Unit 6 The financial sector: Debt, money, and financial markets
6.7 Who really signs the banknotes? The central bank’s balance sheet and the government
The banking system depends on base money, which is a liability of the central bank. But who stands behind the central bank, ensuring that we can trust its promises? In this section we reach the last link in the chain: the government.
While banknotes are a peculiar kind of liability, the central bank is in one key respect just like any other bank: its liabilities must be matched by an equivalent value of assets, which can be shown on a balance sheet.
The central bank’s balance sheet
Figure 6.10 shows a simplified version of the balance sheet of one central bank, the Bank of England, as of March 2021. Figure 6.11 gives an historical perspective, showing the composition of Bank of England liabilities since just after the Second World War, in 1946. They are shown as a percentage of nominal GDP so that we can compare them over time.
The Bank of England is the central bank of the United Kingdom of England, Scotland, Wales, and Northern Ireland—although the latter three countries do not get a mention on the banknote.
Financial assets | Liabilities and net worth | ||
---|---|---|---|
Asset purchase facility | 794,143 | Notes in circulation | 86,016 |
Term funding for SMEs | 74,129 | Banks’ reserve balances | 790,041 |
COVID corporate financing facility | 7,929 | Banks’ cash ratio deposits | 11,153 |
Other sterling assets | 49,266 | Other sterling liabilities | 36,131 |
Foreign currency assets | 26,849 | Foreign currency liabilities | 24,260 |
Total liabilities | 947,601 | ||
Equity (= net worth) | 4,715 | ||
Total assets | 952,316 | Total liabilities + equity | 952,316 |
Figure 6.10 Bank of England consolidated balance sheet in GBP (millions), 2021.
The Bank of England also has non-financial assets, such as buildings and land, which appear in full balance sheets. But their value is very small relative to other elements, and is typically excluded from brief versions of the balance sheets.
We have laid out the balance sheet as in previous examples, with financial assets on the left, and liabilities plus net worth on the right.
The liabilities of the central bank
The two main categories of liabilities are banknotes in circulation and the reserves held at the central bank by commercial banks: the two forms of base money we have already discussed. We discuss each category in turn, continuing with the example of the Bank of England.
Notes in circulation
For analysis of this question by the Bank of England, read this article.
The first item on the liabilities side of the Bank of England’s balance sheet is the value of notes in circulation. Figure 6.11 shows the long-term downward trend in the total value of banknotes as a percentage of GDP, reflecting a progressive shift to alternative means of payment. The continuing use of banknotes reflects that a substantial minority a substantial minority of households do not have bank accounts. Another key feature to note is how small banknotes, a liability of the central bank, are in relation to GDP. If you look back at Figure 6.5 you will see that total liabilities in the United States were around 8 times GDP. So banknotes represent a very small fraction of total liabilities in the economy.
Figure 6.11 Bank of England liabilities, % of GDP (1946–2023).
Commercial banks’ reserves
The other major category of central bank liabilities is the deposit accounts held at the central bank by the commercial banks. We call these ‘reserves’ for short.
The balance sheet in Figure 6.10 presents the total amount of reserves as two distinct components (the second and third liabilities on the balance sheet):
- Commercial banks’ reserve account balances: These are deposits by the commercial banks in their accounts at the central bank. The central bank acts as banker to commercial banks, enabling individual banks to pay each other the net amount each bank owed at the end of the day. Before the financial crisis, reserve balances—often referred to as ‘operational balances’—were typically very small amounts. But from 2008 onwards these deposits ballooned in size: in the balance sheet for 2021 they represented around 85% of the Bank of England’s liabilities.
- Cash ratio deposits: Central banks may regulate the minimum level of reserves that commercial banks must hold at the central bank to ensure they have adequate liquidity to meet demands for withdrawal of deposits by customers. These are called ‘cash ratio deposits’ in the UK. But, as Figure 6.10 shows, they represent a very small proportion of total liabilities.
The dramatic growth of commercial bank deposits (that is, reserves) at the Bank of England is shown in Figure 6.11. A similar pattern occurs in many other central bank balance sheets during the period of what is commonly referred to as ‘quantitative easing’ (QE). Before explaining more about QE, we make a very important connection between the government and the monetary base of the economy.
The central bank, the monetary base, and government debt
The central bank’s liabilities—banknotes and the reserve accounts of commercial banks—together form the monetary base. And the central bank is owned by the government. We shall show here that the entire monetary base of the economy is actually a form of government debt.
We already had clues to this on at least some of the banknotes shown earlier. For example, US dollar bills, while issued by the Federal Reserve Board (the central bank of the United States), are signed by the Secretary of the Treasury (an arm of the Federal Government) and the 500-rupee note says ‘Guaranteed by the Federal Government’.
The UK government is explicit about this in a publication, ‘The Whole of Government Accounts’, where it includes both banknotes and coins and the Bank of England’s other liabilities as part of UK government debt. We ignored coins in our earlier discussion of banknotes as a liability of the central bank, because coins are explicitly a liability of the government.
Once we recognize that the monetary base (reserves plus banknotes and coins) are a liability of the government, it is easier to understand QE.
Government bonds and quantitative easing
Figure 6.11 shows that until the global financial crisis of 2007–2009, reserves were relatively insignificant in comparison with other liabilities of the Bank of England. Why have they expanded so much in recent years, both in the United Kingdom and in many other countries?
As explained in Unit 5, when the policy interest rate hit the zero lower bound after the global financial crisis, many central banks sought to boost aggregate demand by pushing down long-term interest rates in a policy called quantitative easing (QE). The main way the central bank did this was to buy government bonds in the bond market, mainly from financial institutions such as pension funds and insurance companies.
When governments need to borrow to finance a deficit in the government budget, they issue bonds. Typically, the buyers are insurance companies or pension funds, which hold government bonds as a safe asset in their investment portfolios, to balance their liabilities to their underlying customers: households. But they are willing to sell them in the bond market, depending on the price.
When the central bank increased its demand for bonds, the price of bonds increased in the bond market. This was indeed the aim: a higher price meant that the fixed payments to bondholders corresponded to a lower interest rate. So while the short-term policy rate was stuck at zero, the interest rate on longer-term bonds fell. (The relationship between the price of a bond and the interest rate is explained further in Section 6.12.)
This QE process shows up in the central bank’s balance sheet because the central bank bought bonds with newly created base money, which the sellers of the bonds deposited in banks. Banks in turn deposited some of these ‘excess reserves’ in their accounts at the central bank, resulting in the recent high levels of bank deposits shown in the central bank’s liabilities in Figure 6.11.
What are the central bank’s assets?
The bonds purchased by the central bank as part of the quantitative easing policy are to be found as the first item on the left-hand side of the Bank of England’s balance sheet in Figure 6.10, with the title ‘Asset purchase facility’ (APF). This is where the total value of UK government bonds (Assets) that were Purchased by the Bank of England is recorded. Before the introduction of QE, the Bank’s total assets (and liabilities) were very much smaller, and government bonds were only a small proportion of assets. But they are now by far the largest proportion: the APF represents over 80% of the total.
These bonds are an asset for the central bank, but a liability for the government. So in March 2021, the UK government owed the Bank of England nearly £800 billion. This was just under half the total value of UK government debt at the time.
QE and government debt
At this point, you may start to wonder what is going on. Almost everywhere in the world, the government owns the central bank. In the UK, the government owns everything that the Bank of England owns and therefore owes itself everything the Bank of England owes it. That being the case, as of March 2021, in effect the UK government owed itself £800 billion!
You might be tempted to think that a debt to yourself is not a debt at all. So does this mean that UK government debt was actually roughly £800 billion less than the official total?
Sadly, no. Because, while the government owed this amount to the Bank of England, at the same time the Bank of England had matching liabilities, which it owed to the private sector, in the form of banknotes and commercial bank reserves. When government bonds are bought by the central bank, the debt does not disappear; it just takes a different form.
Figure 6.10 shows that for the UK, this component of public debt had increased to nearly 30% of GDP in recent years, so it represented a significant proportion of total government debt. What happened was that when the Bank of England’s monetary policy (QE) took the form of purchasing existing government debt (long-term bonds) with new base money, this had the effect of significantly changing the average maturity of its outstanding debt from predominantly long-term debt to give a much bigger role to short-term borrowing. This short-term borrowing takes the form of the increase in bank reserves on which it pays interest. A similar pattern occurred in many other countries.
QE, government debt, and inflation
There have been two unusual episodes of very deep recession this century: following the global financial crisis of 2007–2009 and due to the COVID-19 pandemic of 2020. The normal monetary policy to stabilize an aggregate demand shock and avoid deflation by cutting the policy rate was impossible because of the zero lower bound.
Governments used expansionary fiscal policy to increase aggregate demand and sold long-term bonds to finance this. But in most countries, the central bank ended up buying these bonds via QE, so that effectively most of the borrowing was financed by expanding central bank reserves—and hence by a different form of government debt.
This raises the question: what happens to these reserves and does the increase in government debt (part of which is now in the form of higher bank reserves) cause inflation? This is a hotly disputed question. However, the models we have studied provide useful guidance in answering it.
- Phillips curve
- An inverse relationship between the rate of inflation and the rate of unemployment. It is named after Bill Phillips, who observed the relationship empirically, but it can also be derived from a theoretical model of wage and price setting.
- The central bank will continue to pursue its inflation target, raising the policy interest rate to curb aggregate demand if it produces a positive bargaining gap (taking the economy along the Phillips curve to a higher rate of inflation).
- Commercial banks make a loan (and therefore increase aggregate demand) when they detect a profitable lending opportunity. The presence of high reserves will not itself cause them to make loans. This means that the reserves will simply sit idly in reserve accounts accruing interest.
When QE was adopted as monetary policy, central banks began to pay interest on reserves and that interest rate is the policy interest rate. Extension 6.7 explains why this happened. In the extension, we also explain how a situation of rapidly rising inflation can arise in an economy that does not have an inflation-targeting central bank.
Exercise 6.8 Alternative forms of money?
Not everyone accepts that banknotes are the best form of money. Nearly a hundred years after the convertibility of fiat money (banknotes) into gold was abandoned in most countries, there are still many people who argue that gold should be reinstated as the ultimate measure of value. And in more recent years, cryptocurrency has emerged as a new alternative. Consider these alternatives (gold and cryptocurrency) and how they meet the three functions of money. You may find the following sources helpful:
- Section 10.4 of Carlin, Wendy and David Soskice. 2024. Macroeconomics: Institutions, Instability, and Inequality. Oxford University Press.
- Eichengreen, Barry. 2019. ‘From Commodity to Fiat and Now to Crypto: What Does History Tell Us?’ NBER Working Paper.
Question 6.8 Choose the correct answer(s)
Read the following statements about central banks and choose the correct option(s).
- Commercial banks’ deposits appear as two separate items in the liabilities section: voluntary deposits and required (cash ratio) deposits.
- This approach is known as quantitative easing and it can boost aggregate demand.
- The bonds purchased by the central are still a liability for the government (reserves of commercial banks at the central bank).
- The aim of QE is to prevent deflation. This would only cause inflation to rise above target if the central bank does not raise the policy rate to control aggregate demand. Commercial banks do not increase their lending just because they have high levels of reserves.