amount of central bank money to the state. In this case the bank’s balance sheet is shortened and both types of money expire when being paid back to the issuer. 

With this translation in the middle, government spending and taxes overcome the boundaries of the two separate money cycles. In contrast, the deposit money created by banks remains in the deposit money cycle and central bank money created by the central bank for the financial system remains in the central bank money cycle (see chart). This money cycle issue seems quite technical, but it lets us understand why the different ways of money creation have such different effects. Additionally, it is also very important for the understanding of government bonds, as we will see below.