Monetary Base
The monetary base, also called base money, high-powered money, or reserve money, is the total stock of money that is created directly by the central bank. It consists of currency in circulation outside the central bank, together with the reserves that depository institutions hold at the central bank. The monetary base is the foundation of the broader money supply, because the banking system can create deposits on the basis of the reserves it holds, and the relationship between the base and broader money is described by the money multiplier.
Components
Currency in circulation is the notes and coins held by the public and by institutions outside the central bank. Reserves are the balances that depository institutions hold at the central bank, which they use to settle payments among themselves, to meet reserve requirements, and to hold as a buffer. Reserves may be held as required reserves, which are mandated, or as excess reserves, which are held voluntarily.
The monetary base is a liability of the central bank, matched on the asset side by holdings of foreign exchange, government securities, loans to financial institutions, and other assets. Changes in the base arise from central bank operations, such as open market purchases and sales of securities, lending to institutions, and intervention in foreign exchange markets, and from flows of funds between the government and the central bank.
The money multiplier
The money multiplier is the ratio of the broad money supply to the monetary base. In the simplest model, the multiplier is the reciprocal of the reserve ratio, so that if institutions hold ten per cent of deposits as reserves, the multiplier is ten, and each unit of base money supports ten units of deposits. The multiplier is therefore a measure of the banking system's capacity to create money from the base.
In practice, the multiplier is more complex and less stable than the simple model suggests. It depends on the reserve ratio chosen by institutions, on the currency drain, that is, the amount of cash the public chooses to hold relative to deposits, and on the demand for excess reserves. Central bank operations, regulatory requirements, and the behaviour of households and firms all influence the multiplier, and it can change over time. Since the global financial crisis, large holdings of excess reserves have lowered measured multipliers in several economies.
Control by the central bank
The central bank controls the monetary base through its operations. Open market operations, in which the central bank buys or sells securities, directly change the quantity of reserves. Lending facilities provide reserves to institutions on request, at a rate set by the central bank. Foreign exchange intervention changes the base when the central bank buys or sells foreign currency, and the resulting impact may be offset by other operations to avoid unwanted changes in the money supply.
Historically, some central banks sought to control the money supply by controlling the base and relying on a stable multiplier. In practice, the instability of the multiplier and the difficulty of controlling the base precisely led many central banks to target interest rates instead, using the base as an instrument to achieve the desired rate rather than as a target. The base remains an important indicator and an instrument, but it is no longer the primary target of policy in most economies.
Significance
The monetary base is significant for several reasons. It is the ultimate source of the money supply, and its growth is related, over long periods, to the growth of nominal income and to inflation. It is a measure of the stance of monetary policy and of the scale of central bank operations, and it is closely watched as an indicator of liquidity conditions. Understanding the base is essential to understanding how central banks create money and how monetary policy is transmitted.
The base also matters for the analysis of financial stability. Large expansions of the base, as occurred during periods of quantitative easing, change the composition of central bank balance sheets and affect the operations of financial markets. The composition of the base, including the split between currency and reserves, provides information about the demand for liquidity and about the behaviour of the public and of institutions, and it is monitored by analysts for signals about conditions in the economy.
Historical development
The concept of the monetary base developed with the understanding of central banking and of the money supply process. Early analyses of money creation focused on the relationship between reserves and deposits, and on the role of the central bank in supplying reserves. The identification of the base as the ultimate source of money, and of the multiplier as the link to broader aggregates, provided a framework for analysing monetary policy and for measuring its stance.
The framework was central to the monetarist approach, which emphasised the control of the money supply as the means of controlling inflation. In that approach, the central bank would target the growth of the money supply and, through it, the growth of nominal income. The approach encountered difficulties as the relationship between money and income became unstable, and central banks turned to interest rate targeting, but the concept of the base remained central to understanding how policy is implemented.
The base and the balance sheet
The monetary base is the liability side of the central bank's balance sheet, and its composition reflects the central bank's assets and operations. Holdings of government securities, of foreign exchange, and of claims on financial institutions correspond to the base plus other liabilities. Changes in the central bank's assets, whether from open market operations, from lending, or from foreign exchange intervention, change the base and affect liquidity conditions.
Understanding the balance sheet is essential to understanding monetary policy. Operations that expand the balance sheet, such as asset purchases, create reserves and increase the base, while operations that shrink it, such as redemptions or sales, reduce it. The composition of the balance sheet, including the maturity and risk of the assets held, affects the central bank's income and its exposure to risk, and it is closely monitored by markets and by analysts.
Measurement and interpretation
The monetary base is measured and published by central banks, with components reported separately for currency and for reserves. The data are used to monitor conditions and to assess the stance of policy, and they are inputs to forecasts and to the analysis of money creation. Interpretation requires attention to the factors that affect supply and demand for the base, including fiscal flows, foreign exchange operations, and the behaviour of institutions.
The base is also used in international comparisons. Differences in the size and growth of the base across countries reflect differences in monetary regimes, in the size of the banking system, and in the demand for currency. Comparisons must account for these differences, and they are most informative when used alongside other indicators of monetary conditions, such as interest rates, credit growth, and inflation expectations.