Monetary base

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Monetary base
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Monetary base - is the sum of currency in circulation and the reserves that banks hold on deposit at the central bank. The European Central Bank defines base money (the monetary base) as "currency (banknotes and coins) in circulation plus the minimum reserves credit institutions are required to hold with the Eurosystem and any excess reserves they may voluntarily hold in the Eurosystem's deposit facility, all of which are liabilities on the Eurosystem's balance sheet"[1]. Economists also call it M0, base money, central bank money or, following an older tradition, high-powered money.

The last name explains why anyone cares. Base money is the only kind of money a central bank creates directly. Everything else counted in the monetary aggregates (current accounts, savings deposits, money market fund shares) is a liability of commercial banks or other private institutions. For decades textbooks described the base as the foundation on which banks build a much larger pyramid of deposits. That picture still turns up in lecture halls. It has also taken a beating since 2008, as this article explains below.

Components of the monetary base

Two items, both on the liability side of the central bank's balance sheet:

  • Currency in circulation - banknotes and coins held by the public and by banks in their vaults and ATMs. In the US the Federal Reserve's figure includes Federal Reserve notes and coin outside the Treasury and Reserve Banks, plus Treasury estimates of coins and Treasury paper currency outstanding.
  • Bank reserves - balances that commercial banks keep in their accounts at the central bank. They're used to settle payments between banks, to meet any reserve requirement and as a liquid buffer. In the euro area the definition covers both required reserves and funds placed in the deposit facility.

Some countries add smaller items. The Bank of Japan, which publishes a monthly "Monetary Base" release, counts banknotes in circulation, coins in circulation and current account balances held at the Bank. The idea is the same everywhere: base money = what the central bank owes to the rest of the economy in the form of cash and settlement balances.

Note the trick with vault cash. Banknotes sitting in a bank's own vault are currency, but before 2020 the Fed allowed them to count towards reserve requirements. Statistics therefore distinguish "total reserves" (which included such vault cash) from "reserve balances" held at the Fed. Add total reserves to currency and you double count. The Fed's current definition avoids that: the monetary base "equals currency in circulation plus reserve balances"[2].

Background

The term high-powered money became standard through Milton Friedman and Anna Schwartz's A Monetary History of the United States, 1867-1960 (1963)[3]. Friedman and Schwartz treated the stock of money as the product of three "proximate determinants": the amount of high-powered money, the ratio of deposits to bank reserves and the ratio of deposits to currency held by the public. A change in any of them changed the money stock. Their account of the early 1930s, when banks hoarded reserves and the public fled to cash, rested heavily on that framework.

Monetarism took the next step. If the central bank controls the base and the ratios are reasonably stable, it should be able to steer the broader money stock and, through it, nominal spending. Several central banks experimented with money growth targets in the 1970s and 1980s. Most dropped them as the link between money and prices weakened, and short-term interest rates became the usual operating target.

The base came back to centre stage after 2008. Large asset purchases, later known as quantitative easing (QE), expanded central bank balance sheets on a scale nobody had seen in peacetime. The Bank of Japan went furthest in formal terms. In April 2013 it changed its main operating target from the overnight call rate to the monetary base itself.

Money multiplier

The classic link between base money MB and a money aggregate M is the money multiplier m:

\[ M = m \times MB \]

Following the standard textbook derivation (for example Mishkin's), define three ratios relative to checkable deposits D: the currency ratio \( c = C/D \), the required reserve ratio \( r \) and the excess reserve ratio \( e \). Since \( MB = C + R = (c + r + e) \cdot D \) and \( M = C + D = (1 + c) \cdot D \), the multiplier is[4]:

\[ m = \frac{1 + c}{r + c + e} \]

Read the formula as a list of leaks. Every euro or dollar of new base money either ends up as cash in someone's wallet (c), as required reserves (r) or as reserves banks choose to hold on top of the minimum (e). The larger the leaks, the smaller m. A higher reserve ratio lowers the multiplier. So does a panic in which households withdraw cash, or a bank sector that sits on reserves instead of lending.

The textbook story behind the formula runs like this. The central bank adds reserves. A bank lends out the part it doesn't need to keep, the borrower spends the money, it lands as a deposit in another bank, which lends out part again, and so on. Each round is smaller, and the total converges to m times the initial injection. It's the process described in creation of money as secondary money creation.

How the monetary base changes

Because base money is a liability of the central bank, it changes whenever the central bank buys or sells assets or lends, unless something else on the balance sheet offsets the move. A simplified balance sheet:

Assets Liabilities
Government securities Currency in circulation
Loans to banks (refinancing, discount window) Bank reserves (current accounts, deposit facility)
Foreign exchange reserves and gold Government deposits
Other assets Other liabilities and capital

The main channels:

  • Open market operations - when the central bank buys a government bond from a bank, it pays by crediting the bank's reserve account. Reserves go up, the base goes up. A sale works in reverse. Outright purchases on a huge scale are what QE consists of.
  • Lending to banks - refinancing operations, repo and the discount window create reserves for as long as the loan is outstanding. Repayment destroys them.
  • Foreign exchange purchases - a central bank that buys dollars to hold down its own currency pays with domestic base money. Countries that accumulated large foreign exchange reserves often "sterilised" those purchases by selling domestic securities, so that the base didn't balloon.
  • Autonomous factors - movements the central bank doesn't directly decide. If the Treasury moves funds from commercial banks into its account at the central bank (tax payments, bond issuance), bank reserves fall. Currency demand matters too: when people withdraw cash before holidays, reserves turn into banknotes. That shifts the composition of the base but leaves its total unchanged.

The full list of tools is in monetary policy instruments. One detail is worth stressing. Banks as a group can't get rid of reserves by lending them to each other. A loan on the interbank market merely moves reserves from one bank's account to another's. Only the central bank, the government's account or a cash withdrawal changes the total.

Critique of the multiplier

The multiplier is an identity: given c, r and e, the arithmetic is always right. The trouble is causality. The textbook reading assumes the ratios are stable and that the central bank sets the base, after which banks expand lending. Practice has looked rather different.

Many central banks have long steered an interest rate rather than a quantity of reserves. Under that regime the central bank supplies whatever reserves banks need at the target rate, so the base adjusts to lending, not the other way round. A Bank of England paper by McLeay, Radia and Thomas (2014) put it bluntly: banks do not "multiply up" central bank money to create new loans and deposits[5]. Loans create deposits; the reserves follow.

Then came 2008. US reserve balances, about $17 billion in August 2008, reached roughly $790 billion by December 2008 (monthly averages, computed as monetary base minus currency in circulation)[2]. If the multiplier had held, the money supply would have exploded. It didn't. Banks simply held the extra reserves. Keister and McAndrews (2009) of the New York Fed explained why: the quantity of reserves in the system is determined by the size of the central bank's policy initiatives, and says little about whether those initiatives have encouraged lending[6]. In multiplier terms, e jumped and m collapsed.

Interest on reserves changed the economics further. The Federal Reserve gained authority to pay interest on reserve balances under the Financial Services Regulatory Relief Act of 2006, with an original effective date of October 1, 2011. The Emergency Economic Stabilization Act of 2008 advanced that date to October 1, 2008[7]. Marvin Goodfriend had argued in 2002 that paying interest on reserves lets a central bank set short-term rates independently of the quantity of reserves. That's how it worked out. When reserves earn a policy rate, holding them is no longer costly, and a bank has no reason to lend just because its reserve account is large. Since July 29, 2021 the Fed has paid a single interest rate on reserve balances (IORB), replacing the separate rates on required and excess reserves.

The final blow was regulatory. The Board reduced reserve requirement ratios to zero percent effective March 26, 2020[8]. With r = 0 and all reserves technically excess, the parameter the formula relied on most disappeared. Ihrig, Weinbach and Wolla (2021), writing for the St. Louis Fed, concluded: "So, mathematically, the money multiplier equation is literally no longer definable"[9]. They recommended that introductory courses teach the "ample reserves" framework instead, in which the Fed steers rates through administered rates such as IORB.

Not everybody throws the base away. It remains a clean measure of the size of the central bank's monetary liabilities, and in a currency crisis or a hyperinflation rapid base growth is still a warning sign. What has gone is the belief that the base is a lever whose movements translate mechanically into broad money.

Example of the monetary base and the multiplier

Hypothetical textbook example

A banking system has a currency ratio c = 0.25, a required reserve ratio r = 0.10 and an excess reserve ratio e = 0.05. The central bank's monetary base is 500 billion.

\[ m = \frac{1 + 0.25}{0.10 + 0.25 + 0.05} = \frac{1.25}{0.40} = 3.125 \]

Then:

  • Deposits: D = 500 / 0.40 = 1,250 billion
  • Currency: C = 0.25 × 1,250 = 312.5 billion
  • Reserves: R = (0.10 + 0.05) × 1,250 = 187.5 billion
  • Check: C + R = 312.5 + 187.5 = 500 billion (the base)
  • Money supply: M = C + D = 312.5 + 1,250 = 1,562.5 billion = 3.125 × 500

Now a shock. Banks get nervous and raise excess reserves to e = 0.45. The multiplier becomes 1.25 / 0.80 = 1.5625. With an unchanged base, M would fall to 781.25 billion, a 50% contraction. To keep M at 1,562.5 billion, the central bank would have to double the base to 1,000 billion. That, in miniature, is the textbook reading of 2008: the base doubled and the money supply barely moved, because the extra base money ended up as reserves.

Actual US figures

The data tell the same story more dramatically. Monthly values from the Federal Reserve's H.6 release, in billions of US dollars, not seasonally adjusted[2]:

Month Monetary base Currency in circulation Reserve balances (difference) Currency share of base
August 2008 847.6 831.0 16.6 98.0%
December 2008 1,666.4 878.3 788.1 52.7%
August 2014 4,075.0 1,288.2 2,786.8 31.6%
December 2021 6,413.1 2,225.1 4,188.0 34.7%
August 2026 5,411.6 2,475.6 2,936.0 45.7%

Between August 2008 and December 2021 the base grew about 7.6 times. M2 (seasonally adjusted) grew from about $7.8 trillion to $21.5 trillion, under 2.8 times. The crude M2-to-base ratio fell from roughly 9.2 to roughly 3.4. Before 2008 the base was almost entirely cash. At the December 2021 peak, about two thirds was bank reserves. Since then the Fed's balance sheet runoff has shrunk reserves again, while currency has kept growing slowly.

Data sources

  • United States - the Federal Reserve Board's H.3 release, "Aggregate Reserves of Depository Institutions and the Monetary Base", was the traditional source. The last H.3 was published on September 17, 2020, and certain items, including the monetary base, were consolidated onto the H.6 "Money Stock Measures" release as of September 24, 2020[10]. The H.6 is monthly. Weekly balance sheet data, including reserve balances and currency, are in the H.4.1 release. FRED (St. Louis Fed) carries the series as BOGMBASE; the old weekly series derived from H.3 is marked discontinued.
  • Euro area - the ECB publishes Eurosystem balance sheet items (banknotes in circulation, current accounts, deposit facility) in its weekly financial statement and in the ECB Data Portal.
  • Japan - the Bank of Japan's monthly Monetary Base statistics.
  • Other countries - most central banks publish a balance sheet from which the base can be assembled; international comparisons can be found in IMF statistics.

When comparing countries, check what is in the definition. Some include all central bank deposits of banks, others only required reserves, and the treatment of vault cash and deposit facilities differs.

Advantages of the monetary base as a measure

  • Precisely measurable - it comes straight from the central bank's own balance sheet, often weekly or even daily, and with little revision. Broad aggregates rely on reports from thousands of institutions.
  • Directly controllable - the central bank can set it if it wants to, as the Bank of Japan did from 2013.
  • Shows the scale of balance sheet policy - QE, emergency lending and foreign exchange intervention all show up in the base, which makes it a quick gauge of how much liquidity the central bank has supplied.
  • Links to seigniorage and fiscal questions - currency is an interest-free liability, so the base helps estimate the income a central bank earns from issuing money (see money emission).
  • Useful in crisis diagnosis - in a currency crisis or a high inflation episode, fast base growth financed by lending to the government is a red flag.

Limitations

  • Weak link to spending and prices - the multiplier is unstable and, with zero reserve requirements, not even well defined. A large base doesn't mean high inflation, as US and Japanese experience after 2008 showed.
  • Endogenous under interest rate targeting - when the central bank steers rates, the base mostly reflects demand for cash and reserves, not a policy decision.
  • Mixes two very different things - cash held by households (including large amounts held abroad, in the case of the dollar) and bank reserves react to different forces. Many analysts look at the components separately.
  • Definitions vary - cross-country comparisons need care.
  • Distorted by autonomous factors - movements in the Treasury's account or in reverse repo facilities can shift reserves by hundreds of billions without any change in the policy stance.

Related concepts

  • Monetary aggregates (M1, M2, M3) - broader measures that include bank deposits; the base is the narrowest layer under them.
  • Narrow money - sometimes used as a synonym for M0 or M1, depending on the country.
  • Free reserves - excess reserves minus borrowed reserves, an indicator popular in the era of reserve targeting.
  • Quantitative easing - large-scale asset purchases that expand the base, discussed together with expansionary monetary policy and accommodative monetary policy.
  • Money market - the market in which banks trade reserves and short-term instruments, and where policy rates are transmitted.

References

Footnotes

  1. ↑ European Central Bank, Glossary, entry "Base money (monetary base)", https://www.ecb.europa.eu/services/glossary/html/glossb.en.html
  2. ↑ Board of Governors of the Federal Reserve System, H.6 Money Stock Measures; series BOGMBASE (with series notes), MBCURRCIR and M2SL as published in FRED, Federal Reserve Bank of St. Louis, accessed October 2026
  3. ↑ Friedman M., Schwartz A.J., A Monetary History of the United States, 1867-1960, Princeton University Press, 1963
  4. ↑ Mishkin F.S., The Economics of Money, Banking, and Financial Markets, Pearson, chapter on the money supply process
  5. ↑ McLeay M., Radia A., Thomas R., Money creation in the modern economy, Bank of England Quarterly Bulletin, 2014 Q1
  6. ↑ Keister T., McAndrews J., Why Are Banks Holding So Many Excess Reserves?, Federal Reserve Bank of New York Staff Reports No. 380, 2009
  7. ↑ Board of Governors of the Federal Reserve System, Interest on Reserve Balances, https://www.federalreserve.gov/monetarypolicy/reserve-balances.htm
  8. ↑ Board of Governors of the Federal Reserve System, Reserve Requirements, https://www.federalreserve.gov/monetarypolicy/reservereq.htm
  9. ↑ Ihrig J.E., Weinbach G., Wolla S.A., Teaching the Linkage Between Banks and the Fed: R.I.P. Money Multiplier, Page One Economics, Federal Reserve Bank of St. Louis, 2021
  10. ↑ Board of Governors of the Federal Reserve System, H.3 Aggregate Reserves of Depository Institutions and the Monetary Base, https://www.federalreserve.gov/releases/h3/
Monetary base — recommended articles
Monetary aggregates — Broad money — Creation of money — Reserve ratio — Monetary policy instruments — Federal reserve system — Monetarism
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