Economic monetary base

What Is Economic Monetary Base?

The economic monetary base represents the foundational component of a nation's money supply, encompassing all physical currency in circulation and the reserves held by commercial financial institutions at the central bank. It is a critical concept within macroeconomics and monetary policy, as central banks exert direct control over its size. The monetary base is also known as "high-powered money" because changes in this aggregate can have a magnified effect on the broader money supply through the money multiplier process.²⁹

Central banks, such as the Federal Reserve in the United States, primarily influence the monetary base through operations like buying or selling government securities, known as open market operations.²⁸ This direct control makes the monetary base a key lever for central banks in managing the economy.

History and Origin

The concept of a monetary base is intrinsically linked to the evolution of central banking itself. Historically, early forms of banking and currency issuance lacked centralized control, often leading to financial instability, panics, and fragmented currency systems. The establishment of national central banks, such as the Bank of England in 1694, marked a significant step in centralizing the control of money.²⁷ These institutions provided governments with access to credit and began issuing standardized banknotes, which formed the precursor to modern physical currency.²⁶

Over time, central banks developed their role as lenders of last resort and supervisors of the banking system, gaining increasing influence over the amount of "base money" in an economy. The Federal Reserve System, created in the United States in 1913, was specifically designed to provide a more stable and flexible financial system, addressing the frequent financial crises and bank runs that characterized the preceding era.²⁵ The Federal Reserve's balance sheet, which includes its liabilities such as currency in circulation and commercial bank reserves, directly reflects the size of the economic monetary base it controls.²⁴ This centralized control mechanism for the monetary base became a cornerstone of modern monetary policy, allowing authorities to influence economic activity.

Key Takeaways

• The economic monetary base is the sum of physical currency held by the public and commercial bank reserves held at the central bank.²³
• It is directly controlled by the central bank, primarily through open market operations.²²
• Changes in the monetary base have a multiplied effect on the broader money supply due to the fractional reserve banking system.²¹
• It serves as a foundational tool for implementing monetary policy goals like controlling inflation and promoting price stability.²⁰
• While central banks control the monetary base, their control over the broader money supply is not absolute, as banks can choose to hold excess reserves.¹⁹

Formula and Calculation

The formula for the economic monetary base is straightforward, encompassing its two primary components:

Where:

• Currency in Circulation (CiC) refers to all physical currency (e.g., banknotes and coins) held by the public outside of the central bank and the vaults of commercial banks.
• Bank Reserves are the balances that commercial banks and other depository institutions hold in their accounts at the central bank, plus the physical currency held in their vaults (vault cash).¹⁸

This formula highlights that the monetary base represents the most liquid liabilities of the central bank.¹⁷

Interpreting the Economic Monetary Base

Interpreting the economic monetary base involves understanding its implications for the broader economy and the transmission of monetary policy. A larger monetary base generally indicates that the central bank has provided more liquidity to the banking system and the public. When the central bank increases the monetary base through actions like buying government bonds, it injects new funds into the financial system, initially boosting bank deposits and reserves.¹⁶

This expansion aims to encourage banks to lend more, thereby increasing the overall money supply and stimulating economic growth. Conversely, a contraction of the monetary base signals a tightening of monetary conditions, which typically leads to higher interest rates and reduced lending.¹⁵ Policymakers and analysts monitor trends in the monetary base (often available from central bank publications, such as the Federal Reserve's H.6 release¹⁴) to gauge the stance of monetary policy and its potential impact on credit availability, spending, and inflation.

Hypothetical Example

Consider the central bank of a hypothetical country, "Economia." Economia's central bank decides to increase the liquidity in its financial system to stimulate lending and economic activity. It announces that it will conduct open market operations by purchasing government bonds from commercial banks.

Suppose the central bank buys \( $100 \) million worth of government bonds from various commercial banks. In exchange for these bonds, the central bank credits the reserve accounts of these commercial banks by \( $100 \) million.

Initial Situation:

• Currency in Circulation: \( $500 \) billion
• Bank Reserves: \( $200 \) billion
• Economic Monetary Base: \( $500 \text{ billion} + $200 \text{ billion} = $700 \text{ billion} \)

After the open market purchase:

• Currency in Circulation: Remains \( $500 \) billion (assuming no immediate change in public holdings).
• Bank Reserves: Increase by \( $100 \) million to \( $200 \text{ billion} + $0.1 \text{ billion} = $200.1 \text{ billion} \)
• New Economic Monetary Base: \( $500 \text{ billion} + $200.1 \text{ billion} = $700.1 \text{ billion} \)

This increase in the economic monetary base provides commercial banks with additional reserves. These reserves can then be used to make new loans, expanding the overall money supply through the money multiplier process, provided banks choose to lend rather than hold excess reserves.

Practical Applications

The economic monetary base is a fundamental concept with several practical applications in the realm of finance and economics. Central banks primarily use their control over the monetary base as a key instrument of monetary policy. By adjusting the monetary base through open market operations, they aim to influence short-term interest rates and the availability of credit in the economy.¹³ For instance, during periods of economic slowdown, a central bank might expand the monetary base to lower interest rates and encourage borrowing and investment, thereby stimulating aggregate demand.

Another application is in the analysis of central bank balance sheets. The liabilities side of a central bank's balance sheet directly reflects the components of the monetary base, offering insights into the central bank's operations and its financial health. The International Monetary Fund (IMF), for example, develops frameworks for stress-testing central bank balance sheets, recognizing the crucial role these balance sheets play in maintaining economic and financial stability.¹²

Furthermore, economists and analysts monitor the monetary base as one of several monetary aggregates to gain insights into liquidity conditions and potential future inflationary or deflationary pressures. While its direct link to broader money supply measures (like M1 or M2) can vary due to factors like bank lending behavior and public currency preferences, it remains a closely watched indicator of the central bank's actions. The Federal Reserve Bank of St. Louis provides extensive economic data, including historical data on the monetary base, which is utilized by researchers and policymakers.¹¹

Limitations and Criticisms

Despite its direct control by central banks, the economic monetary base has certain limitations as a sole indicator or policy target. One primary criticism is that while the central bank can precisely control the monetary base, its influence over the broader money supply is less direct. Commercial financial institutions can choose to hold excess reserves rather than lending them out, especially during times of economic uncertainty or low loan demand.¹⁰ This can weaken the effect of an increase in the monetary base on the overall economy, a phenomenon sometimes observed during periods of quantitative easing.

Moreover, the relationship between the monetary base and economic outcomes like inflation or economic growth can be unpredictable and subject to time lags.⁹ Factors such as changes in the public's desire to hold cash versus bank deposits, and shifts in bank lending behavior, can significantly alter the money multiplier. Consequently, a growing monetary base does not always translate into proportionate growth in the broader money supply or robust economic activity.⁸

Critics also point out that focusing solely on the monetary base overlooks other channels through which monetary policy affects the economy, such as expectations about future interest rates and financial conditions. Some argue that central banks cannot permanently increase the rate of economic growth or lower unemployment through monetary expansion and that an overreliance on increasing the monetary base can lead to distortions and inflation.⁷ The effectiveness of controlling the monetary base as a policy tool has also been debated, particularly in environments with ample reserves or at the zero lower bound for interest rates.⁶

Economic Monetary Base vs. Money Supply

The terms "economic monetary base" and "money supply" are often used interchangeably, but they refer to distinct yet related concepts in monetary policy. The key distinction lies in their components and the degree of central bank control.

The economic monetary base forms the foundation upon which the larger money supply aggregates are built. The central bank's actions to increase or decrease the monetary base are intended to cascade through the banking system, affecting lending, and ultimately, the overall money supply. However, the extent to which this "cascading" occurs depends heavily on the decisions of commercial banks regarding their reserves and the public's demand for currency versus bank deposits.

FAQs

What is the primary purpose of the economic monetary base?

The primary purpose of the economic monetary base is to serve as the foundational component of the money supply that a central bank directly controls. By managing the monetary base, central banks aim to influence credit conditions, interest rates, and the overall level of economic activity to achieve goals such as price stability and full employment.⁴

How does the central bank control the monetary base?

A central bank primarily controls the monetary base through open market operations. To increase the monetary base, it buys government securities from commercial banks or the public, crediting their accounts at the central bank (increasing reserves) or issuing new physical currency in circulation. To decrease it, the central bank sells securities, thereby reducing bank reserves.³

Is the monetary base the same as the money supply?

No, the monetary base is not the same as the total money supply. The monetary base is a narrower measure, consisting only of physical currency in circulation and commercial bank reserves held at the central bank. The money supply (M1, M2, etc.) includes broader categories of money, such as checking and savings bank deposits, which are created through the lending activities of commercial banks based on the monetary base.²

Why is the monetary base called "high-powered money"?

The monetary base is referred to as "high-powered money" because a change in its size can have a much larger impact on the overall money supply through the money multiplier effect. This occurs because commercial banks can lend out a significant portion of their reserves, which then get redeposited, leading to further lending and money creation throughout the banking system.¹