Monetary Base
Candlefocus EditorThe monetary base can be divided into two main components: the notes and coins (also known as currency) in circulation, and banks’ reserves held with the central bank. The notes and coins component is made up of all physical money circulating within the economy (thus consisting both of cash in circulation and cash from ATMs). The second component, the reserves held by the commercial banks with the Federal Reserve, is more commonly known as the monetarybase.
The Federal Reserve can influence the monetary base by either increasing or decreasing the amount of currency in circulation. When it does this, the effect is immediate and can have a sizeable impact on the economy. This is primarily because the size of the monetary base has a direct effect on the ability of commercial banks to lend, which then impacts consumer spending, economic activity, and economic growth.
The monetary base is also referred to as “high-powered money” as banks can use it to expand the money supply through the money multiplier effect, i.e. allowing customers to effectively borrow money that the bank didn’t have before. This is done by setting loan-deposit ratios, with each bank having a certain amount of money set aside to extend their lending.
Although the monetary base plays an important role in controlling the money supply, and thus influencing the economy, economists typically look at more comprehensive monetary aggregates such as M1 and M2 for an accurate picture of the economy. These include the notes and coins along with other components such as the amount of money people hold in their checking accounts and the money deposited in savings accounts.
In conclusion, the monetary base, or M0, is the underlying foundation of all money circulation in an economy. It consists of the notes, coins and reserves held by commercial banks which are owned by the Federal Reserve. It is more widely referred to as "high-powered money" because it is used to expand the money supply through the money multiplier effect. It plays an important role in controlling the money supply and various aspects of the economy, however economists usually utilize more comprehensive monetary aggregates such as M1 and M2 when analyzing economic performance.