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20 CHAPTER 1. SOME INSTITUTIONAL BACKGROUNDif the home country spends less abroad than it receives there will bea privately determined excess supply of foreign exchange. The centralbank can absorb the excess supply by accumulating foreign exchangereserves. Changes in the central bank’s foreign exchange reserves arerecorded in the official settlements balance, which we argued above isthe balance of payments. Central bank foreign exchange reserve lossesare credits and their reserve gains are debits to the official settlementsaccount.1.3 The Central Bank’s Balance SheetThe monetary liabilities of the central bank is called the monetary base,B. It is comprised of currency and commercial bank reserves or depositsat the central bank. The central bank’s assets can be classiÞed into twomain categories. The Þrst is domestic credit, D. In the US, domesticcredit is extended to the treasury when the central bank engages inopen market operations and purchases US Treasury debt and to thecommercial banking system through discount lending. The second assetcategory is the central bank’s net holdings of foreign assets, NFA cb .These are mainly foreign exchange reserves held by the central bankminus its domestic currency liabilities held by foreign central banks.Foreign exchange reserves include foreign currency, foreign governmentTreasury bills, and gold. We state the central bank’s balance sheetidentity asB =D+NFA cb . (1.22)Since the money supply varies in proportion to changes in the monetarybase, you see from (1.22) that in the open economy there aretwo determinants of the money supply. The central bank can alter themoney supply either through a change in discount lending, open marketoperations, or via foreign exchange intervention. Under a regimeof perfectly ßexible exchange rates, ∆NFA cb = 0, which implies that,the central bank controls the money supply just as it does in the closedeconomy case.