Monetary Base

The monetary base (also called M0 or base money) is the most fundamental measure of money in an economy—all the money created and controlled directly by a central bank. It comprises cash in circulation and the electronic reserves that banks hold at the central bank. Everything else in the broader money supply is built on top of the monetary base through the money multiplier.

The foundation and the building

Think of the monetary base as the foundation of a house and the broader money supply (M1, M2) as the walls and roof built on top. The central bank controls the foundation entirely—it determines how much base money exists.

But the foundation alone is not the whole building. Through the banking system and the money multiplier, the monetary base gets expanded into a much larger quantity of money that circulates through the economy. A central bank deposit of $1 becomes $10 or more in total money supply through lending and redepositing.

The two types of base money

Currency: The paper money and metal coins issued by the central bank and held by the public. When you withdraw $20 from an ATM, you receive currency.

Reserves: Electronic balances that banks hold in accounts at the central bank. A bank cannot see or spend these directly; they are a number in the Federal Reserve’s computer system. But they are as good as cash for a bank because they can be withdrawn instantly.

Together, currency and reserves make up the monetary base.

Central bank control

The central bank has absolute control over the monetary base. It can increase it by:

• Purchasing assets (via open-market-operations): The Fed buys a bond and pays with new reserves.
• Lending (via discount window): The Fed lends to a bank, crediting reserves to its account.
• Printing currency: The Fed supplies banks with new notes and coins.

It can decrease the monetary base by:

• Selling assets: The Fed sells a bond, and the buyer pays with reserves that are removed from circulation.
• Allowing loans to be repaid: Discount-window loans, when repaid, reduce reserves in the system.
• Accepting currency for shredding: If the public withdraws less currency than the Fed is printing, and old currency is retired, the monetary base shrinks.

The monetary base and inflation: the theory

Traditional monetary theory holds that inflation is proportional to the money supply. If the monetary base doubles, and the money multiplier holds constant, then the total money supply doubles, and prices (in the long run) should double as well.

This relationship is captured in the equation of exchange: M × V = P × Q, where M is the money supply, V is velocity (how fast money circulates), P is the price level, and Q is real output. A doubling of M, holding V and Q constant, means P doubles.

The empirical puzzle

In practice, the relationship between the monetary base and inflation is much looser than theory suggests. For example, during 2008–2015, the Fed tripled the monetary base (from roughly $900 billion to $2.7 trillion) via quantitative easing, yet inflation remained subdued. Why?

The answer is that the money multiplier collapsed. Banks, starved for safe borrowers and fearing another crisis, hoarded the new reserves instead of lending them out. The velocity of money fell—people and firms spent money more slowly. As a result, M1 and M2 grew much less than the monetary base, and inflation remained low.

This experience showed that expanding the monetary base, while necessary, is not sufficient to ensure inflation if the money multiplier and velocity are in free fall.

See also