The Concept of Monetary Base
The monetary base (MB) is a measure of the total amount of money in an economy that is created and controlled by a central bank.
It includes physical currency, such as coins and banknotes, as well as the reserves held by commercial banks with the central bank.
- Physical Currency means: The total currency circulating in the public + currency physically held in the vaults of commercial banks
- The commercial banks reserves: Total of reserve that are held in the central bank.
The monetary base is a critical factor in the implementation of monetary policy by the central bank, as changes in the monetary base can influence the money supply and ultimately impact inflation and economic growth. For instance, if the central bank wishes to increase the money supply, it can inject more money into the economy by purchasing government bonds or other assets, thereby increasing the monetary base. Alternatively, if the central bank wishes to reduce inflation, it can decrease the monetary base by selling bonds or other assets, thereby removing money from the economy.
Commercial banks reserves
To get the whole picture we need to explain the Commercial banks reserves in some detail.
In most countries each commercial bank has an account and some balance at the Central Bank. Commercial bank is able to withdraw cash from this account and this lowers the account’s balance. Physically it means Cash-in-transit companies transport the banknotes and coins from the central-bank to the commercial bank. It also works in the opposite direction of course (but probably happened rarely)
Commercial banks reserves are funds that banks are hold on account with their central bank. Banks hold reserves as a buffer against potential losses and to ensure that they have sufficient funds on hand to meet customer withdrawals and other obligations. They are required to maintain a certain level of reserves, which is typically set as a percentage of their deposits.
Reserves can be held in the form of cash, deposits with the central bank, or other approved securities. When a bank holds reserves in excess of the required amount, these excess reserves can be used to make loans and other investments.
In some countries, such as the United States, commercial banks may also be able to earn interest on their reserves held at the central bank, which can provide an additional source of income for the bank.
Central Banks operations
When a central bank sells bonds, it does so by offering the bonds to the market. Investors who want to purchase these bonds will pay for them by transferring funds from their central bank accounts to the central bank. This reduces the amount of Commercial banks reserves, as the funds used to purchase the bonds are no longer available.
Let’s say that the central bank sells $10 million worth of bonds to investors. To purchase the bonds, the investors will need to transfer $10 million from their bank accounts to the central bank’s account. When the central bank receives the $10 million payment, it will credit its own account and debit the investors’ accounts at their respective banks. This means that the investors’ bank accounts will now have $10 million less in funds, and the central bank’s account will have $10 million more.
As a result of this transaction, the monetary base has decreased by $10 million, and as result there is now $10 million less currency in circulation. Money on the central bank’s account is not available to the markets in that sense.
Why do commercial banks need to hold balances at the central bank
Commercial banks are in constant need of central bank money to meet their minimum reserve requirements, to be able to withdraw cash and to settle cashless payment transactions. Let’s break down:
to maintain a minimum reserve requirement. If the banks create additional funds (“book money”), they are also required to increase their minimum reserves held at the central bank.
Commercial banks need central bank reserves because their customers are withdrawing more and more cash. The commercial banks have to obtain this additional cash from the central bank. To do so, they need central bank reserves that they can draw upon.
to settle cashless payment transactions. It’s not obvious for not professional bankers, but in fact the system works like this: If Bob a customer of Bank A, transfers money to Alice, a customer of Bank B, Bob’s bank balance at Bank A goes down. At the central bank, the amount is transferred from Bank A’s account to Bank B’s account. Bank B credits the amount to Alice’s account. Central bank reserves are only ever transferred between accounts held at the central bank.
Managing Monetary Base
Monetary base is controlled by a country’s central bank. Central Banks changes the monetary base either by expanding or contracting through open market operations or monetary policies. E.g the Central bank ha the option of using the policy rate – that is to say, the rate at which the commercial banks pay interest on central bank money – to influence interest rate levels in region.
The government can maintain a measure of control over the monetary base by buying and selling government bonds in the open market.
United States Monetary Base example
United States M0 Total was $5.582.300.000 in August of 2022, according to the United States FED. Historically, reached a record high of $6.413.100.000 in December of 2021.
Monetary Base as Liability
Monetary base can be seen as the sum of liabilities of the central bank towards the commercial banks. To make it precise:
MB = C + R
- C is Currency in circulation
- R is Federal Reserve Deposits (Special deposits that only banks can have at the Fed)
Monetary Base Synonyms
Synonyms to monetary base are:
narrow money . In some countries or out of hobbit it also referred as M0 but it’s not quite correct, see Monetary Supply
As only the central bank can create this form of money, It’s basically exists in the balance of the central bank only , the Central Bank Money is alo used as synonym to MB.