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.

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

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.

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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.

Extension 6.7 The central bank and monetary policy

As explained in Unit 5, in many countries, governments have delegated responsibility for monetary policy to central banks, which choose the policy interest rate to adjust aggregate demand in order to achieve an inflation target set by the government. In this extension, we first explain how the central bank actually sets the interest rate it has chosen. We then consider the relationship between monetary and fiscal policy, and what can happen to inflation without central bank independence.

Setting the policy interest rate

Inflation-targeting central banks typically have a monetary policy committee which meets regularly to adjust the policy interest rate in accordance with the principles set out in Unit 5. They announce the policy rate following the meeting. The central bank can set any policy interest rate it chooses. What mechanisms allow the announced policy rate to be implemented throughout the economy? We explain two methods used in the recent past.

• In the first method, the central bank ensures that commercial banks’ demand for reserves is equal to the supply (which the central bank controls) at exactly the policy interest rate. The central bank does not pay interest on reserves.
• In the second method, it controls the policy rate directly because it pays interest on reserves and that interest rate is the policy interest rate.

We shall learn that both methods depend—in different ways—on the fact that there is a demand for reserves from commercial banks, which only the central bank can create. (It has a monopoly on the supply of reserves.)

Scarce reserves regime—before the financial crisis and QE

In this regime, banks will hold the minimum level of reserves they can to satisfy their needs for their interbank operations and liquidity purposes. Recall that commercial banks have to have reserves to clear balances with other banks (operational purposes) and to convert to currency when customers withdraw their deposits (liquidity purposes). Commercial banks also pay the policy rate in interest to the central bank when borrowing.

There is a downward-sloping demand curve for reserves by commercial banks, shown in Figure E6.1a. The central bank controls the supply of reserves and it is therefore not sensitive to the policy rate. The policy rate is fixed at the point where the vertical supply curve intersects the downward-sloping demand curve, as shown in the left-hand panel of Figure E6.1.

The right-hand panel shows what happens if the policy rate is \(i_H\) and the central bank wishes to stimulate aggregate demand. It announces a lower policy rate, \(i_L\). This raises the demand for loans from households and firms. Banks respond by supplying more loans, and they demand somewhat more reserves to maintain their liquidity. The curve is steep because banks don’t want to adjust their reserves a great deal when the interest rate falls. To bring about the fall in the policy rate it has announced, the central bank responds to the increase in demand for reserves by increasing the supply (by buying bonds), thereby ensuring that the market for reserves clears (that is, demand = supply) at the new lower policy rate.

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Figure E6.1a Determining the policy rate when reserves are scarce.

Ample reserves regime—since the financial crisis and QE

As a result of QE, commercial bank reserves ballooned. Remember that only banks can have reserve accounts and while any single bank could get rid of reserves by buying bonds, another bank would then have more reserves. The total supply of reserves in the economy is fixed at any point in time by the central bank.

In Figure E6.1b, the supply of reserves is shown by the vertical red line, while the double-headed arrow shows the excess reserves (supply > demand).

In this regime, the central bank can only change the policy rate by changing the interest rate it pays on reserves. Here, the demand for reserves does not respond to the interest rate because banks already have more than enough reserves. This means that the demand curve for reserves is horizontal at whatever policy rate the central bank decides to set. For example, an announcement by the central bank of an increase in the policy rate from \(i_L\) to \(i_H\) will reduce aggregate demand and increase the extent of excess reserves.

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Figure E6.1b An ample reserves regime.

The relationship between monetary and fiscal policy: Government debt and hyperinflation

When monetary policy succeeds in controlling inflation at a target rate, whether in the scarce or ample reserves regime, the real value of banknotes is stabilized and their role as a unit of account is maintained. But once we take into account that banknotes (and base money as a whole) are really just a particular kind of government debt, it becomes clear that we cannot separate out the role of money from fiscal policy. Trust in the central bank as the supplier of money requires trust in the viability of the government as a debtor.

This linkage is often crucial in situations of high or very high inflation (called hyperinflation). If a government increases its borrowing and raises spending to keep unemployment below equilibrium, inflation will go up, as described in Unit 4. An independent inflation-targeting central bank will counteract this by raising the policy interest rate. But if there is no independent central bank and fiscal policy continues to prioritize higher spending, inflation will continue to rise. The government will find it increasingly difficult to fund its higher spending because domestic and foreign lenders from whom it would have to borrow will become increasingly sceptical about its credibility as a borrower. No one will want to buy government bonds.

There is a way out of this immediate problem for a government that prioritizes higher spending over stabilizing inflation. The government owns the central bank and the government can require the central bank to lend to it by buying newly issued government bonds; the central bank can create new base money to do this. In this economy, one form of government debt (bonds) is being replaced by another (base money).

Remember the crucial difference between QE undertaken by an independent inflation-targeting central bank to stabilize aggregate demand, and the motivation (in this case, of the government) to prioritize its spending irrespective of its effect on inflation.

But eventually, as inflation rises higher and higher, people will not only refuse to buy government bonds; they will also refuse to hold the other form of government debt, banknotes, which are becoming increasingly worthless. In situations like this, we often observe people switching to the use of another currency such as the US dollar.

The linkage between government debt and hyperinflation is explored further in Unit 7.