Keeping an economy prime for growth is definitely a tough balancing act. You have to make sure there is ample cash and credit floating around in the economic system, while making sure that their isn’t too much liquidity out there as well. Too much cash and credit flowing around an economy will give rise to major economic problems like inflation, or the ugly cousin of inflation, hyperinflation. Both are enough to completely destroy an economy and significantly lower the standard of living. So who’s in charge of maintaining the balance? That would be central banks and the policy makers who run them.
If there isn’t enough money in an economy’s money supply, central bankers must consider implementing expansionary monetary policies to infuse an economy with more cash and credit. There are a few ways of doing that. One is to lower interest rates. Another is to lower commercial bank reserve requirements. Another popular way to loosen monetary policy is for a central bank to buy assets and add them to their balance sheets by either reinvesting payments from existing assets or using newly created money.
If a central bank takes too long to infuse an economy in need with additional liquidity, the labor market will suffer, retail sales will decline, the housing market will deteriorate and a host of other economic indicators will show signs of a faltering economy. Disinflation will occur and possibility deflation. If the opposite were to occur and there is too much liquidity in an economy, a central bank would have to enact contractionary monetary policies, which would result in a reduction of an economy’s money supply.
To reduce an economy’s money supply, a central bank can raise interest rates, raise commercial bank reserve requirements and or start selling assets on its balance sheet. You may have an understanding of what interest rates are and what commercial banking reserve requirements are, but do you know what a central bank balance sheet is and the assets contained within?
If you’re an investor, whether it be a real estate, stocks, bonds, commodities or currencies, it is important to know what a central bank balance sheet is as well as know why having too many assets or too few assets on a central bank’s balance sheet is significant. If you don’t know what a central bank balance sheet is, you’re in luck. Because on this page, I will be going over exactly what a central bank balance sheet is and touch a little about the assets stored on it. Ready? Let’s begin.
What is a Central Bank Balance Sheet?
A central bank balance sheet is a document that lists all the assets and liabilities taken on by a central bank. Investors should familiarize themselves with central banks’ balance sheets because it is an excellent place to learn how a central bank has been implementing monetary policy because it shows what a central bank has been buying, selling and holding. It should also be important to everyone because a central bank, which is the institution that is in charge of issuing your currency has the power to destroy the value of your currency. The central bank balance sheet will give you insight on the actions of a central bank. And if you’re a holder of a currency, then you may want to pay attention.
Enough talking. I want to show you a Federal Reserve balance sheet. First up is the assets portion of the Federal Reserve balance sheet.
Notice on the left, under the assets column, how all the FED’s assets are listed out. In the column titled “June 1st, 2011″ is the value amount of each asset. Those number are in the millions of United States dollars, so we’re talking about a significant amount of money. Next up is the liability portion of the FED’s balance sheet.
Central bank balance sheets are always balanced. That’s why they’re called balance sheets.
Central Bank Balance Sheet Size and Its Affect on an Economy
You should now have a good understanding of what a central bank’s balance sheet is and why it is important. Now I want to discuss the repercussions of when a central bank has too many assets on its balance sheet. You may be saying to yourself, “Isn’t it a good thing when a central bank has a large amount of assets on it’s balance sheet?” The answer to that is no. Remember, a central bank balance sheet is always balanced. That means the central bank has just as many liabilities as it has assets.
Central bank liabilities are banknotes and electronic currency in the form of credit. So the more assets a central bank has on its balance sheet, the more cash and credit is circulating in an economy. A big balance sheet is a sign of expansionary monetary policy being implemented. If a central bank’s balance sheet remains too large for an extended amount of time, then inflationary pressures will build. Large balance sheets are very accommodative for economic growth because it makes cash and credit easy to obtain.
The more money available to producers, the more employment opportunities there will be. As more and more people get hired, the more demand there will be for goods and services and the more money consumers can spend. This helps the economy grow. But like I said earlier, inflation can build and become a threat.
But what happens when there are too few assets on a central bank’s balance sheet. Naturally, the complete opposite happens. Inflation becomes more subdued and cash and credit become harder to acquire. A small balance sheet suggests that a central bank has or is currently implementing contractionary monetary policies because its balance sheet has contracted and so has the money supply as too.
I now want to touch briefly on the assets themselves. What are the assets that central banks buy and sell? Those assets are usually investment securities like bonds. Central banks typically buy bonds from their country of origin because they usually the safest investments.