Monetary base

What Is Monetary Base?

The monetary base, often called "high-powered money" or "base money," is the total amount of a currency that is either in circulation among the public or held as bank reserves at the central bank⁴². It represents the most liquid forms of money in an economy and forms the foundation upon which the broader money supply is built through the process of fractional reserve banking. In the realm of macroeconomics, understanding the monetary base is crucial for grasping how central banks influence economic activity, including inflation and economic growth⁴⁰, ⁴¹. The monetary base is a direct liability of the central bank.

History and Origin

The concept of a monetary base is intrinsically linked to the evolution of central banking itself. Early central banks, like the Bank of England established in 1694, began to formalize the issuance of banknotes, which served as a form of the monetary base, often backed by commodities like gold³⁹. Before the establishment of formal central banks, currency often comprised various forms of notes issued by private banks, leading to instability. The need for a stable and uniform currency system, especially in growing industrial economies, spurred the creation of national central banks with a monopoly on currency issuance.

In the United States, the formation of the Federal Reserve System in 1913 was a pivotal moment. Prior to its establishment, the nation experienced a series of banking panics due to the absence of a centralized authority to provide liquidity and manage the money supply³⁸. The Federal Reserve was created to address these issues, tasked with providing an "elastic currency" and serving as a "lender of last resort," thereby taking direct control over the nation's monetary base³⁶, ³⁷. Over time, particularly after the abandonment of the gold standard, the central bank's influence over the monetary base became a primary tool for conducting monetary policy.

Key Takeaways

• The monetary base consists of physical currency in public circulation and commercial bank reserves held at the central bank.³⁵
• It is directly controlled by a nation's central bank, typically through tools like open market operations.³⁴
• The monetary base is also known as "high-powered money" because it forms the foundation for the broader money supply through the money multiplier effect.³³
• Changes in the monetary base can influence inflation, interest rates, and economic growth.³¹, ³²
• While a critical component, the monetary base is a narrower measure compared to broader money supply aggregates like M1 and M2.³⁰

Formula and Calculation

The monetary base (MB) is calculated as the sum of currency in circulation (C) and total bank reserves (R) held by commercial banks at the central bank²⁹.

The formula is expressed as:

Where:

• $MB$ = Monetary Base
• $C$ = Currency in Circulation (physical currency held by the non-bank public)
• $R$ = Bank Reserves (vault cash held by banks plus deposits by banks at the central bank)

For instance, if a country has $100 billion in currency circulating among the public and commercial banks hold $50 billion in reserves at the central bank, the monetary base would be $150 billion.

Interpreting the Monetary Base

Interpreting the monetary base involves understanding its role as the foundation of the financial system and an indicator of central bank policy. An increase in the monetary base suggests an expansionary monetary policy, where the central bank is injecting more liquidity into the banking system. This typically occurs through actions such as purchasing government securities via open market operations, which increases bank reserves²⁸.

Conversely, a decrease in the monetary base indicates a contractionary policy aimed at reducing liquidity. While the monetary base is a fundamental measure, economists often look at broader aggregates like M1 and M2 (which include demand deposits and savings accounts) for a more comprehensive view of the money supply available for spending in the economy²⁷. However, the monetary base remains crucial because the central bank has direct control over it, influencing the lending capacity of banks and, by extension, the overall economy.

Hypothetical Example

Consider the central bank of a hypothetical country, "Financia." To stimulate the economy, Financia's central bank decides to inject more money into the system. It does this by purchasing $100 million worth of government bonds from commercial banks through open market operations.

Here's how this impacts the monetary base:

1. Initial State: Before the operation, Financia's monetary base consists of $500 million in currency in circulation and $200 million in bank reserves.

   • MB = $500 million (C) + $200 million (R) = $700 million.

2. Central Bank Action: The central bank buys $100 million in bonds from commercial banks. In return, it credits the banks' reserve accounts at the central bank by $100 million.

   • Currency in circulation remains unchanged for now.
   • Bank reserves increase by $100 million, from $200 million to $300 million.

3. New Monetary Base:

   • MB = $500 million (C) + $300 million (R) = $800 million.

Through this action, the monetary base has expanded by $100 million. This increase in bank reserves provides banks with more funds that they can lend out, potentially leading to an increase in the broader money supply through the money multiplier effect.

Practical Applications

The monetary base is a critical input for policymakers and analysts in understanding and influencing economic conditions. Central banks primarily use it as a lever for implementing monetary policy. By adjusting the monetary base, they aim to achieve macroeconomic objectives such as price stability, full employment, and sustainable economic growth²⁶.

Key applications include:

• Influencing Interest Rates: An increase in the monetary base often leads to lower short-term interest rates as banks have more reserves available to lend, increasing the supply of funds in the interbank market. Conversely, reducing the monetary base tends to push interest rates higher.
• Controlling Inflation: Central banks can use the monetary base to manage inflation. If inflation is too high, they can reduce the monetary base to curb spending. If inflation is too low or deflation is a concern, expanding the monetary base can stimulate demand²⁵.
• Quantitative Easing and Tightening: During periods of economic crisis, central banks might engage in large-scale asset purchases (known as quantitative easing) to significantly expand the monetary base and provide liquidity when conventional interest rate tools are exhausted²⁴. The reverse process, quantitative tightening, involves reducing the monetary base.
• Indicator of Bank Liquidity: The level of bank reserves, a component of the monetary base, provides insight into the liquidity position of the banking system. Sufficient reserves ensure banks can meet withdrawal demands and facilitate interbank transactions.

The Federal Reserve, for example, reports detailed data on money stock measures, including the monetary base, which are used by economists and financial professionals to assess the state of the economy and anticipate policy changes. This data is regularly updated and published on the Federal Reserve Board's website.²³

Limitations and Criticisms

Despite its importance, the monetary base has limitations and faces criticisms as a sole measure for gauging economic conditions or controlling the broader money supply.

One primary limitation is that the relationship between the monetary base and the overall money supply is not always stable or predictable. While central banks directly control the monetary base, the ultimate impact on the money supply depends on the behavior of commercial banks (their willingness to lend out excess reserves) and the public (their willingness to borrow and hold deposits)²². During periods of economic uncertainty, banks may choose to hold onto more reserves rather than lend, leading to a weak or ineffective money multiplier effect²¹. This phenomenon can result in a "liquidity trap," where increasing the monetary base does not stimulate lending or economic activity because interest rates are already near zero¹⁹, ²⁰.

Critics also point out that focusing solely on the monetary base overlooks other factors that influence economic activity, such as fiscal policy, consumer confidence, and global economic conditions. Furthermore, the effectiveness of monetary policy and control over the monetary base can be constrained when interest rates hit their zero lower bound, limiting the central bank's ability to stimulate the economy further through conventional means¹⁸. The Cato Institute discusses these limitations, noting that the Federal Reserve's direct control over the monetary base does not guarantee perfect control over economic outcomes like employment or long-run economic growth.¹⁷

Monetary Base vs. Money Supply

The monetary base and money supply are related yet distinct concepts in finance and economics, often a source of confusion. The fundamental difference lies in their scope and what they measure.

In essence, the monetary base is the raw material (currency and central bank reserves) that the central bank issues, while the money supply is the total amount of money circulating within the economy, including the money created by commercial banks through lending based on those reserves.⁶

FAQs

What is "high-powered money"?

"High-powered money" is another term for the monetary base. It's called this because it serves as the foundation for the creation of a much larger amount of money in the economy through the fractional reserve banking system. A small change in the monetary base can lead to a multiplied change in the overall money supply.⁵

How does a central bank change the monetary base?

A central bank primarily changes the monetary base through open market operations, which involve buying or selling government securities. When the central bank buys securities, it pays by crediting the bank reserves of commercial banks, thereby increasing the monetary base. When it sells securities, it debits those accounts, reducing the monetary base.⁴

Why is the monetary base important for the economy?

The monetary base is important because it is the fundamental tool through which a central bank influences the availability of credit and the overall level of economic activity. By controlling the monetary base, the central bank can impact interest rates, inflation, and ultimately, economic growth.², ³

Does the monetary base include all the money in my checking account?

No, the monetary base does not include the money in your checking account. Your checking account balance is part of the broader money supply (specifically M1). The monetary base only includes physical currency in circulation (like cash in your wallet) and the reserves that banks hold at the central bank.¹