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15.1 The Central Bank’s Balance Sheet

Learning Objectives

  1. Who determines the money supply?
  2. How does the central bank’s balance sheet differ from the balance sheets of other banks?
  3. What is the monetary base?

In most countries today, a central bank or other monetary authority is charged with issuing domestic currency. That is an important charge because the supply of money greatly influences interest and inflation rates and, ultimately, aggregate output. If the central bank’s monetary policy is good, if it creates just the right amount of money, the economy will hum, and interest and inflation rates will be low. If it creates too much money too quickly, prices will increase rapidly and wipe out people’s savings until even the poorest people are nominal billionaires (as in Zimbabwe recently); If it creates too little money too slowly, prices will fall, wiping out debtors and making it nearly impossible to earn profits in business (as in the Great Depression). But even less extreme errors can have serious negative consequences for the economy and hence your wallets, careers, and dreams. This chapter is a little involved, but it is worth thoroughly understanding the money supply process and money multipliers if you want you and yours to be healthy and happy.

Ultimately, the money supply is determined by the interaction of four groups: commercial banks and other depositories, depositors, borrowers, and the central bank. Like any bank, the central bank’s balance sheet is composed of assets and liabilities. Its assets are similar to those of common banks and include government securitiesStudents sometimes become confused about this because they think the central bank is the government. At most, it is part of the government, and not the part that issues the bonds. Sometimes, as in the case of the BUS and SBUS, it is not part of the government at all. and discount loans. The former provide the central bank with income and a liquid asset that it can easily and cheaply buy and sell to alter its balance sheet. The latter are generally loans made to commercial banks. So far, so good. The central bank’s liabilities, however, differ fundamentally from those of common banks. Its most important liabilities are currency in circulation and reserves.

It may seem strange to see currency and reserves listed as liabilities of the central bank because those things are the assets of commercial banks. In fact, for everyone but the central bank, the central bank’s notes, Federal Reserve notes (FRN) in the United States, are assets or things owned. But for the central bank, its notes are things owed (liabilities). Every financial asset is somebody else’s liability, of course. A promissory note (IOU) that you signed would be your liability, but it would be an asset for the note’s holder or owner. Similarly, a bank deposit is a liability for the bank but an asset for the depositor. In like fashion, commercial banks own their deposits in the Fed (reserves), so they count them as assets. The Fed owes that money to commercial banks, so it must count them as liabilities. The same goes for FRN: the public owns them, but the Fed, as their issuer, owes them. (Don’t be confused by the fact that what the Fed owes to holders is nothing more than the right to use the notes to pay sums the holders owe to the government for taxes and the like.)

Currency in circulation (C) and reserves (R) compose the monetary baseThe most basic, powerful types of money in a given monetary system, that is, gold and silver under the gold standard, FRN, and reserves (Federal Reserve deposits) today.(MB, aka high-powered money), the most basic building blocks of the money supply. Basically, MB = C + R, an equation you’ll want to internalize. In the United States, C includes FRN and coins issued by the U.S. Treasury. We can ignore the latter because it is a relatively small percentage of the MB, and the Treasury cannot legally manage the volume of coinage in circulation in an active fashion, but rather only meets the demand for each denomination: .01, .05, .10, .25, .50, and 1.00 coins. (The Fed also supplies the $1.00 unit, and for some reason Americans prefer $1 notes to coins. In most countries, coins fill demand for the single currency unit denomination.) C includes only FRN and coins in the hands of nonbanks. Any FRN in banks is called vault cash and is included in R, which also includes bank deposits with the Fed. Reserves are of two types: those required or mandated by the central bank (RR), and any additional or excess reserves (ER) that banks wish to hold. The latter are usually small, but they can grow substantially during panics like that of September–October 2008.

Central banks, of course, are highly profitable institutions because their assets earn interest but their liabilities are costless, or nearly so. Printing money en masse with modern technology is pretty cheap, and reserves are nothing more than accounting entries. Many central banks, including the Federal Reserve, now pay interest on reserves, but of course any interest paid is composed of cheap notes or, more likely, even cheaper accounting entries. Central banks, therefore, have no gap problems, and liquidity management is a snap because they can always print more notes or create more reserves. Central banks anachronistically own prodigious quantities of gold, but some have begun to sell off their holdings because they no longer convert their notes into gold or anything else for that Gold is no longer part of the MB but is rather just a commodity with unusually good monetary characteristics (high value-to-weight ratio, divisible, easily authenticated, and so forth).

Key Takeaways

  • It is important to understand the money supply process because having too much or too little money will lead to negative economic outcomes including high(er) inflation and low(er) total output.
  • The central bank, depository institutions of every stripe, borrowers, and depositors all help to determine the money supply.
  • The central bank helps to determine the money supply by controlling the monetary base (MB), aka high-powered money or its monetary liabilities.
  • The central bank’s balance sheet differs from those of other banks because its monetary liabilities, currency in circulation (C) and reserves (R), are everyone else’s assets.
  • The monetary base or MB = C + R, where C = currency in circulation (not in the central bank or any bank); R = reserves = bank vault cash and deposits with the central bank.