For anyone who has followed finance or economics for any period of time, they have probably noticed that there are different types of money or currency. And no, I am not just talking about the currencies of foreign countries. What I am talking about is much more subtle than that. Ever wonder why you cant just buy things with the money you have in a savings account? You have to transfer it into a checking account first. It’s the same “money”, the same amount of dollars, but in a different form. It is these different forms that I am alluding too. That being said, there must be a form that is the most basic for money, in the United States monetary system, that is our base money, (aka the monetary base). So, what is base money?
Base money is the most liquid form of currency because it doesn’t need to be transferred into a different form before it can be transacted, this includes all of the physical currency, checking deposits and bank reserves. This statement allows for some nuance that unfortunately most people do not make. Bank reserves are basically the checking deposits of commercial banks that are held in their respective reserve account at the central bank. These bank reserves are what the Fed can create, not the money that circulates in the real economy. In other words, bank reserves are a form of inter-bank money that can only be used with the other depository institutions of the Federal reserve system.
Even though this is the monetary base of the economy and monetary system, it is not cited as often as other forms of money aggregates because it doesn’t include other forms of dollar denominated cash-equivalents. Other names for base money are M0 or “high-powered money”. M0 comes from the fact that it is the base layer or initial group if you will. The name high-powered money comes from the fact that it can be multiplied through fractional reserve banking, remember, bank reserves are included in this, and we know how those are used in fractional reserve banking.
Above is a Fred chart of the monetary base broken up into two different components. In red, we have the amount of currency in circulation. These are the coins and green pieces of paper we know as federal reserve notes. In blue, we have the amount held in reserve balances by commercial banks.
One interesting note to consider is that the amount of currency in circulation has been increasing at a more of less steady pace since 1960. There is obviously a bit of an uptake where that rate of change started to increase in the 2000s decade, but compared to most financial graphs, that’s pretty constant. Bank reserves, on the other hand, are a much different story. We see the appear to be essentially zero in this graph, they aren’t, it’s just because the scale had to increase so much due to the increase in bank reserves. This is the obvious change of reserve regime discussed in a previous post (Linked here). Finally, notice how the amount of currency in circulation was much larger than the amount of bank reserves until the Great Recession. This happened again in late 2019, right when there was a massive spike in the repo market and the fed blamed it on the amount of bank reserves no longer being “ample”.
Why is it important?
So why do we even care about our monetary base? According to the federal reserve, these measures on money supply have shown close relationships with other economic variables such as nominal gross domestic product in the past. I mean, with more money in circulation it would make sense that the amount of money producing goods and services would increase as well, right? Therefore, increasing GDP. However, that is with all other things being equal and not considering inflation, which we are becoming all too familiar with at this point in time.
I’m sure you have heard the phrase from Milton Friedman “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than output.” The idea behind this is that as the amount of money in circulation increases, there is more money chasing the same amount of goods and services, therefore the prices of those goods and services increase as well.
Ultimately what matters in this respect is the amount of money in circulation apropos to the amount of goods and services. If the amount of money in circulation increased in such a way that it induces a proportional increase in the amount of goods and services, then we are good. However, if this is not the case and the amount of currency circulating in the real economy relative to goods and services decreases, prices increase.
How does it change?
Obviously, the amount of base money in the United States changes. In the era of Quantitative Easing (QE) and an ample reserve-regime, the amount of bank reserves fluctuates constantly. Below is a historical chart going back to 1960, if you notice, it is just a superposition of the separate factors discussed in the previous chart.
Now, with bank reserves being a portion of M0, that means that the open market operations by the Fed changes the amount of base money in the monetary system. This is typically an ability of the country’s central bank, from there, the private banking system multiplies it through their lending practices.
Why does base money change?
As discussed in previous post, the Fed injects or removes bank reserves from the monetary system in order to implement monetary policy. This involves influencing interest rates and providing liquidity. In the case of QE, the Fed buys a U.S. Treasury from a depository institution with bank reserves. So, an asset swap occurred in which a more liquid form of cash (bank reserves) was swapped out for the U.S. Treasuries which are less liquid.
Base Money Vs. Broad Money
I am sure you have heard of the money supply or broad money. This is different from base money. Here is where we must distinguish between the various money aggregates and where money is created. As naming goes in the sciences, at least for the most part, it is either self-explanatory or follows a pattern. In our case where base money is considered M0, when we add a level of complexity by including demand deposits and other checkable deposits, we have M1.
Another rung up the complexity ladder we have M2, which includes savings and time deposits, as well as retail money market securities. These are not as convenient of a medium of exchange because they need to be converted into cash or some checkable deposit before they can be transacted. You can’t just whip out a debit card and pay for things out of your savings account without transferring those funds to your checking account first. This nuance may seem negligible; however, it is necessary to look under the hood (or behind the curtain if you aren’t into cars) to understand how something works in case it breaks.
We can even go higher up in this ladder, M3 and M4, but this is where the measures start to depend on the country of discussion. For example, the Fed no longer publishes data on M3 which used to include institutional money market funds, short-term repos, and other large liquid assets. Either way, I have seen some arguments on where the line is with what is considered broad money. Some say it starts at M1 and others have said it is anything M2 and above. So, regardless of it seems there is a consensus that M2 is broad money.
A possible distinction between the two types of money is who created them. The fed creates base money (M0), and the commercial banking system creates broad money.
Final words
Understanding the plumbing of the monetary system provides one with an edge. Now, this edge can be used to become a better investor, or just to fulfil an interest. Regardless of your reason for wanting to understand the monetary system, it will help you make educated financial decisions throughout your life. In this world of monetary insanity, it is through understanding that we receive the clarity required to make educated decisions about of future and hopefully our posterity as well.
To your wealth and future,
James Forsythe
Links to repo market posts referenced in video
[1] Board of Governors of the Federal Reserve System (US), Monetary Base; Currency in Circulation [MBCURRCIR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MBCURRCIR, May 7, 2022.
[2] Board of Governors of the Federal Reserve System (US), Monetary Base; Reserve Balances [BOGMBBM], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BOGMBBM, May 7, 2022 [3] https://www.federalreserve.gov/faqs/money_12845.htm
