The monetary base refers to the amount of cash circulating in the economy. It is composed of two parts: currency in circulation and bank reserves. Currency in circulation refers to banknotes and coins held by the public – money we use in our everyday lives. Bank reserves are cash deposits that financial institutions hold in their accounts at the central bank.
The two components above account for an economy’s most liquid assets – cash and cash deposits. Overall, the monetary base provides a measure of how much cash currency is circulating in the economy.
The monetary base refers to the amount of cash circulating in the economy.
The monetary base is composed of two parts: currency in circulation and bank reserves.
Not to be confused with the money supply, the monetary base does not include non-cash assets, such as demand deposits, time deposits, or checks.
Understanding the Monetary Base
The monetary base is usually measured by the central bank, which controls the circulation of currency in the economy. It’s easy to think of the monetary base as the physical money in the economy, whether it’s in your wallet or the vault of a bank.
Not to be confused with the money supply, the monetary base only includes cash and cash deposits, such as banknotes, coins, cash held by commercial banks, and cash held in bank reserves. In some instances, the monetary base can also be referred to as M0, money base, or base money.
Monetary Base vs. Money Supply
In comparison to the money supply, the monetary base only includes currency in circulation and cash reserves at a bank. In contrast, the money supply is a broad term that encompasses the entire supply of money in a country.
Money supply includes fewer liquid assets, such as demand deposits (money in a checking account), time deposits (CD, GIC), or checks. The assets will be included in the money supply but not in the monetary base. Therefore, we can view the money supply as an extension of the monetary base.
Importance of the Monetary Base
Central banks can increase or decrease the monetary base through various forms of monetary policy. For many central banks, the monetary base is increased through the purchase of government bonds, also known as open market operations. By purchasing bonds from commercial banks, the central bank can replace the illiquid bonds with a cash deposit in the bank’s reserve account.
Central banks can also increase the reserve requirements, which are the requirements on how much cash banks must keep in their reserve accounts. As a result of increasing the cash supply, market interest rates will decrease.
Therefore, adjusting the monetary base is another tool that central banks use to modify interest rates. By using monetary policy to maintain the monetary base, central banks can also ensure that a steady supply of cash is always available for use.
Let’s suppose that the fictional country of Anko owns $250 million in banknotes and coins circulating for public use. The commercial banks also got $100 million in cash held in their vaults and $150 million in cash reserves held in Anko’s central bank. In total, Anko’s monetary base would be $500 million.
Now suppose the Central Bank of Anko decides to increase the monetary base by buying back some government bonds. If the central bank repurchases $50 million worth of bonds, they deposit $50 million in cash into a bank’s reserve account. It will increase the country’s monetary base by $50 million to a total of $550 million.