Financial Instrument Generation in the U.S. Financial System

Abstract

A four sector model of the U.S. financial system is used to analyze the June 7, 2012 flow of funds accounts (FOFA) obtained from the Federal Reserve via its data download facility. The four sectors are identified as Fed, Treasury, Banks, and Nonbanks. The four sector model provides a foundation to study how the macroeconomy generates and destroys financial instruments via credit interactions involving an aggregate Bank, an aggregate Nonbank, a federal monetary authority (Fed), and the fiscal agent of the federal government (Treasury). Financial instruments are generated and destroyed by credit deals made between banks and nonbanks, by credit deals made among nonbanks, and by credit operations necessary to implement federal monetary and fiscal policy. Net generation of financial instruments sustains aggregate demand. Net destruction of financial instruments accompanies balance sheet recessions and depressions. Banks and Nonbanks demand liabilities of Fed and Treasury (Sovereign agents) as financial security systems and thus federal government does not face a budget constraint. Congress can use deficit spending to increase levels of employment and economic output by providing markets with secure savings instruments. But Congress must avoid causing financial injustice and instability.