Monetary Base
It consists of two main entities: the currency in circulation and bank reserves.
What is the Monetary Base?
Money constantly circulates within the public, private sectors, and commercial banks in a revolving economy. In other terms, the cash circulating in the economy is widely known as the monetary base.
The base consists of two main entities: the currency in circulation and bank reserves. The currency in circulation is simply paper money and coins used by the public.
Bank reserves are considered the financial institution's central bank, where cash is held for commercial banks. The bank reserves also manage the central bank to control an economy's price stability.
Many countries around the world abide by this management, a few of which are well-known central banks, namely:
- The Federal Reserve (US)
- The European Central bank
- The Bank of England
- The Deutsche Bundesbank
- The Bank of Japan
Key Takeaways
- The monetary authority can alter the monetary base through economic activity through transactions or power over the monetary policy.
- Significant reduction in employment rates creates an economic shift in the job market and money supply.
- Reserve requirements are crucial to upholding base money for the public and
- banking needs.
- Ultimately, the base is regulated and controlled through monetary policy and the economic goal set in place.
Understanding the Monetary Base
Within these regulated bank reserves are restrictions on money handling and conversion. For example, bank reserves only accept cash or any liquidated assets. However, one exception to money conversion would be government bonds.
In the rare occurrence that money is converted, government bonds like savings bonds, treasury notes, and treasury inflation-protected securities (TIPS) are the few exceptions to money conversion activity.
In one commonly used activity known as "open market operations," government bonds are eligible for liquidation into cash deposits at central banks. Most importantly, the federal reserve controls open market operations to manage interest rates.
Suppose the federal reserve plans to increase the money supply by purchasing treasury bills. In that case, it can lower interest rates and positively impact the economy by producing more loans for the public. This performance is known as expansionary open market operations.
On the contrary, if the federal reserve chooses to sell treasury bills, it would lower the money supply and hike up interest rates to decelerate inflation in an economy. The second performance is known as contractionary open market operations.
In addition to the role of central banks, reserve requirements are frequently practiced and influential to the base money. Moreover, since central banks have the authority to adjust reserve requirements and interest rates, it heavily influences the involvement of bank reserves.
Over the years, reserve requirements have played a major influential part in monetary policy but have recently changed in 2020. The federal reserve has lowered reserve requirements to zero percent to support household and business lending.
Monetary Base formula
To understand how to calculate the monetary base of an economy, compute the currency in circulation and reserve balances together.
MB = currency in circulation (C) + reserve balances (R)
For example, the federal reserve economic data (FRED) breaks down the entity into two main subparts. First, let's look over FRED's release tables. The currency in circulation and the total balances of the current US economy are summed together to over five trillion dollars as of July 2022.
Furthermore, each calculation is detailed in graphs generated by FRED for a broader understanding of computations and the overall economic growth or decline of the US economy.
Over the decades, we can note the signs of progress and downslopes of the economic state through which currency is being passed in a given economy.
To briefly overview, the currency in circulation graph reveals a steady growth of money measures over a five-decade period. However, from January 2022 to April 2022, we notice a sharp increase in money, which continues to grow over the next year.
Consequently, the growth in money from the currency in circulation will result in about two trillion by July 2022.
As for reserve balances, the cash held in central banks had remained relatively in the same ballpark for almost five decades, up until 2008. However, by this time, the reserve balances had reported a wave fluctuation of cash held throughout the years and currently holding about three trillion.
As a result, the total assets currently land above five trillion dollars. Similar to the increasingly fluctuating reserve balances, the monetary base appears to move close to the reserve balances from the central banks.
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factors affecting the monetary base
Now, the base money is influenced by various economic activities and decision-making officials. A few of those influencers will be discussed further, including
- Monetary economics
- Supply and demand
- Monetary policy
Monetary Economics
Monetary economics acts as an influential factor through the exchange of money and storage of value. But, first, financial economics authorities' transactions and monetary policy governance influence the base's size.
Take open market operations as an example of high authority transactions. When a purchase or sale transaction occurs between the federal reserve and the bank reserve, the actions ultimately affect the economy and change the base money.
Secondly, and in coherence with the economic influence, changing interest rates affect the monetary base of an economy. As economic activity shifts, everything else in connection shifts as well.
Another common aspect is the employment rate. Take the 2008 financial crisis, for example, as one of the significant downdrifts in the employment rate and economic downfall that generated an increase in the size of the base.
For several factors leading to the financial crisis, employment rates took a toll on individuals' livelihoods. They inevitably propelled the federal reserve to purchase long-term assets in the changing economic environment.
Supply and demand
Regarding purchasing assets, supply and demand ultimately shift the monetary base size. If the federal reserve decides to buy assets, the size will increase. Vice versa, the selling of assets will decrease the size.
Demand-wise, the base is influenced by public and banking demand for money and base money, in which the needs must meet the reserve requirements.
The supply of assets and demand for money held by the banks or the public can be essential factors in monetary economics. In return, that economic activity creates a movement within the size of the base.
Monetary Policy
Similar to meeting the requirements of money demands, the monetary policy requires US central banks to have standard interest levels met by the overnight federal funds rate, more commonly known as the overnight bank funds rate.
Monetary policy can adjust the supply growth or decrease base money to meet the interest levels. Additionally, congress and monetary policy can enable US central banks to moderate long-term interest rates following the country's economic goals.
Domestically, monetary policy has a similar effect in influencing the size of the base money. From a worldview standpoint, monetary policy controls short-term interest rates in correlation to the economic activities occurring in the country and its specified financial goals.
All in all, the goals for controlling long or short-term interest rates drive the decision-making of the monetary policy. The economic activities can be manipulated to engross standardized interest levels depending on the economic conditions.
For example, the government wants to raise short-term interest rates. To do so, they will buy treasury bills to offset the current economic conditions. Also, in efforts to influence interest rates, price stability is at the bottom line of the monetary policy.
Allan Meltzer’s Framework
In addition to the list of influential factors, Allan Meltzer provides his theoretical framework on how instrumental the monetary base is on the central banks. Meltzer was a renowned economist who played a significant role in the business community.
Meltzer taught as an economic professor at the Carnegie Mellon Tepper School of Business. His specialization in monetary policy and the federal reserve guided him in authorizing multiple books on the history of the federal reserve and central banks within the US.
He was considered an advocator for monetary policy, an economic influencer, and one of our most incredible economic professors. Throughout his career, Meltzer has created changes in economic policies and influenced economic activity through progressive involvement.
Jumping into the methodical framework, Meltzer emphasized the possible benefits of using base money as the main component for central banks. For two reasons, the base money can determine future money stock and the behavior of asset prices.
Although his theories provided a great understanding of economic development and the utilization of different components, Meltzer noted the stabilization benefits of prioritizing interest-rate-based rules.
In support of the base money framework, Meltzer produced solutions to five paradoxes concerning the advantages of base money. In this article, we will only go over two crucial paradoxes for interpretation.
Paradox three supports the idea that the money multiplier is a good indicator for policy analysis. Through the model building of the money multiplier equation, Meltzer and his partner, Brunner, discovered a connection between their research and the average multiplier.
The money multiplier analysis uncovers a mix of economic conditions and asset liquidity within a policy. As a result, the study proved to be an accurate indicator in providing answers for economic policies.
Paradox four analyzes the behavior of long-term money stock that is associated with the money base. Again, Meltzer pointed out the valuable connection between an increased money base and money stock.
Also, Meltzer's research notes the behavioral effects of the price level and spending in connection to the behavioral effects base money has on the economy, central banks, and money stock.
Monetary Base and the Money Supply
As previously mentioned, the monetary base focused on the total liquid assets held by the public and deposited in bank reserves. Here, the money supply refers to the elements in the base plus all the liquid and less-liquid assets.
The contributing factors to the entity's size are only partially accounted for in the money supply. Although contributing factors differ, the overall control of the assets and banking activity lies within the monetary policy from the federal reserve and congress decisions.
Conversely, money supply accounts for the liquid and non-liquid assets for the entire base money. Therefore, the money supply is categorized into three measures: M0, M1, and M2.
The M0 category consists of the total monetary base of an economy. The M0 can deal with money in different forms, whether that be:
- Currency with the public
- Commercial deposits
- Currency in circulation
M1 of the money supply is the physical currency and reserves from the base money. It includes demand deposits, other checkable deposits (narrow money), and traveler's checks.
Examples of traveler's checks include insurance firms and currency exchanges.
Similar to M1, the M2 money supply accounts for the elements from M1 plus money market securities, savings deposits, and mutual funds. Money market accounts are used like savings accounts with the inclusion of interest.
For centuries, the government had regulated the money supply to meet the federal reserve's target goals, similar to the monetary base. However, in recent years, the federal reserve decided to remove target marks for money growth due to previous economic failings.
Overall, the money supply factors in each category's liquid and non-liquid assets. These factors help to determine the economic supply, economic influencers, and projected outcomes within a country.
Summary
The monetary base is an economic indicator of a country's total currency in circulation and the balances within the bank reserves. Under the provision and decisions made by the bank authorities, federal reserve, and principles of the monetary policy, the base size can differentiate.
On top of that, outside economic factors are other key players in determining the entity's size. Monetary economics, whether inflation or employment rates, are just a couple of significant creators in uplifting or disturbing the economic conditions of a country.
Similarly, the demand of the public and banks is intertwined with the supply of money going towards the economy. So as one aspect fluctuates, let's say demand spikes up, the other aspect must respond following economic needs.
As a result of the regulations of the monetary policy and general economic activity, the entity's size is greatly affected.
Again, the money supply is independent of the monetary base in various ways. The most distinct difference to take away between the two are the type of assets played into each. Money supply comprises liquid and non-liquid assets such as real estate, arts, and collectibles.
The base money narrows down on liquid assets only, the goods that can be converted into cash.
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