Fed Balance Sheet and Monetary Base

Assets 1. Securities. These are the Fed’s holdings of securities, which consist primarilyof Treasury securities but in the past have also included banker’s acceptances.The total amount of securities is controlled by open market operations (theFed’s purchase and sale of these securities). As shown in Table 1, “Securities”is by far the largest category of assets in the Fed’s balance sheet. 2. Discount loans. These are loans the Fed makes to banks. The amount isaffected by the Fed’s setting the discount rate, the interest rate that theFed charges banks for these loans. These first two Fed assets are important because they earn interest.Because the liabilities of the Fed do not pay interest, the Fed makes billionsof dollars every year—its assets earn income, and its liabilities cost nothing Liabilities 1.Federal Reserve notes (currency) outstanding. The Fed issues currency(those green-and-gray pieces of paper in your wallet that say “FederalReserve note” at the top). The Federal Reserve notes outstanding are theamount of this currency that is in the hands of the public. (Currency heldby depository institutions is also a liability of the Fed but is counted as partof the reserves liability.)Federal Reserve notes are IOUs from the Fed to the bearer and are alsoliabilities, but unlike most liabilities, they promise to pay back the bearersolely with Federal Reserve notes; that is, they pay off IOUs with otherIOUs. Accordingly, if you bring a $100 bill to the Federal Reserve anddemand payment, you will receive two $50s, five $20s, ten $10s, or onehundred $1 bills.People are more willing to accept IOUs from the Fed than from youor me because Federal Reserve notes are a recognized medium ofexchange; that is, they are accepted as a means of payment and so functionas money. Unfortunately, neither you nor I can convince people thatour IOUs are worth anything more than the paper they are written on.1THE FED’S BALANCE SHEET AND THE MONETARY BASE W-412. 2.Reserves. All banks have an account at the Fed in which they holddeposits. Reserves consist of deposits at the Fed plus currency that is physicallyheld by banks (called vault cash because it is stored in bank vaults).Reserves are assets for the banks but liabilities for the Fed, because thebanks can demand payment on them at any time and the Fed is requiredto satisfy its obligation by paying Federal Reserve notes. As shown in thechapter, an increase in reserves leads to an increase in the level of depositsand hence in the money supply.Total reserves can be divided into two categories: reserves that the Fedrequires banks to hold (required reserves) and any additional reserves thebanks choose to hold (excess reserves). For example, the Fed mightrequire that for every dollar of deposits at a depository institution, a certainfraction (say, 10 cents) must be held as reserves. This fraction (10%)is called the required reserve ratio. Currently, the Fed pays no intereston reserves.3. U.S. Treasury deposits. The Treasury keeps deposits at the Fed, againstwhich it writes all its checks. Monetary Base The first two liabilities on the balance sheet, Federal Reserve notes (currency)outstanding and reserves, are often referred to as the monetary liabilities ofthe Fed. When we add to these liabilities the U.S. Treasury’s monetary liabilities(Treasury currency in circulation, primarily coins), we get a construct called themonetary base. The monetary base is an important part of the money supply,because increases in it will lead to a multiple increase in the money supply (everythingelse being constant). This is why the monetary base is also called high-powered money. Recognizing that Treasury currency and Federal Reservecurrency can be lumped together into the category currency in circulation,denoted by C, the monetary base equals the sum of currency in circulation plusreserves R. The monetary base MB is expressed as follows: MB = (Federal Reserve notes + Treasury currency
coin) + reserves= C + R