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$$1$B. The monetary base rises by that same$$1$B. 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 actual money supply (M1, M2) is much larger because banks lend out a fraction of every deposit, and those loans become new deposits at other banks. The ratio between $M$ and $MB$ is the money multiplier $m$:

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

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), $M$ rose much less than $MB$ did.

Play with it

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

Multiplier m

3.25

Money supply M

$3250B

Deposits D

$2500B

Currency C

$750B

Money supply M = 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. This is why QE's effect on M depends on what banks do with the new reserves.

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 directly controls $MB$ (through open-market operations, discount lending, and the size of its balance sheet). It 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.