Thursday, March 12, 2009

Federal Balance Sheet and monetary base

Federal balance sheet and monetary base Liabilities 1. Federal Reserve notes (currency) outstanding. The Fed issues currency (those green-and-gray pieces of paper in your wallet that say “Federal Reserve note” at the top). The Federal Reserve notes outstanding are the amount of this currency that is in the hands of the public. (Currency held by depository institutions is also a liability of the Fed but is counted as part of the reserves liability.) Federal Reserve notes are IOUs from the Fed to the bearer and are also liabilities, but unlike most liabilities, they promise to pay back the bearer solely with Federal Reserve notes; that is, they pay off IOUs with other IOUs. Accordingly, if you bring a $100 bill to the Federal Reserve and demand payment, you will receive two $50s, five $20s, ten $10s, or one hundred $1 bills. People are more willing to accept IOUs from the Fed than from you or me because Federal Reserve notes are a recognized medium of exchange; that is, they are accepted as a means of payment and so function as money. Unfortunately, neither you nor I can convince people that our IOUs are worth anything more than the paper they are written on.1 2. Reserves. All banks have an account at the Fed in which they hold deposits. Reserves consist of deposits at the Fed plus currency that is physically held by banks (called vault cash because it is stored in bank vaults). Reserves are assets for the banks but liabilities for the Fed, because the banks can demand payment on them at any time and the Fed is required to satisfy its obligation by paying Federal Reserve notes. As shown in the chapter, an increase in reserves leads to an increase in the level of deposits and hence in the money supply. Total reserves can be divided into two categories: reserves that the Fed requires banks to hold (required reserves) and any additional reserves the banks choose to hold (excess reserves). For example, the Fed might require that for every dollar of deposits at a depository institution, a certain fraction (say, 10 cents) must be held as reserves. This fraction (10%) is called the required reserve ratio. Currently, the Fed pays no interest on reserves. 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 of the 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 the monetary 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 (everything else being constant). This is why the monetary base is also called high-powered money. Recognizing that Treasury currency and Federal Reserve currency can be lumped together into the category currency in circulation, denoted by C, the monetary base equals the sum of currency in circulation plus reserves R. The monetary base MB is expressed as2:

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