Monetary base
The central bank has a liability - it accepted deposits from banks. Another liability of a central bank is what you see written on notes (or coins) that you have in your wallet or purse; the central bank ‘promises to pay the bearer on demand the sum of...'.
As well as reserves at the central bank a typical commercial bank will hold some of its assets in the form of vault cash in hand. Finally, the economy has currency in circulation, that is, outside of banks. The combination of reserves and currency in circulation is the monetary base:Monetary base = currency in circulation + reserves
Reserves = required reserves + vault cash (excess reserves)
It is important to note that the sole supplier of reserves - notes and coins, and balances at the central bank as liabilities of the central bank - is the central bank.
It is changes in these accounts that can have an influence on the size of a nation's money supply. The relationship between the amount of money in banks or the wider economy and changes in the monetary base or reserves is very far from a mechanical mathematical relationship - the downturn in 2008-2013 rammed that home - but nevertheless there is, holding all else constant, a relationship. If there is an increase in either the currency in circulation or reserves there is likely (but not always) to be an increase in the money supply. Normally, an increase in reserves, either cash deposited by a bank at the central bank or vault cash, leads to an increase in the level of loans and deposits and thus contributes to the money supply.
Central banks can conduct monetary policy by changing the country's monetary base.
The monetary base described above is sometimes referred to as M0, which is a very extreme form of narrow money, i.e. defining what money is in a very narrow way. Banks can use this base to create broad money, which is a multiple of the monetary base.
The definitions of broad money vary from country to country, but generally include money that is held in the form of a current (checking) account or deposit account, and some money market instruments such as certificates of deposit. These broad money aggregates often have names such as M3 or M4. You can see why it is difficult to define money because banks can ‘create money' - see the Example 16.1 below.Example 16.1
Money creation - the deposit multiplier
Assume that all banks in a monetary system are required to keep 20% of deposits as reserves. Bank A has $100 million of deposits from customers. Because it is sticking to the reserve requirement, both required by the central bank and its own prudential reserves policy, it lends out only $80 million and keeps $20 million as cash or in its account with the central bank (assume no vault cash for simplicity).
Bank A's opening balance sheet
| Assets | Liabilities |
| Reserves $20m Loans $80m | Deposits $100m |
Now, if deposits in Bank A are increased by $5 million, the position changes (we'll look at where it got $5 million from in a minute - this is crucial). Deposits rise to $105 million and reserves rise to $25 million as the additional $5 million is initially held as reserves at the central bank.
Bank A: an increase in deposits - intermediate period
| Assets | Liabilities |
| Reserves $25m Loans $80m | Deposits $105m |
This means that the reserve ratio has risen to $25m ÷ $105m = 23.8%. The bank earns no or little interest from reserves, so it will wish to reduce it back to 20% by lending out the extra. The next balance sheet shows the amount of lending that leaves a 20% reserve ratio, $84 million.
Bank A: lending out just enough to attain minimum reserve ratio
| Assets | Liabilities |
| Reserves $21m Loans $84m | Deposits $105m |
Now let us bring in more banks.
In lending an additional $4 million Bank A will have an impact on the rest of the banking system. If the $4 million is lent to a company and, initially at least, that company deposits the money in Bank B, then at the central bank, Bank A's account will be debited (reserves go down) and Bank B's account will be credited (reserves increase). Bank B will lend out 80% of the amount, or $3.2 million, keeping $800,000 in reserves to maintain its 20% ratio of reserves to deposits. The $3.2 million lent finds its way to Bank C, which, again, holds 20% as reserves and lends the rest... and so on. At each stage 80% of the deposit is lent out, increasing the deposits of other banks, encouraging them to lend.The effect on the banking system of an injection of $5 million of money, under a reserve ratio of 20%
| Change in deposits, $m | Change in loans, $m | Change in reserves, $m | |
| Bank A | 5.00 | 4.00 | 1.00 |
| Bank B | 4.00 | 3.20 | 0.80 |
| Bank C | 3.20 | 2.56 | 0.64 |
| Bank D | 2.56 | 2.05 | 0.51 |
| Bank E | 2.05 | 1.64 | 0.41 |
| Bank F | |||
| Bank G | |||
| Bank... | |||
| Total of all banks | 25 | 20 | 5 |
The deposit multiplier is a reciprocal of the reserve ratio, which in this case = 1 ÷ 0.20 = 5.
Following an injection of $5 million into the financial system, the whole process ends when an additional $25 million of deposits have been created; equilibrium has been reached again. Broad money grows by $25 million.Reality check: please note that the model is a simplification for illustrative purposes. In reality, there might be leakages from the system due to money flowing abroad, or people increasing currency holdings,[37] or buying government bonds rather than placing it in bank deposits. People and companies might be so shocked by an economic downturn that instead of borrowing more they repay old debt, thus working against the multiplier. Banks might also be in such turmoil that they would rather reduce their loan book than expand lending despite huge injections of deposits (they increase excess reserves). But for now we'll go along with the logic of the deposit or money multiplier in ‘normal' times, with an assumed mathematically pure relationship between narrow and broad money.
The key point to remember is: the creator of the monetary base is the central bank because it has a monopoly on the issuance of currency. If it has control over this then it can influence the broader money supply (including deposits at banks) through the reserves requirements. So, once the system has settled down from the injection of a new deposit, it will be fairly stable - little money creation or removal.
Here is the crucial bit about the source of the additional deposits of $5 million: if it came from a customer who withdrew it from another bank then the example is null and void because while Bank A benefits from the $5 million deposit, the other bank, Bank X, sees a reduction in its reserves at the central bank by an equal amount. It can now lend less than it could before because it has to rebuild its reserves. Thus the stimulus effect of Bank A's deposit is exactly offset by the removal of money from the system by Bank X. If, however, the
$5 million came from the central bank purchasing Treasury bills from an investor who then put the newly created cash received into his account with Bank A, then we have new money coming into the system and we can expect something like the multiplier effect shown above.
The central bank is the only player here that can create money out of thin air and pump it into the system if the system is at equilibrium.Thus, despite commercial banks' ability to create money on the way to equilibrium, there is a limit to the amount that the system as a whole can go up to because for every dollar, pound, euro, etc. created there has to be a fraction held as a cash reserve. It is the central bank that controls the total volume of monetary base (reserves at the central bank plus cash in circulation and at deposit-taking institutions) and so the broader aggregates of money have an upper limit. Small changes in the monetary base can have a large impact on the amount of broad money in the system and so we often refer to the monetary base as high-powered money.
Central banks have three major tools they use to increase or decrease the money supply and interest rates:
• open market operations
• standing lending facilities/discount rate
• reserve requirement ratio changes.