Basic Monetary Economics For The Monetary Economics Challenged

I have been asked by a reader to comment on this article that Mark Thoma linked to that criticized Ron Paul's monetary economics:

"The Fed has the ability to create money "out of thin air!" Whenever I hear this expression, I chuckle. We all have the power to create debt out of "thin air." When Microsoft creates shares to finance an acquisition, it creates the shares "out of thin air." If you bum a beer from a friend and promise to repay him next week, you create a debt obligation "out of thin air." Ooooo..."out of thin air!""

While this may appear convincing to some at first glance, it is actually nonsensical. The difference between these transactions is of course that debt or equity is not the same thing as money. When the Fed buys some asset (and doesn't neutralise it by selling some other asset) it doesn't require for someone else to voluntarily give up his money, whereas when Microsoft issues shares or you borrowing money from a friend to buy beer does require for someone else to give up his or her money. The reason why the Fed can buy stuff without convincing someone else to give up his or her money is of course because the Fed unlike everyone else can create money out of thin air. Issuers of shares or or debt obligations financing beer purchases doesn't involve the creation of money, but the re-allocation of already existing money.

The appropriate real life analogy to the money creation abilities of the Fed and other central banks would in fact be the legalization of counterfeiting.