Wednesday, 28 November 2012

Monetary Base

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U.S. Monetary base

Euro monetary base
In economics, the monetary base (also base money, money base, high-powered money, reserve money, or, in the UK, narrow money) is a term relating to (but not being equivalent to) the money supply (or money stock), the amount of money in the economy. The monetary base is highly liquid money that consists of coins, paper money (both as bank vault cash and as currency circulating in the public), and commercial banks' reserves with the central bank. Measures of money are typically classified as levels of M, where the monetary base is smallest and lowest M-level: M0. Base money can be described as the most acceptable (or liquid) form of final payment. Broader measures of the money supply also include money that does not count as base money, such as demand deposits (included in M1), and other deposit accounts like the less liquid savings accounts (included in M2) etc.
(The narrow money supply is an earlier term used in the U.S to describe currency held by the non-bank public and demand deposits of banks, M1).

[edit] Management

"Open market operations" are monetary policy tools that affect directly the monetary base; the monetary base can be expanded or contracted using an expansionary policy or a contractionary policy, but not without risk.
The monetary base is typically controlled by the institution in a country that controls monetary policy. This is usually either the finance ministry or the central bank. These institutions change the monetary base through open market transactions (i.e., the buying and selling of government bonds). These institutions also typically have the ability to influence banking activities by manipulating interest rates and changing bank reserve requirements (how much money banks must keep on hand instead of loaning out to borrowers).
The monetary base is called high-powered because an increase in the monetary base (M0) can result in a much larger increase in the supply of bank money, an effect often referred to as the money multiplier. An increase of 1 billion currency units in the monetary base will allow (and often be correlated to) an increase of several billion units of "bank money". This is often discussed in conjunction with fractional-reserve banking systems. A system of full-reserve banking would not allow for an increase of currency in the banking system on top of the monetary base.
The Austrian School of economics is critical of fractional-reserve banking, stating that the increase of money in the banking system is equivalent to an artificial injection of credit, which is the source of the business cycle. This is elaborated in the Austrian business cycle theory, for which Friedrich Hayek won the Nobel Prize in economics in 1974. However, in 1976, in a paper on The Denationalization of Money,[1] Hayek advocated that rather than re-instituting a government-mandated gold standard, a free market in money be allowed to develop, with issuers of money competing with each other to produce the best, most stable and healthy currency. This sparked an entire school of thought within economics, Free Banking, with banks not being banned from having fractional reserves as other Austrians such as Murray Rothbard advocated, but instead being free to experiment and discover the best method of conducting business.

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