Money Supply and the Central Bank's Balance Sheet

Traditionally, money was created by either minting coins or printing currency. Nowadays, most money is stored electronically as account information, and can be created or destroyed simply by changing the information in the accounts. Before 1900, sovereign governments were in charge of minting coins or printing currency — sometimes with disastrous results.

Today, the supply of money is managed by central banks, not to satisfy the whims of politicians, but to achieve specific well-established objectives, such as low inflation, maximum growth, or high employment. Money is usually created — or destroyed — electronically as information in accounts held by central banks. The creation or destruction of money is recorded in the central bank's balance sheet. Therefore, to understand the supply of money, one must understand how it is recorded in the bank's balance sheet.

A central bank's balance sheet, like most balance sheets, is divided into assets and liabilities. The central bank's balance sheet can also be divided further into assets and liabilities as the bankers' bank and assets and liabilities as the government's bank, as shown in the following table:

Central Bank Balance Sheet
AssetsLiabilities
Bankers' BankLoansBank Accounts
Government's BankSecurities
Foreign Exchange Reserves
Currency
Government's Account

To simplify this discussion, we will focus on the supply of money by the Federal Reserve (Fed) of the United States and its balance sheet. Although the Fed's balance sheet is rather complicated, only the main components are necessary to understand the money supply process. Central bank assets include:

Of these, the most important asset is securities, which the Fed uses to directly control the supply of money in the United States. In other countries, where exports are important, such as China, federal exchange reserves may be the dominant asset.

Central bank liabilities include:

Reserves can be further classified as either required reserves or excess reserves. Required reserves are those reserves that banks must hold as a legal minimum to ensure their financial soundness while excess reserves is any amount above the required reserves, which banks keep to conduct their daily business or because they failed to lend all of it out.

Because changes in the supply of money are revealed in the central bank's balance sheet, the balance sheet is the most important item that the central bank discloses. The Federal Reserve and most other central banks publish their balance sheets weekly as a way to maintain transparency. When a central bank fails to publish its balance sheet, it often indicates trouble, usually in the form of increasing the supply of money at the behest of politicians.

Monetary Base

The quantity of money in any economy is determined by the monetary base, which are the banking reserves and currency held by the public. In other words, the monetary base consists of the actual quantity of money. However, because money also has velocity, in that the same dollar is used in multiple transactions over time, the monetary base is often called high-powered money because the total value of all financial transactions is a multiple of the monetary base.

The Federal Reserve usually creates money by purchasing Treasuries from one of its 18 primary dealers. For instance, recently the Fed decided to purchase $600 billion worth of Treasuries to lower the interest rate by increasing the supply of money. Let's see how a purchase of a $1 million Treasury differs from an consumer purchase.

You go to the grocery store and buy $100 worth of groceries for which you pay by debit card. The grocer's network credits his bank account by $100, then sends information to your bank to debit your account by the same amount. Hence, money — or rather, information — is transferred from you to your grocer by changing the information, which is the amount in the account, in both of your accounts.

When the Federal Reserve purchases a $1 million Treasury from a primary dealer, which is a bank, it simply increments the banks reserve account at the Federal Reserve by $1 million. No other account is debited. Hence, money is created rather than transferred.

When the bank receives the $1 million for the Treasury, it will generally want to lend the money out, since it will only receive about 0.25% interest on its reserve account at the Fed. When the money is lent, the borrower will use it to pay someone else, and so on.

However, although the $1 million is created out of nothing, it is, nonetheless, recorded in the Fed's balance sheet. Because the accounts of commercial banks are a liability to the Fed, when the Fed increments the dealers account by $1 million, it increases its own liability by an equal amount, which is offset by the Treasury, which is an asset. Likewise, when the Fed decides to lower the supply of money, it sells Treasuries to its own dealers. Hence, in the above example, the Fed would sell its dealer the $1 million Treasury, debiting the dealers account, transferring the Treasury to the dealer, and reducing both the Fed's liability and its assets by the same amount.

Only a central bank can control its balance sheet at will, since only a central bank can create or destroy money. Because of the relationship between the supply of money and the bank's balance sheet, the creation of money is sometimes referred to as expanding the central bank's balance sheet, because both its assets and liabilities increase; likewise, the destruction of money causes the contraction of the central bank's balance sheet.