There are around 4 types of USD. And usually it is possible to convert between them. When the convertibility fails we get the Great Financial Crisis or the COVID-19 crash in March 2020.

The different types of USD are:

Type 1. Cash: These are pieces of paper with people’s pictures on them. When ATMs or banks run out cash, they can ask the government who will ship it to them in armored vehicles.

Type 2. Bank deposit: This is what you see when you login to your bank account online, or on ATM or on a bank statement. Bank deposits are FDIC insured up to a limit (e.g. 50k USD). So even if a bank fails you can claim up to 50k from the insurer. The insurer is itself backed by the government. Bank deposits are just numbers on a bank’s balance sheet. Banks hope to be able to honor your deposits when you need it (e.g. when you transfer it to another bank).

Type 3. Central bank reserves: This is what your bank sees when they login to their account held at the Central Bank. These days it pays a small interest (0.1% IIRC). Even though these reserves are USD, they cannot be used for anything and everything. In some sense it is not a real USD and it is more like a USD voucher. It can only be used to settle interbank debts (e.g. when you transfer money from one bank to another), buy government bonds, “create” bank deposits against these reserves as part of issuing loans. In other words central bank reserves never “leave” the central bank.

Type 4. Government bonds: These are also a type of money. But they earn interest paid for by the tax payer. Any high net worth individual (HNI) or corporation uses government bonds as their “bank account” because regular banks can only insure about 50k USD (iirc) and corporations and HNI have a lot more money than that. This is also why there is so much hand wringing about interest rates of bonds. Big corps and HNI want at least “inflation + growth expectations” from these bonds.

When Type 2 USD is transferred between banks, banks transfer Type 3 USD between bank’s central bank accounts held at the central bank.

When Type 2 USD is transferred to a foreign bank, foreign banks have accounts held at local banks which have Type 2 USD which is updated.

When money is borrowed from a bank Type 2 USD is created from nothing. Creating money like this is the easy part. The real trick is transferring this Type 2 bank deposit money to another bank which does not trust your bank. This is where Type 3 USD comes in. Type 3 USD is used to settle interbank debts. Type 3 USD never leaves a central bank and it is like a score on a video game or like a voucher. During QE any amount of Type 3 USD can be created. The reason why Type 3 USD in trillions created during QE is not creating inflation now is because it never leaves the central bank. Even though banks can create Type 2 loans using Type 3 reserves, they don’t because the economy is risky.

(to be continued).