Nearly every country in the world has what is referred to as a central bank.  Unlike commercial banks used by businesses and consumers, central banks serve the needs of their respective federal government.  The most important of these to us is the role central banks play in managing a country’s money supply. 

The Federal Reserve System, the central bank of the United States, was established in 1913.  The Fed (as it’s commonly referred to as) is made up of twelve banks distributed across the United States.  The headquarters though, along with the chairperson and board of governors, is located in Washington DC.  While the Fed exists by act of congress and so at the pleasure of the US federal government, is actually a non-governmental entity.  

Like most central banks, one of the most important tasks of the Fed is the management of the US monetary system.  And to correctly understand this, we must first discuss the idea of a balance sheet. 

A balance sheet is a visual representation of both the assets and liabilities of a company or individual.  For example, the following balance sheet is for Stanley Lee.  He has started a business to invest in collectable comic books.  For seed money, he borrowed $100 from his mother.  With this he purchased a collection of early edition Marvel comics. 

The $100 loan belongs on the right-hand side under liabilities.  Liabilities are financial obligations the business or individual has to someone else.  The comic book collection is an asset and so belongs on the left-hand side. 

The left and right-hand sides should always balance.  And so, if Stanley’s collection were to go up in value, we’d need to add another obligation to the right-hand side – profit owed to Stanley (or owners’ equity technically). 

The Federal Reserve works the same way.  Its balance sheet includes many assets and liabilities.  But we’re interested in two very specific ones.  Let’s say the Fed decides to purchase a bunch of US government bonds from other investors.  Remember, the Fed is a non-governmental entity and so must buy and sell them like anyone else.  Perhaps, it decides to buy $10 million worth.   

The bonds will obviously be added to the left-hand side of the balance sheet.  They’re an asset.  But what’s the offsetting entry.  Well, the Fed generally pays for assets through a form of borrowing.  Essentially it borrows the assets.  And so, it has an obligation to the seller that it carries on its balance sheet. 

But then things get a bit weird.  A fancy name for an IOU is a promissory note.  For example, when you buy a car on credit, you sign a promissory note with the bank (or dealer).  And so, when the Federal Reserve buys bonds on credit it issues a bunch of IOUs, or notes. 

But then what does the original seller of these bonds do with the Fed Reserve notes she or he received in exchange.  Luckily, other people trust the Fed enough to be willing to accept these notes in exchange for other goods.  And so, the seller can use them just like money.  The obligation of the Fed simply changes hands to someone else.  

As a matter of fact, so long as most everyone trusts the Fed and so is willing to accept these notes, they become a kind of de facto money.  In case you haven’t seen one of these Federal Reserve Notes (i.e. IOUs) in person, one is pictured here. 

How does a central bank increase or decrease the money supply?  By buying or selling assets.  When they buy assets and issue new IOUs, they increase the amount of money in circulation.  When they sell assets and are able to therefore eliminate these IOUs, they decrease the amount of money in circulation.  That’s it.  That’s all our money is – central bank IOUs that are backed by financial assets that at best could be sold for…more central bank IOUs.