Base money

What Is Base Money?

Base money, also known as the monetary base or high-powered money, represents the most fundamental component of a country's money supply, directly controlled by its central bank. Within the broader field of Monetary Economics, base money comprises two main elements: all physical currency in circulation (banknotes and coins held by the public) and the reserves that commercial banks hold with the central bank. This measure is critical because it forms the foundation upon which the entire money supply of an economy is built through mechanisms like fractional reserve banking.⁴⁹

History and Origin

The concept of a monetary base is intrinsically linked to the evolution of central banking. Early forms of central banks emerged in Europe during the 17th century, often established to manage government debt and issue currency. The Bank of England, founded in 1694, is a notable example, created as a joint-stock company to purchase government debt and act as a clearing house for commerce.⁴⁸ These early institutions began to consolidate the various instruments used for currency and provide greater financial stability.⁴⁷

In the United States, the need for a stable and elastic currency became particularly apparent after a series of financial panics in the 19th and early 20th centuries, notably the Panic of 1907.⁴⁶ This led to the enactment of the Federal Reserve Act in 1913, establishing the Federal Reserve System as the nation's central bank.⁴⁵ One of the Fed's initial mandates was to provide a uniform and elastic currency that could adapt to economic fluctuations, effectively controlling the monetary base.⁴³, ⁴⁴ Prior to this, the U.S. had experienced periods with different central banking systems, including the First and Second Banks of the United States, which also issued currency and managed reserves. The creation of a unified system allowed for a more centralized management of the nation's currency and bank reserves, which are the core components of base money.⁴² The history and roles of the Federal Reserve are further detailed on the Federal Reserve History website.⁴¹

Key Takeaways

• Base money includes all physical currency in circulation and commercial bank reserves held at the central bank.⁴⁰
• It is directly controlled by the central bank and serves as a primary tool for implementing monetary policy.³⁸, ³⁹
• Changes in base money can significantly influence broader monetary aggregates through the money multiplier effect, though this relationship can vary.³⁷
• Economists often refer to base money as "high-powered money" due to its potential to expand the money supply in an economy.³⁶
• Central banks adjust the monetary base primarily through open market operations.³⁵

Formula and Calculation

The formula for base money (MB) is straightforward, representing the sum of currency in circulation (CC) and bank reserves (R) held by commercial banks at the central bank:³⁴

Where:

• (MB) = Monetary Base
• (CC) = Currency in Circulation (physical currency held by the public)
• (R) = Bank Reserves (deposits held by commercial banks at the central bank, plus vault cash)

For instance, if a country has $100 billion in currency in circulation and $200 billion in bank reserves, its monetary base would be $300 billion. These reserves include both required reserves and any excess reserves banks choose to hold.³³

Interpreting the Base Money

Interpreting base money involves understanding its implications for the broader economy and the central bank's policy stance. An increase in base money typically signifies an expansionary monetary policy, where the central bank aims to stimulate economic growth by increasing the amount of readily available funds in the financial system. Conversely, a decrease often indicates a contractionary policy aimed at curbing inflation.³¹, ³²

However, the relationship between base money and the total money supply is not always linear. While an increase in the monetary base provides banks with more reserves, their willingness to lend and the public's demand for loans ultimately determine how much new money is created through the money multiplier effect.³⁰ Therefore, while the central bank directly controls base money, the overall impact on the economy depends on the behavior of commercial banks and the public.²⁸, ²⁹ Analyzing base money alongside other monetary aggregates like M1 and M2 provides a more complete picture of the economy's liquidity and monetary conditions.²⁷

Hypothetical Example

Consider the central bank of a hypothetical country, "Economia." Economia's central bank decides to increase the monetary base to encourage lending and stimulate its economy. It does this by conducting open market operations, purchasing $500 million worth of government bonds from commercial banks.

1. Central Bank Action: The central bank buys bonds from commercial banks. Instead of paying with existing money, it electronically credits the reserve accounts of these commercial banks by $500 million.
2. Impact on Base Money: The total amount of bank reserves in the system increases by $500 million. Since reserves are a component of base money, the monetary base immediately expands by $500 million.
3. Bank Behavior: With increased reserves, commercial banks now have more funds available to lend. Assuming a reserve requirement, any reserves above this minimum are considered excess reserves. The banks might lower interest rates on loans to attract borrowers.
4. Money Creation: A business takes out a $200 million loan from a commercial bank. When the bank makes this loan, it effectively creates new money as a deposit in the borrower's account. This new deposit becomes part of the broader money supply. The original $200 million in reserves remains in the banking system, potentially enabling further lending and money creation through the multiplier process.

This scenario illustrates how a change in base money, initiated by the central bank, can set in motion a chain of events that influences lending, deposits, and ultimately the overall money supply available in the economy.

Practical Applications

Base money serves as a crucial metric for central banks in executing their monetary policy mandates. By controlling the size of the monetary base, central banks can influence short-term interest rates, which in turn affect long-term rates and overall economic activity.²⁶ For instance, during times of economic slowdown or recession, central banks might increase the monetary base through actions such as quantitative easing, where they purchase large quantities of government securities. This infusion of liquidity aims to reduce borrowing costs and encourage lending and investment, thereby stimulating demand.²⁵

The management of base money is fundamental to achieving macroeconomic objectives such as stable prices, full employment, and sustainable economic growth.²⁴ For example, during the global financial crisis of 2008, major central banks, including the Federal Reserve and the European Central Bank, substantially increased their monetary bases to stabilize financial markets and prevent a severe credit crunch.²³ This strategic expansion of base money was a key measure to ensure banks had sufficient liquidity to meet demand and support the economy. An economic letter from the Bank of England provides further insights into how changes in base money can directly affect aggregate demand.²²

Limitations and Criticisms

While base money is a direct tool for central bank control, its influence on the broader economy has certain limitations. One significant critique, particularly relevant in periods of unconventional monetary policy like quantitative easing, is that a large increase in base money does not always translate into a proportional increase in the broader money supply or credit growth.²⁰, ²¹ Commercial banks may choose to hold excess reserves rather than lend them out, thereby weakening the money multiplier effect.¹⁸, ¹⁹ This can occur if banks are risk-averse, face insufficient loan demand, or if regulatory requirements encourage higher reserve holdings.¹⁷

Furthermore, the effectiveness of controlling the monetary base to influence economic outcomes can be hampered by various factors outside the central bank's direct control. These include the public's preference for holding currency versus deposits, the willingness of banks to lend, and the demand for credit from businesses and households.¹⁶ Monetary policy effects also involve time lags, meaning that actions taken today may only fully impact the economy months or even years later, making precise control challenging.¹⁴, ¹⁵ An analysis from the European Central Bank highlights the weak impact of base money on broader money aggregates in the context of unconventional monetary policy, especially after the 2008 financial crisis.¹³

Base Money vs. Money Supply

Base money and the money supply are distinct yet related concepts in monetary economics. Base money, as defined, is the narrowest measure, consisting only of physical currency in circulation and commercial bank reserves held at the central bank. It represents the foundation of a country's monetary system, directly managed by the central bank.¹²

In contrast, the money supply is a broader concept that includes base money plus other liquid assets held by the public. Standard measures of money supply, such as M1 and M2, encompass various forms of money created largely through the commercial banking system's lending activities. M1 typically includes demand deposits (checking accounts), while M2 expands on M1 by adding savings deposits, small-denomination time deposits, and retail money market mutual funds.¹⁰, ¹¹

The key difference lies in control and breadth: the central bank directly controls base money, whereas the overall money supply is influenced by both central bank actions and the behavior of commercial banks and the public. The relationship between the two is typically described by the money multiplier, where a change in base money can lead to a larger change in the money supply, assuming stable banking and public behavior.⁸, ⁹

FAQs

Q: Who controls base money?
A: The central bank of a country has direct control over its base money. In the United States, this is the Federal Reserve.⁶, ⁷

Q: How does a central bank increase or decrease base money?
A: Central banks primarily adjust base money through open market operations. To increase it, they buy government securities from commercial banks, crediting their reserve accounts. To decrease it, they sell securities, which reduces bank reserves.⁵

Q: Is base money the same as the money supply?
A: No, base money is a component of the total money supply, but they are not the same. Base money is the most liquid form (currency and bank reserves), while the money supply (M1, M2) includes broader forms of money like checking and savings deposits.⁴

Q: Why is base money sometimes called "high-powered money"?
A: It's called "high-powered money" because an increase in base money can lead to a much larger expansion of the overall money supply through the money multiplier process in a fractional reserve banking system.³

Q: What is the relationship between base money and inflation?
A: While changes in base money can influence inflation, the relationship is not always direct. An increase in base money can lead to higher inflation if it results in a significant expansion of the broader money supply and increased spending in the economy. However, if banks hold onto excess reserves or demand for credit is weak, the inflationary impact may be limited.¹, ²