The Fed's Balance Sheet and the Money Supply

The Fed’s balance sheet

The Federal Reserve, like any bank, has a balance sheet. Its assets are primarily Treasury securities and (since 2008) mortgage-backed securities. Its liabilities are currency in circulation and bank reserves. Together those two liabilities form the monetary base, often denoted $MB$ or $B$:

$$MB \;=\; \text{Currency} \;+\; \text{Reserves}.$$

When the Fed buys $1 billion of Treasuries on the open market, it pays with newly created reserves — both sides of its balance sheet grow by $1B. The monetary base rises by that same $1B. This is the central fact that makes the Fed’s open-market operations a monetary-policy tool.

From base to broad money

The monetary base is small. The stylized deposit-multiplier model below describes transaction money — currency plus checkable deposits, an M1 proxy — because bank lending creates deposits. It is not a structural model of M2. For that stylized aggregate, the ratio of $M1$ to $MB$ is the money multiplier $m$:

$$M1 \;=\; m \cdot MB.$$

In the simple case where banks hold a fraction $r$ of every deposit as reserves and the public holds no currency, repeated re-lending gives the simple deposit multiplier $m_{\text{simple}} = 1/r$. With $r = 0.10$, $1 of base creates $10 of deposits.

The realistic money multiplier

Two leakages shrink the multiplier:

1. The public chooses to hold some currency. Let $C/D$ be the currency-deposit ratio.
2. Banks hold some reserves beyond what’s required (excess reserves). Let $R/D$ be the total reserve-deposit ratio.

The full money multiplier is

$$m \;=\; \frac{1 + C/D}{(C/D) + (R/D)}.$$

Both leakages reduce $m$. After 2008, $R/D$ rose dramatically because the Fed began paying interest on reserves and banks chose to park excess reserves there instead of lending. The multiplier fell, so even though the Fed expanded $MB$ enormously (quantitative easing), the deposit-multiplier channel weakened substantially.

Play with it

Monetary base (MB): $1000BReserve ratio (R/D): 10%Currency ratio (C/D): 0.30Reset

Multiplier m

3.25

Modeled M1

$3250B

Deposits D

$2500B

Currency C

$750B

This stylized transaction-money model uses M1 = m · MB where m = (1 + C/D) / ((C/D) + (R/D)). As banks hold more excess reserves (R/D ↑) or the public holds more cash (C/D ↑), the multiplier shrinks. It does not model M2, whose ratio to the monetary base is a descriptive aggregate rather than this deposit-multiplier identity.

Try raising $R/D$ from 0.10 to 0.30. Notice that the multiplier roughly halves — that’s the QE-era story in one chart.

Where the policy lever is

The Fed uses open-market operations, discount lending, and its balance sheet to influence the supply of reserves and therefore the monetary base. The realized base also reflects currency demand and bank borrowing. The Fed influences $R/D$ indirectly through the interest rate it pays on reserves. It does not control $C/D$ — that’s a household choice driven by trust in banks and the cost of holding cash. This division of control is why monetary-policy transmission can be slow and uncertain.