When the gold standard was in operation, central bank balance sheets comprised mostly gold, some government bonds and private bills. In 1940, just before the US entered World War II, the Fed’s balance sheet reached a historic peak of 23% of GDP, of which 85% of assets were gold certificates, due to gold inflows from war-torn Europe. Its composition shifted to more government bonds to finance the US government’s fiscal deficit arising from explosive wartime military spending.
Central banks were created to deal with crises. The first, Sveriges Riksbank, was founded in 1668 to deal with a Swedish banking collapse. The Bank of England was founded in 1694 to finance Britain’s war against France. The US Federal Reserve (Fed) banking system was created in 1913 to manage a volatile money supply generated by cycles of banking panics or excess liquidity.
Today, without gold as the anchor of value, money is created mostly by government debt or private credit. Since the private sector hardly borrows from the central bank, most of the central bank’s monetary creation is driven by government debt. Essentially, the central bank uses its balance sheet to manage the money supply and interest rates, thereby influencing the real economy.
