The amount of money that people hold must equal the amount of money created by the banking system. You can't see "spending" anywhere in that fundamental accounting identity, can you? Therefore, people do not "spend" money!

To see what is wrong with that standard textbook view, we need to consider the following fundamental accounting identity:

John Maynard Keynes famously wrote that: "Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist." A modern example of that dictum, relevant to the economy, policy, and markets, is the widespread view that people can "spend" their money, as if money represented a pool that is just waiting to "flow into" spending. Because such a thing cannot occur and therefore has not occurred, the point is usually made in reverse: people currently are not "spending" their money--rather they are "parking" their money at the bank or leaving it "idle." But that they might spend it in the future is a lurking risk and a reason to be cautious about the central bank engaging in aggressive quantitative easing (QE).

A key distinction to bear in mind is between individual people and people in aggregate. Neither individual people nor people as a whole can "spend" money, but individual people can and do offload their money (particularly excess money) by lending it to other people or by buying goods and assets; but people in aggregate cannot do this--in such cases, the money that leaves one person's balance sheet just pops up on another person's balance sheet, remaining on the banking system's balance sheet all the while.

Therefore, people cannot and do not "spend" money. This explains why creating money does not work to increase spending. Except, maybe, via obscure indirect mechanisms.

The above is total rubbish, of course. It is also heavily plagiarised, from an article by Paul Sheard (pdf) (HT David Andolfatto). Basically, I just changed his "banks" to "people", his "lend" to "spend", and his "reserves" to "money".

Now let me be sensible:

We define "excess money" as the actual stock of money that people hold minus the stock of money they desire to hold (given prices, income, interest rates etc.).

If an individual person has excess money, he can and will get rid of it, by spending it or by lending it. (And "lending" means "buying an IOU from someone", so it's the same as spending.) But that just means another individual person now holds it.

If the banking system creates an excess supply of money, and holds that stock of money constant, each individual person can get rid of it, but people in aggregate cannot get rid of it. It just keeps circulating back to them, as quickly as they spend it. But their individual attempts to get rid of it are what create the increased demand for goods, which will ultimately raise the prices of goods above what they would otherwise have been. The fact that people cannot in aggregate get rid of the excess money is a central part of the standard story of why excess money raises the demand for goods and the prices of goods. If they could get rid of it by spending it, the excess money would have at most only a temporary effect.

It's exactly the same with excess reserves. But here we need to be careful about how we define "excess reserves". The economically relevant definition is "actual stock of reserves minus desired stock of reserves". We should not define "excess reserves" as "actual stock of reserves minus legally rquired stock of reserves". The former definition works for economists in all countries, regardless of whether or not there are legal reserve requirements (Canada has none). The latter definition is only good for US lawyers.

It makes absolutely no difference whether banks make loans in the form of currency or in the form of creating demand deposits. An individual bank that makes a loan of $100 by creating a deposit of $100 will lose $100 of reserves to a second bank when the borrower spends that $100 on a bike, and the bike seller deposits the cheque in that second bank. If the bike seller will only accept currency, so the first bank swaps $100 in reserves for $100 in currency, then lends $100 currency to the borrower, the loss in reserves is immediate, rather than delayed by a day or two. But the end result is exactly the same.

Let's cut to the goddamn chase: banks lend reserves.

And the fact that banks cannot in aggregate get rid of the excess reserves is a central part of the standard textbook story of why excess reserves raise the stock of money, which creates an excess supply of money, which raises the demand for goods and the prices of goods. If banks in aggregate could get rid of reserves by lending them, the excess reserves would have at most only a temporary effect.

(I could do another post on the "needs of trade" fallacy (the idea that "interest-rate-targeting central banks supply whatever reserves are needed") in that paper, but I have already done several related posts, like this one. So I think I will drive to Wawa instead.)