Monetary Base: Definition, What It Includes, Example

What Is the Monetary Base?

The monetary base is the total amount of a currency in circulation or held in reserves. Money in circulation is anything that is held and used by the general public while reserves refer to commercial bank deposits and any money held in reserves by these institutions at the central bank. This measure of the money supply is not often cited since it excludes other forms of non-currency money that are prevalent in a modern economy.

Understanding the Monetary Base

The monetary base is a component of a nation’s money supply. It refers strictly to highly liquid funds including notes, coinage, and current bank deposits. When the Federal Reserve creates new funds to purchase bonds from commercial banks, the banks see an increase in their reserve holdings, which causes the monetary base to expand.

The monetary base is a monetary aggregate that is not widely cited and differs from the money supply. But it is nonetheless very important. It includes the total supply of currency in circulation in addition to the stored portion of commercial bank reserves within the central bank. This is sometimes known as high-powered money since it can be multiplied through the process of fractional reserve banking.

The monetary base is most commonly divided into levels, listed as M0 through M3 or M4 depending on the system, with each representing a different facet of a nation’s assets:

• M1: This is a narrow measure of the money supply that also includes physical currency and reserves. This measure also counts demand deposits, traveler’s checks, and other checkable deposits
• M2: This is a calculation of the money supply that includes all elements of M1 as well as near money, which refers to savings deposits, money market securities, mutual funds, and other time deposits. These assets are less liquid than M1 and not as suitable as exchange mediums, but they can be quickly converted into cash or checking deposits.
• M3: This is a measure of the money supply that includes M2 as well as large-time deposits, institutional money market funds, short-term repurchase agreements (repo), and larger liquid assets.
  

The monetary base’s funds are generally held within the lower levels of the money supply, such as M1 or M2, which encompasses cash in circulation and specific liquid assets including, but not limited to, checking and savings accounts.

Monetary Base and the Money Supply

The money supply expands beyond the monetary base to include other assets that may be less liquid in form. The funds must be considered a final settlement of a transaction in order to qualify.

For example, if a person uses cash to pay a debt, that transaction is final. Additionally, writing a check against money in a checking account or using a debit card may also be considered final since the transaction is backed by actual cash deposits once they have cleared.

In contrast, using credit to pay a debt does not qualify as part of the monetary base, as this is not the final step in the transaction. That's because using credit just transfers a debt owed from one party (the person or business receiving the credit-based payment) and the credit issuer.

Smaller Scale Monetary Bases and Money Supplies

The monetary base consists of all notes and coins in the possession of the household at that level, as well as any funds in deposit accounts. The money supply of a household may be extended to include any available credit open on credit cards, unused portions of lines of credit, and other accessible funds that translate into a debt that must be repaid.

Managing Monetary Bases

Most monetary bases are controlled by one national institution, usually a country's central bank. This body can usually change the monetary base through open market operations or monetary policies. This can be accomplished by implementing expansionary or contractionary policies.

For many countries, the government can maintain a measure of control over the monetary base by buying and selling government bonds in the open market.

Example of a Monetary Base

Here's a hypothetical example to show how a monetary base works. Let's suppose that Country Z has 600 million units of currency circulating in the public and its central bank has 10 billion currency units in reserve as part of deposits from many commercial banks. In this case, the monetary base for country Z is 10.6 billion currency units.

The Bottom Line

Central banks have a variety of functions for their economies. One of the primary functions is to provide money and bank reserves. The money that they provide and inject into their economies is called the monetary base. The monetary base is important in any economy because it is used to complete and settle transactions and pay off debt.