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Chapter 17 – The Central Bank Balance Sheet and the Money Supply Process

Chapter 17

The Central Bank Balance Sheet

and the Money Supply Process

Chapter Overview

In this chapter we develop an understanding of how the central bank interacts with the

financial system and how its balance sheet is connected to the money and credit that

flows through the economy.

Learning Objectives: Establish an understanding of:

1. The central bank’s balance sheet

2. Changing the size and mix of the balance sheet

3. The deposit expansion multiplier

4. The monetary base and the money supply

Important Points of the Chapter

One of the great successes of modern central banking is the story of the U.S. Federal

Reserve on September 11. Because of its quick action, the Fed kept the financial markets

afloat, and the financial system returned to near normal within weeks. In reaction to the

financial crisis of 2007-2009, the Fed’s actions were critical in preventing a global

financial meltdown. This is a marked contrast to what happened in the 1930’s, and the

difference is that in the 30’s Fed officials failed to provide the liquidity that sound banks

needed to stay in business. In 2001, the statement that came from the Fed was: “The

Federal Reserve is open and operating. The discount window is available to meet

liquidity needs.”

Application of Core Principles

Principle #3: Information. The balance sheet published by the central bank is probably

the most important information that it makes public.

Principle #4: Time. If a bank sells an interest-bearing U.S. Treasury bond to the Fed and

receives reserves it will want to lend those reserves because holding them for any period

of time means foregoing interest income (reserves are noninterest-bearing).

Teaching Tips/Student Stumbling Blocks

Students will likely have difficulty understanding the impact of different transactions

on the central bank’s balance sheet. Emphasize the rule from page 433: When the

value of an asset on the balance sheet increases, either the value of another asset

decreases (so the net change is zero) or the value of a liability rises by the same

amount (and similarly for an increase in liabilities).

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Chapter 17 – The Central Bank Balance Sheet and the Money Supply Process

Features in this Chapter

Applying the Concept: The Fed’s Balance Sheet: Impact of the Crisis

The Fed’s response to the financial crisis of 2007-2009 transformed the size and

composition of its balance sheet. Assets increased by 2.5 times, mostly during September

and October, 2008, following the collapse of Lehman Brothers. The composition of

assets was concentrated in securities, including MBSs. Liabilities increased as well, with

commercial bank deposits increasing nearly 100 times. Even as the crisis tamed, banks

remained cautious, maintaining considerable excess reserves.

Your Financial World: Why We Still Have Cash

Despite the technological changes that have brought us credit cards and electronic money,

there is still a tremendous amount of cash in use. The reasons for this are convenience,

tax avoidance, and the anonymity that cash provides.

Applying the Concept: The Fed’s Response on September 11, 2001

In the aftermath of September 11, Fed officials saw a looming crisis and reacted

immediately, providing reserves to anyone who needed them. Reserves increased by an

astonishing $145 billion over a two-day period. This massive injection of reserves was

quickly drained out over the next week, as the system got back to normal.

Your Financial World: Your Excess Reserves

Just as banks hold excess reserves, individuals need to have an emergency fund to pay for

unexpected expenses that can’t be postponed. Most financial planners recommend that

these funds should equal a minimum of three months’ income in cash accounts.

Lessons from the Crisis: The Impact on Money Supply

Banks supply money to the economy. The financial crisis of 2007-2009 highlighted the

role of bank behavior in the money supply process as the deposit expansion multiplier

plummeted. The deposit expansion multiplier describes how deposits are multiplied

through the economy as banks loan out money that is deposited. Following the collapse

of Lehman Brothers, banks panicked and short-circuited the deposit expansion process by

holding excess reserves rather than loaning out the deposits. These excess reserves held

with the Fed are the most liquid asset in the U.S. financial system. The Fed responded to

the surge in liquidity demand by increasing reserves by 20 times. Had the Fed not done

this, banks would have stopped lending to even well-qualified borrowers, and the money

supply would have collapsed.

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Chapter 17 – The Central Bank Balance Sheet and the Money Supply Process

Applying the Concept: Monetary Policy in the 1930s

One of the important lessons of the Great Depression of the 1930s is that central bankers

need to look at both the monetary base and the money multiplier to figure out whether

their policies are working.

In the News: The Monetary Base is Exploding. So What?

According to Greg Mankiw, the monetary base is growing significantly, however this is

not a sign of inflation. The story is that an increase in the monetary base will increase

bank lending, which will increase the broad monetary aggregates such as M2, which

increases inflation in the long run. His argument is that those broader monetary

aggregates are not increasing and as long as the Fed continues to pay an interest on

reserves that will encourage banks not to lend, the monetary base will not be inflationary.

Additional Teaching Tools

Information about tools the Federal Reserve used in the financial crisis of 2007-2009 can

be found at http://www.federalreserve.gov/monetarypolicy/bst.htm.

Virtual Tools

Learn more about reserve requirements on this site from the New York Federal Reserve

Bank:

http://www.newyorkfed.org/aboutthefed/fedpoint/fed45.html

Learn more about open market operations on this site from the New York Federal

Reserve Bank:

http://www.newyorkfed.org/aboutthefed/fedpoint/fed32.html

For the latest data on the M1 money multiplier, visit this site from the St. Louis Federal

Reserve Bank:

http://research.stlouisfed.org/fred2/series/MULT/24

What happens to all that borrowing by the federal government? Deficits accumulate into

the national debt. Find out how much the debt is “to the penny” at this Treasury web site:

http://www.treasurydirect.gov/NP/BPDLogin?application=np.

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Lessons of the Article: The link between rapid money growth and inflation is well

established. But rapid growth of the monetary base need not lead to rapid money

growth. Beginning in 2008, the M1 and M2 money multipliers (the ratios of the

monetary aggregates to the monetary base) collapsed as banks hesitated to lend out

their reserves (see Figure 17.11). As usual, when the U.S. recovery strengthens

enough, the Fed will have to raise interest rates to keep inflation low.

Chapter 17 – The Central Bank Balance Sheet and the Money Supply Process

For More Discussion

How much cash do we really use? Have students keep a journal for a week tracking how

much cash they spend and where they obtain it; i.e., how often do they use ATMs?

How has the increased use of electronic money affected the multiplier? If the United

States moves closer to a cashless society, how will that affect the Fed in its conduct of

monetary policy?

Chapter Outline

I. The Central Bank’s Balance Sheet

1. The central bank engages in numerous financial transactions, all of which

cause changes in its balance sheet.

2. Central banks publish their balance sheets regularly; the Fed and the ECB do

so weekly. Publication is a crucial part of transparency.

A. Assets

1. The central bank’s balance sheet shows three basic assets: securities, foreign

exchange reserves, and loans.

2. Securities: the primary assets of most central banks; independent central banks

determine the quantity of securities that they purchase. For the U.S. Federal

Reserve, these are primarily U.S. Treasury securities.

3. Foreign Exchange Reserves: the central bank’s and government’s balances of

foreign currency and are held as bonds issued by foreign governments. These

reserves are used in foreign exchange market interventions.

4. Loans are extended to commercial banks. There are several kinds. Discount

loans are the loans the Fed makes when commercial banks need short-term

cash. (In the financial crisis of 2007-2009, the Fed also loaned to nonbanks.)

5. Through its holdings of U.S. Treasury securities the Fed controls the federal

funds rate and the availability of money and credit.

B. Liabilities

1. There are three major liabilities: currency, the government’s deposit account,

and the deposit accounts of the commercial banks.

2. The first two items represent the central bank in its role as the government’s

bank, and the third shows it as the bankers’ bank.

3. Currency: nearly all central banks have a monopoly on the issuance of

currency, and currency is the principal liability of the Fed.

4. Government’s account: the central bank provides the government with an

account into which it deposits funds (primarily tax revenues) and from which

it writes checks and makes electronic payments.

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Chapter 17 – The Central Bank Balance Sheet and the Money Supply Process

5. Reserves: Commercial bank reserves consist of cash in the bank’s own vault

and deposits at the Fed, which function like the commercial bank’s checking

account.

6. Central banks run their monetary policy operations through changes in

banking system reserves.

C. The Importance of Disclosure

1. The balance sheet published by the central bank is probably the most

important information that it makes public; it is an essential aspect of central

bank transparency.

D. The Monetary Base

1. Currency in the hands of the public and the reserves of the banking system are

the two components of the monetary base, also called high-powered money.

2. The central bank can control the size of the monetary base and therefore the

quantity of money.

II. Changing the Size and Composition of the Balance Sheet

1. The central bank controls the size of its balance sheet. Policymakers can

enlarge or reduce their assets and liabilities at will.

2. The central bank can buy things, like a bond, and create liabilities to pay for

them. It can increase the size of its balance sheet as much as it wants.

3. There are four specific types of transactions which can affect the balance

sheets of both the central bank and the banking system: (1) an open market

operation, in which the central bank buys or sells a security; (2) a foreign

exchange intervention, in which the central bank buys or sells foreign

currency reserves; (3) the central bank’s extension of a discount loan to a

commercial bank; and (4) the decision by an individual to withdraw cash from

a bank.

4. Open market operations, foreign exchange interventions, and discount loans

all affect the size of the central bank’s balance sheet and they change the size

of the monetary base; cash withdrawals by the public create shifts among the

different components of the monetary base, changing the composition of the

central bank’s balance sheet but leaving its size unaffected.

5. One simple rule will help in understanding the impact of each of these four

transactions on the central bank’s balance sheet: When the value of an asset

on the balance sheet increases, either the value of another asset decreases (so

that the net change is zero) or the value of a liability rises by the same amount

(and similarly for an increase in liabilities).

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Chapter 17 – The Central Bank Balance Sheet and the Money Supply Process

A. Open Market Operations

1. OMO is when the Fed buys or sells securities in financial markets.

2. These purchases and sales have a straightforward impact on the Fed’s balance

sheet: its assets and liabilities increase by the amount of a purchase, and the

monetary base increases by the same amount.

3. In terms of the banking system’s balance sheet, the purchase has no effect on

the liabilities, and results in two counterbalancing changes on the asset side,

so the net effect there is zero.

4. For an open market sale the effects would be the same but in the opposite

direction.

B. Foreign Exchange Intervention

1. The impact of a foreign exchange purchase is almost identical to that of an

open market purchase: the Fed’s assets and liabilities increase by the same

amount, as does the monetary base.

2. If the Fed buys from a commercial bank, the impact again is like the open

market purchase, except the assets involved are different.

C. Discount Loans

1. The Fed does not force commercial banks to borrow money; the banks ask for

loans and must provide collateral, usually a U.S. Treasury bond.

2. When the Fed makes a loan it creates an asset and a matching increase in its

reserve liabilities.

3. The extension of credit to the banking system raises the level of reserves and

expands the monetary base.

4. The banking system balance sheet shows an increase in assets (reserves) and

an increase in liabilities (the loan).

D. Cash Withdrawal

1. Cash withdrawals affect only the composition, not the size, of the monetary

base.

2. When people withdraw cash they force a shift from reserves to currency on

the Fed’s balance sheet.

3. The withdrawal reduces the banking system’s reserves, which is a decrease in

its assets, and if the funds come from a checking account, there is a matching

decrease in liabilities.

4. On the Fed’s balance sheet both currency and reserves are liabilities, so there

is just a change between the two with a net effect of zero.

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Chapter 17 – The Central Bank Balance Sheet and the Money Supply Process

III. The Deposit Expansion Multiplier

A. Deposit Creation in a Single Bank

1. If the Fed buys a security from a bank, the bank has excess reserves, which it

will seek to lend.

2. The loan replaces the securities as an asset on the bank’s balance sheet.

B. Deposit Expansion in a System of Banks

1. However, the loan that the bank made was spent and as the checks cleared,

reserves were transferred to other banks.

2. The banks that receive the reserves will seek to lend their excess reserves, and

the process continues until all of the funds have ended up in required reserves.

3. Assuming no excess reserves are held and that there are no changes in the

amount of currency held by the public, the change in deposits will be the

inverse of the required deposit reserve ratio (rD) times the change in required

reserves, or ∆D = (1/rD) ∆RR

4. The term (1/rD) represents the simple deposit expansion multiplier.

5. A decrease in reserves will generate a deposit contraction in a multiple amount

too.

IV. The Monetary Base and the Money Supply

A. Deposit Expansion with Excess Reserves and Cash Withdrawals

1. The simple deposit expansion multiplier was derived assuming no excess

reserves are held and that there is no change in currency holdings by the

public. These assumptions are now relaxed.

2. The desire of banks to hold excess reserves and the desire of account holders

to withdraw cash both reduce the impact of a given change in reserves on the

total deposits in the system; the two factors operate in the same way as an

increase in the reserve requirement.

B. The Arithmetic of the Money Multiplier

1. The amount of excess reserves a bank holds depends on the costs and benefits

of holding them, where the cost is the interest foregone and the benefit is the

safety from having the reserves in case there is an increase in withdrawals.

2. The higher the interest rate, the lower banks’ excess reserves will be; the

greater the concern over possible deposit withdrawals, the higher the excess

reserves will be.

3. Similarly, the decision of how much currency to hold depends on the costs and

benefits, where the cost is the interest foregone and the benefit is the lower

risk and greater liquidity of currency.

4. As interest rates rise cash becomes less desirable, but if the riskiness of

alternative holdings rises or liquidity falls, then it becomes more desirable.

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Chapter 17 – The Central Bank Balance Sheet and the Money Supply Process

5. Deriving the money multiplier tells us that the quantity of money in the

economy depends on the monetary base, the reserve requirement, the desire

by banks to hold excess reserve and the desire by the public to hold currency.

6. The quantity of money changes directly with the base, and for a given amount

of the base, an increase in either the reserve requirement or the holdings of

excess reserves will decrease the quantity of money.

7. But currency holdings affect both the numerator and the denominator of the

multiplier, so the effect is not immediately obvious. Logic tells us that an

increase in currency decreases reserves and so decreases the money supply.

C. The Limits of the Central Bank’s Ability to Control the Quantity of Money

1. There is no tight link between the monetary base and the quantity of money.

2. In places like the United States, Europe, and Japan, the link between the

central bank’s balance sheet and the quantity of money circulating in the

economy has become too weak and unpredictable to be exploited for policy

purposes.

3. The problem is that the money multiplier is too variable.

4. Therefore, modern central banks keep an eye on trends in money growth since

that is what ultimately determines inflation. For short-run policy, interest rates

have become the monetary policy tool of choice.

Terms Introduced in Chapter 17

central bank’s balance sheet

currency-to-deposit ratio

deposit expansion multiplier

discount loans

excess reserves

excess reserve-to-deposit ratio

foreign exchange reserves

foreign exchange intervention

high-powered money

monetary base

multiple deposit creation

open market operations (OMO)

open market purchase

open market sale

required reserve ratio

required reserves

reserves

T-account

vault cash

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Chapter 17 – The Central Bank Balance Sheet and the Money Supply Process

Using FRED: Codes for Data in This Chapter

Data Series FRED Data Code

Nominal GDP GDP

M1 M1SL

M2 M2SL

Monetary base BOGAMBSL

Currency in circulation CURRSL

Checkable deposits TCDSL

Excess reserves (NSA) EXCRESNS

Required reserves (NSA) REQRESNS

Discount window borrowings DISCBORR

Treasury securities held by Fed (NSA) TREAST

Federal Reserve assets (NSA) WALCL

MBS held by Fed (NSA) MBST

NSA: not seasonally adjusted.

Lessons of Chapter 17

1. The central bank uses its balance sheet to control the quantity of money and credit

in the economy.

a. The central bank holds assets and liabilities to meet its responsibilities as

the government’s bank and the bankers’ bank.

b. Central bank assets include securities, foreign exchange reserves, and

loans.

c. Central bank liabilities include currency, the government’s account, and

reserves.

d. Reserves equal commercial bank account balances at the central bank plus

vault cash.

e. The monetary base, also called high-powered money, is the sum of

currency and reserves, the two primary liabilities of the central bank.

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Chapter 17 – The Central Bank Balance Sheet and the Money Supply Process

2. The central bank controls the size of its balance sheet.

a. The central bank can increase the size of its balance sheet, raising reserve

liabilities and expanding the monetary base, through

i. Open market purchases of domestic securities.

ii. The purchase of foreign exchange reserves (in the form of bonds

issued by a foreign government).

iii. The extension of a loan to a commercial bank.

b. The central bank can decrease the size of its balance sheet, lowering

reserve liabilities and reducing the monetary base through the sale of

domestic or foreign securities.

c. The public’s cash withdrawals from banks shift the central bank’s

liabilities from reserves to currency and shrink the size of the banking

system balance sheet.

3. Bank reserves are transformed into checkable deposits through multiple deposit

creation. In the simplest case, this process is limited by the reserve requirement.

a. When a bank’s reserves increase, it makes a loan that becomes a deposit at

a second bank.

b. The second bank then makes another loan, but the amount of the loan is

limited by the reserve requirement.

c. This process continues until deposits have increased by a multiple that is

equal to one over the reserve requirement.

4. The money multiplier links the monetary base to the quantity of money in the

economy.

a. The size of the money multiplier depends on

i. The reserve requirement.

ii. Banks’ desire to hold excess reserves.

iii. The public’s desire to hold currency.

b. While the central bank controls the level of the monetary base, it cannot

control the money multiplier.

c. Practices such as deposit sweeping have weakened the connection

between the central bank’s balance sheet and the quantity of money.

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