THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet

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Money & Banking MGT411

Lesson 33

THE MONETARY BASE

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.

Bank Reserves = Vault Cash plus Deposits at the central bank

The central bank can control the size of the monetary base and therefore the quantity of money

Changing the Size and Composition of the Balance Sheet

The central bank controls the size of its balance sheet. Policymakers can enlarge or reduce their

assets and liabilities at will

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.

There are four specific types of transactions which can affect the balance sheets of both the

central bank and the banking system:

An open market operation, in which the central bank buys or sells a security;

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

reserves;

The central bank's extension of a discount loan to a commercial bank;

The decision by an individual to withdraw cash from a bank

Open market operations, foreign exchange interventions, and discount loans, all affect the size

of the central bank's balance sheet

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

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)

Open Market Operations

OMO is when the central bank buys or sells securities in financial markets

These purchases and sales have a straightforward impact on the central bank's balance sheet:

Its assets and liabilities increase by the amount of a purchase, and the monetary base increases

by the same amount

Table: Change in the Central Bank's Balance sheet following purchase of a Treasury Bond

Assets

Liabilities

Securities(Treasury Bond)

+$1billion

Reserves

+$1billion

Table: Change in the Banking system's balance sheet following the Central Bank's purchase

of a Treasury Bond

Assets

Liabilities

Reserves

+$1billion

Securities (U.S. Treasury Bond) -$1billion

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

For an open market sale, the effects would be the same but in the opposite direction

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Money & Banking MGT411

Foreign Exchange Intervention

The impact of a foreign exchange purchase is almost identical to that of an open market

purchase:

The central bank's assets and liabilities increase by the same amount, as does the monetary

base.

If the central bank buys from a commercial bank, the impact again is like the open market

purchase, except the assets involved are different.

Table: change in the Central bank's Balance sheet following purchase of Euro-denominated

German Government Bonds

Assets

Liabilities

Foreign exchange reserves

+$1billion Reserves

+$1billion

(German government bonds in euros)

Table: Change in the Banking system's Balance sheet following the Central bank's purchase of

Euro-denominated German Government Bonds

Assets

Liabilities

Reserves

+$1billion

Securities

-$1billion

(German government bonds)

Discount Loans

The central bank does not force commercial banks to borrow money; the banks ask for loans

and must provide collateral, usually a Treasury bond.

When the central bank makes a loan it creates an asset and a matching increase in its reserve

liabilities.

Table: Change in the Central Bank's Balance sheet following a Discount Loan

Assets

Liabilities

Discount loans

+$100million Reserves

+$100million

Table: Change in the Banking System's Balance Sheet following a Discount Loan

Assets

Liabilities

Reserves

+$100million

Discount loans

-$100million

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

monetary base.

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

liabilities (the loan).

Cash Withdrawal

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

When people withdraw cash they force a shift from reserves to currency on the central bank's

balance sheet.

Table: Change in the Nonbank Public's Balance Sheet following a Cash Withdrawal

Assets

Liabilities

Currency

+$100

Checkable deposits

-$100

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.

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Money & Banking MGT411

Table: Change in the Banking system's Balance sheet following a Cash Withdrawal

Assets

Liabilities

Reserves

-$100

Checkable deposits

-$100

On the central bank's balance sheet both currency and reserves are liabilities, so there is just a

change between the two with a net effect of zero.

Table: Change in the Central Bank's Balance Sheet following a Cash Withdrawal

Assets

Liabilities

Currency

+$100

Reserves

-$100

Changes in Size and Composition of Central Bank's Balance Sheet and Monetary Base

Transaction

Initiated by

Typical action

Impact

Open market

Central bank

Purchase of Treasury Increases reserves, the size of central bank's

operation

bond

balance sheet and Monetary base

Foreign Exchange

Central bank

Purchase of foreign Increases reserves, the size of central bank's

Intervention

govt. bonds

balance sheet and Monetary base

Discount Loans

Commercial

Extension of loan to Increases reserves, the size of central bank's

bank

commercial bank

balance sheet and Monetary base

Cash withdrawals

Nonbank public Withdrawal of cash

Decreases reserves and increases currency,

from ATM

leaving size of central bank's balance sheet

and Monetary base unchanged

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