High-Powered Money

Published Apr 29, 2024

Definition of High-Powered Money

High-Powered Money, also known as base money, reserve money, or monetary base, refers to the total amount of currency that is either circulated among the public or held within the reserves of commercial banks plus the reserves held by the banks with the central bank. This form of money is considered “high-powered” because of its ability to influence the overall money supply through the banking system’s ability to lend and thus create new money.

Example

To illustrate high-powered money, imagine a scenario where the central bank decides to increase the monetary base by injecting additional reserves into the financial system. This can be done through open market operations, such as purchasing government securities from banks. When the central bank buys these securities, it pays the banks, which increases the reserves that banks hold at the central bank.

Now assume the central bank injects $1 million into the banking system. If the reserve requirement is 10%, banks are only required to keep 10% of deposits as reserves and can loan out the rest. This means from the $1 million, banks can theoretically lend up to $900,000. The money lent out can then be deposited again in the banking system, and 90% of it can be lent out once more. This process can repeat multiple times, potentially leading to an increase in the overall money supply significantly beyond the initial $1 million provided by the central bank. This multiplicative effect on the money supply illustrates the power of high-powered money.

Why High-Powered Money Matters

The concept of high-powered money is crucial for understanding how monetary policy is implemented and its effects on the economy. Central banks, such as the Federal Reserve in the United States, use the control of the monetary base as a key tool to influence interest rates, control inflation, and steer the economy towards its objectives of maximum employment and stable prices.

Moreover, by controlling the amount of high-powered money, central banks can influence the lending behavior of commercial banks, the overall money supply, and, by extension, economic activity. For instance, during an economic downturn, a central bank might increase the monetary base to encourage more lending and investment, stimulating economic activity. Conversely, to combat inflation, it might reduce the monetary base, tightening the money supply and dampening price pressures.

Frequently Asked Questions (FAQ)

How do central banks create or destroy high-powered money?

Central banks create high-powered money primarily through open market operations, which involve buying or selling government securities in the open market. When a central bank buys securities, it increases the reserves of banks, thereby increasing the monetary base. Conversely, selling securities reduces bank reserves and the monetary base. Additionally, central banks can adjust high-powered money by changing the reserve requirements for commercial banks or through direct lending to financial institutions.

What is the difference between high-powered money and the broader money supply?

High-powered money (monetary base) consists of currency in circulation and reserves held by banks with the central bank. It represents the foundation upon which the broader money supply is built. In contrast, the broader money supply (such as M1, M2) includes not only all of the high-powered money but also other forms of money accessible to the public and businesses, such as checking accounts, savings accounts, and other near-money assets that can be quickly converted into cash. The broader money supply is influenced by the banking system’s ability to lend and create new money through the deposit and lending cycle.

Can the expansion of high-powered money lead to inflation?

Yes, an unchecked expansion of high-powered money can lead to inflation. If the increase in the monetary base leads to a rapid increase in the overall money supply without a corresponding increase in the production of goods and services, the result can be too much money chasing too few goods, causing prices to rise. However, the relationship between the monetary base and inflation is complex and influenced by many factors, including the velocity of money, public expectations, and the economy’s capacity to produce. Central banks must carefully manage the growth of high-powered money to prevent inflation while supporting economic activity.