Learning Objectives
- Who determines the money supply?
- How does the central bank’s balance sheet differ from the
balance sheets of other banks?
- 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).
funkydowntown.com/poor-people-in-zimbabwe-are-millionaires-and-billionaires;
www.hoax-slayer.com/zimbabwe-hyperinflation.shtml
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 base(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 matter. news.goldseek.com/GoldSeek/1177619058.php
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.