Monetary Base
Monetary base is the total amount of cash in
the hands of the public (Lm) + bank reserves (cash in
hands of banks and deposits made to the Central Bank).
Monetary Base = cash
in the hands of the public + bank reserves
The Central Bank determines the monetary
base and from there, the financial intermediaries generate bank
money.
If we look at the composition of
a Central Bank, the monetary base is the same as the total amount
of assets minus the non monetary liabilities.
If the monetary base
increases: it creates money
If the Central Bank's assets increase
(there will be an increase in the reserves of currency, there
will be an increase in the credit in the bank system or in the
public sector), the non monetary liabilities don't increase,
logically the monetary liability will have to increase (creating
money)
If non monetary liabilities decrease,
without effecting the assets, it will be necessary to increase
the monetary liabilities.
If the monetary base
is reduced: this will cause a monetary problem.
If the Central Bank's assets decrease,
without the non monetary liabilities reducing, it will cause
a decrease in the monetary base.
There are variations in the Central Bank's balance
which therefore effect the monetary base. These variations can
not be controlled as they work on their own:
For example, a deficit (or surplus)
of the balance of payments is not controled by the Central Bank,
however it will influence the level of currency reserves.
Other variations in the Central Bank's balance
are controlable and these variations determine (with certain approximation)
the amount of monetary base.
For example, the credits given to
the banking system: if the credits increase, the assets increase
and therefore the liabilities increase. If the non monetary
liabilities do not vary, they will have to increase the monetary
liabilities (and as a result the monetary base will increase).
How does the Central
Bank modify the monetary base?
Through the rediscount rate: this
is the rate which the Central Bank is willing to use to lend
money to banks.
If the rediscount rate increases,
the credits that the Central Bank lend to banks will be more
expensive, then the banks will demand less (contraction of
the monetary base).
If the rediscount rate decreases,
these credits will be cheaper therefore banks will ask for
more money (expasion of the monetary base).
Another way in which the Central Bank acts on the monetary
base is through operations in the open market: buying-selling
banks' Public debt.
If the Central Bank buys public
debt it will increase the liquidity in the system. The banks
will be substituting values of fixed income with liquidity
that they can then use to finance loans.
