Decomposition of high-powered money and its importance

High powered money (HPM), also called reserve money or the monetary base, forms the foundation of a country's money supply. It includes currency held by the public and reserves of commercial banks with the central bank. From the sources perspective, high powered money is created by the central bank through the assets it holds, and its level changes as the central bank conducts various domestic and foreign operations. Understanding the decomposition of HPM by sources helps students and policymakers analyze the factors that influence money supply growth and inflation in an economy.

The major sources of high powered money are grouped into two broad categories: Net Foreign Assets (NFA) and Net Domestic Assets (NDA). These are the assets of the central bank that determine how much money it has injected into the economy.

Net Foreign Assets (NFA)

Net Foreign Assets refer to the net claims of the central bank on the rest of the world. It includes foreign currency assets and gold reserves held by the central bank, minus any foreign liabilities. NFA rises when a country has a balance of payments surplus—such as through exports, foreign aid, remittances, or foreign investment—which leads to an accumulation of foreign exchange reserves.

Components of NFA include:

• Foreign Currency Reserves: These are mainly held in internationally traded currencies like USD, EUR, or GBP, and are used to maintain exchange rate stability or to meet external debt obligations.
• Gold Reserves: Central banks often hold gold as a safe and liquid store of value.
• Special Drawing Rights (SDRs): These are international reserve assets allocated by the International Monetary Fund (IMF).
• Foreign Securities: The central bank may invest in bonds issued by foreign governments.
• Foreign Liabilities: This includes borrowings from international institutions like the IMF, foreign deposits in the central bank, or obligations arising from swap agreements.

NFA = Total Foreign Assets – Foreign Liabilities. An increase in NFA generally leads to an increase in high powered money.

Net Domestic Assets (NDA)

Net Domestic Assets are the central bank’s claims on the domestic economy, primarily through lending to the government and financial institutions. If the central bank buys government securities or extends credit to banks, it injects base money into the system.

Components of NDA include:

1. Net Credit to Government:
   • Loans and advances to the central government (e.g., through Ways and Means Advances or overdraft facilities)
   • Holdings of government securities (T-bills, bonds, etc.)

   This is often referred to as monetization of fiscal deficit and is a major driver of inflation if excessive.

2. Net Credit to Commercial Banks and Financial Institutions:
   • Refinance facilities (short-term credit to commercial banks)
   • Liquidity adjustment operations (e.g., repos)
   • Emergency support during banking stress
3. Other Domestic Assets:
   • Accrued interest income
   • Holdings of non-government bonds
   • Fixed assets of the central bank
   • Claims on cooperative banks or rural financial institutions
   • Loans to employees
4. Minus: Other Liabilities and Capital (OLC):
   • The central bank’s capital
   • Provisions and reserves (for exchange rate revaluation, bad debts, etc.)
   • Miscellaneous liabilities (deferred payments, suspense accounts)

   These items do not contribute to money creation and are therefore deducted from the total assets.

Net Domestic Assets = Domestic Credit to Government + Credit to Banks + Other Assets – Other Liabilities and Capital

The Full Equation

Putting everything together, the sources-side decomposition of high powered money is:

HPM = Net Foreign Assets (NFA) + Net Domestic Assets (NDA)

Or in expanded form:

High Powered Money = (Foreign Currency + Gold + SDRs – Foreign Liabilities)
                    + (Credit to Govt + Credit to Banks + Other Assets – Other Liabilities)

This structure shows how the central bank expands or contracts the monetary base. For instance, when the central bank purchases foreign currency (accumulating NFA), it injects rupees into the economy. Similarly, when it lends to the government or banks, it increases NDA and hence expands reserve money.

Why Decomposition of High Powered Money Matters for Policymakers

Understanding the decomposition of high powered money (HPM) by sources is critically important for policymakers, especially central bankers and fiscal authorities, for several key reasons:

1. Guides Monetary Policy Decisions

Policymakers use the decomposition to monitor whether the expansion in reserve money is being driven by foreign inflows (NFA) or domestic credit (NDA). This helps determine the appropriate monetary policy stance:

• If NFA is rising rapidly, it may be due to remittances, foreign aid, or capital inflows—possibly leading to excess liquidity.
• If NDA is rising, it may be because the central bank is financing fiscal deficits or bailing out financial institutions—potentially more inflationary.

→ Knowing the source allows central banks to decide whether to tighten or loosen policy, use open market operations, or adjust reserve requirements.

2. Inflation Control

Excessive growth in high powered money—especially via net credit to government—can fuel inflation. By analyzing the decomposition, policymakers can:

• Detect early warning signs of inflationary pressures
• Curb deficit monetization by limiting central bank credit to the government
• Sterilize foreign inflows if necessary (e.g., through bond sales)

3. Understanding Money Supply Dynamics

High powered money is the base from which the total money supply is generated via the money multiplier. If reserve money expands, and banks are lending actively, broad money will grow rapidly. Policymakers use this to:

• Forecast money supply growth
• Monitor liquidity conditions
• Coordinate with fiscal authorities to align money growth with real output

4. External Sector Management

A rise in NFA often reflects a balance of payments surplus or strong remittance inflows. While this boosts reserve money, it can also cause:

• Exchange rate appreciation
• Imported inflation if not sterilized
• Challenges in maintaining a fixed exchange rate

→ Understanding the NFA component helps policymakers design intervention strategies in the forex market and plan reserve management.

5. Fiscal-Monetary Coordination

If the central bank is financing large government deficits (i.e., NDA rising due to credit to government), it raises concerns about fiscal dominance. This undermines monetary independence and leads to:

• Inflation expectations
• Erosion of central bank credibility
• Reduced effectiveness of interest rate policy

→ By tracking NDA, policymakers can push for greater fiscal discipline and maintain central bank autonomy.

6. Crisis Management and Financial Stability

During financial crises or liquidity shortages, the central bank might expand NDA by lending to banks or other institutions. Monitoring NDA allows:

• Timely liquidity support
• Transparency in emergency lending
• Ensuring short-term actions do not destabilize long-term price stability

In Summary:

For policymakers, decomposing high powered money is not just a technical exercise—it’s a diagnostic tool. It reveals how and why money is entering the system, highlights inflation risks, informs monetary interventions, and ensures better coordination between central banks, the government, and external sector management.