Base Money

Published Apr 6, 2024

Definition of Base Money

Base money, also known as the monetary base, high-powered money, or M0, refers to the portion of a country’s money supply that is controlled directly by the central bank. This includes the currency (coins and banknotes) in circulation outside the central bank and the commercial banks’ reserves that are held within the central bank. Base money represents the foundation upon which the rest of the money supply is built, as commercial banks can use these reserves to create additional money through the process of fractional reserve banking.

Example

Consider a simplified banking system in which the central bank has issued $1 million in base money. Of this, $800,000 is in the form of currency circulating among the public, and $200,000 is held in reserves by commercial banks. Through the process of fractional reserve banking, these banks can lend out a significant portion of their reserves while keeping a fraction (say 10%) as required reserves. Hence, the original $200,000 in reserves can theoretically support up to $2 million in bank deposits across the economy, showcasing the multiplier effect of base money on the broader money supply.

This process starts when a commercial bank lends $180,000 from its reserves; the borrower then spends this money, which eventually gets deposited in another bank, which then keeps 10% in reserve and lends out the rest, and so on. Each cycle effectively creates new money, expanding the economy’s money supply well beyond the initial amount of base money.

Why Base Money Matters

Base money is crucial for several reasons. Firstly, it is directly controlled by the central bank and serves as the primary tool for implementing monetary policy. By altering the size of the monetary base, central banks can influence interest rates, inflation, and economic growth. For example, during a recession, a central bank might increase the monetary base through open market operations, such as purchasing government securities, effectively lowering interest rates and stimulating borrowing and spending in the economy.

Furthermore, because base money underpins the larger structure of the money supply, changes in its amount have magnified effects on the total money available for consumption and investment within the economy. This underlines the importance of central banks’ roles in managing economic stability and growth, making decisions regarding the monetary base critical for overall economic health.

Frequently Asked Questions (FAQ)

What distinguishes base money from other components of the money supply?

Base money differs from other components of the money supply, such as M1 and M2, in that it includes only the most liquid forms of money: currency in circulation and reserves held at the central bank. M1 and M2 include broader and less liquid assets, like checking deposits (M1) and savings deposits and money market funds (M2). Base money is considered the foundation of the money supply pyramid, as it directly influences the creation of these broader monetary aggregates through the multiplier effect.

How can changes in the monetary base lead to inflation or deflation?

Inflation or deflation can result from changes in the monetary base. If the central bank significantly increases the monetary base by injecting more money into the economy (e.g., through buying government securities), and if this increase is not matched by economic output growth, the result can be inflation. This is because more money is chasing the same amount of goods and services. Conversely, sharply contracting the monetary base (e.g., selling government securities and taking money out of circulation) can lead to deflation if it restricts the money supply too much, reducing spending and investment.

Can base money impact interest rates?

Yes, the central bank can influence interest rates by modifying the monetary base. When the central bank increases the monetary base, it typically purchases government securities, which adds reserves to the banking system and lowers the interest rate (the cost of borrowing money). This is meant to encourage more borrowing and spending. Conversely, reducing the monetary base by selling government securities takes reserves out of the banking system, raising interest rates to curb borrowing and spending, often to control inflation.

In summary, base money is a pivotal component of the financial system, serving as a primary mechanism through which central banks steer a country’s economic direction. Its management is key to achieving macroeconomic objectives like stable prices, full employment, and sustainable growth, showcasing the interconnectedness of monetary policy, banking, and the overall economy.