Central bank money

Central bank money is a liability on the balance sheet of the central bank that is held as a credit balance in the holder's account at the central bank or as a physical object and is denominated in units that are given the name that defines the currency. The sovereign political authority defines it as legal tender and entrusts the central bank with the power of issuing it as sole supplier.

As a physical object, central bank money is called cash or currency and consists of banknotes and coins (note that coins are typically issued directly by the treasury office of governments). Cash provides a means of extinguishing debt with no intermediary and is typically preferred for small-value payments when the transaction cost of alternative means is proportionally large or to prevent the tracing of transactions when parties desire anonymity of payment for privacy, tax evasion or other illegal reasons.

The quantity of cash outstanding at any given time includes cash in circulation held by the non-bank public and vault cash in banks' storage. This quantity is demand-driven: the central bank supplies cash to the banks to remove unfit notes and coins and to meet bank clients' requests. When banks need more cash to meet the public's demand, they request it from the central bank and have their accounts at the central bank debited for that amount. When banks hold more cash than desired, they return it to the central bank, which in turn credits their accounts.

In countries where the banking system is sufficiently developed, cash is a less common settlement asset than bank deposits. As bank deposits (that is, commercial bank money) are a liability of banks, confidence in bank deposits lies in the ability of the banks to convert, upon demand, their sight liabilities into the liabilities of another bank and/or into cash at par. Depositors' confidence in banks' ability to fulfil this function depends on banks having access to central bank funding and, in cases of bank insolvency that prevent access to funding, by credible bank deposit insurance protection.

In the form of a credit balance, central bank money is a claim on the central bank that may be held only by a limited range of entities for which central bank accounts are avail- able, typically including licensed banks, the government, foreign central banks and inter- national financial institutions such as the International Monetary Fund. Credit balances are added (to wit, credited to holders' accounts) or drained (that is, debited from holders' accounts) exclusively in conjunction with each and every payment that the central bank makes to or receives from account holders. Any holder's balance is a settlement asset that can be used only with other authorized holders or directly with its issuer, namely the central bank. As cash circulates freely in the non-bank private sector, while credit bal- ances do not, only cash in circulation is considered a component of the money supply.

The political authority may decide to peg central bank money to an asset such as gold or a foreign currency at a fixed price, thus making central bank money redeemable in the asset backing the currency at a fixed conversion price. When no commitment of this kind exists, central bank money is said to be based on a fiat paper standard.

Credit balances held by banks in their reserve accounts are called bank reserves. Accordingly, bank reserves are a component of overall credit balances at the central bank. Bank reserves are typically included in the monetary base, along with currency in circulation. Banks use these assets as settlement balances with other banks through the interbank funds transfer system or they loan them to other banks. Although the term "reserves" suggests the notion of funds set aside for future contingencies, banks use such reserves daily to fund payments that are typically many times larger than their outstanding overnight balances.

The overall amount of bank reserves varies in response to every payment banks make to or receive from the central bank or other non-bank holders of central bank money, notably the government. For example, government spending adds to bank reserves, while tax payments and newly issued government securities drain bank reserves. These opera- tions, combined with banks' demands for banknotes, typically produce a reserves deficit of the banking sector vis-à-vis the central bank. This structural liquidity deficit can be further enlarged if the central bank imposes binding reserve requirements (Borio, 1997). With a reserve deficit in the banking sector, the central bank can use its monopoly of the supply of central bank money to dictate the terms on which it is willing to relieve the shortage by lending central bank money (Allen, 2004). Likewise, holding central bank money may be costly to banks. If the marginal opportunity cost of holding overnight reserves - that is, the revenue forgone by a bank when it does not lend out its excess reserves - is positive, banks will aim to minimize their holdings of reserves with the central bank by end of day. Alternatively, if the central bank adopts a floor system, the marginal cost of reserves is zero and banks become indifferent between holding reserves and lending them in the interbank market (Goodfriend, 2002).

Because it can supply bank reserves in any demanded amount, the central bank acts as the lender of last resort when banks are subject to a liquidity shock. This function of providing bank reserves, however, can be limited through collateral and borrowing con- straints, as well as monetary financing prohibitions (Bindseil and Winkler, 2013).

When central bank money is backed by an asset that the central bank cannot supply in unlimited quantity, the latter can become a "safe haven" asset and the central bank itself can become subject to a liquidity shock. In such a situation, bank lending becomes con- strained by reserves in the asset backing central bank money, and the central bank loses its discretionary power to fix the interest rate.

See also:

Bank deposits; Cash; Fiat money; Lender of last resort; Money and credit; Money multiplier; Money supply; Reserve requirements; Settlement balances; State money.