This brief essay is a working draft of an article in preparation for the forthcoming International Encyclopedia of the Social Sciences, 2nd ed., examining the role of the monetary base in monetary economics and monetary policymaking. Comments are welcome.Money supply ; Monetary policy

Richard G. Anderson

English

Research Papers in Economics

      Research Division 
          Federal Reserve Bank of St. Louis 
                   Working Paper Series 
 
 
 
 
Monetary Base 
 
 
 
 
 
Richard G. Anderson 
 
 
 
 
 
 
Working Paper 2006-049A 
http://research.stlouisfed.org/wp/2006/2006-049.pdf 
 
 
 
August 2006 
 
 
 
 
FEDERAL RESERVE BANK OF ST. LOUIS 
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St. Louis, MO 63166 
 
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Monetary Base
**
 
 
R.G. Anderson
*
 
August 2006 
 
 
 
 
 
 
Abstract 
 
This brief essay is a working draft of an article in preparation for 
the forthcoming International Encyclopedia of the Social Sciences, 
2
nd ed., examining the role of the monetary base in monetary 
economics and monetary policymaking.  Comments are welcome. 
 
 
 
 
 
 
 
 
 
 
Keywords: monetary base, adjusted monetary base, McCallum rule 
 
JEL Codes:  A20, A30, E42
                                                 
** Essay in preparation for the International Encyclopedia of the Social Sciences, 2
nd edition, Macmillan, 
forthcoming. 
* Economist and vice president, Federal Reserve Bank of St. Louis.  Address correspondence to 
<anderson@stls.frb.org>. 
  1R.G. Anderson
*
Draft, August 24, 2006 
Monetary Base
**
 
 
The monetary base in monetary economics is defined and measured as the sum of currency in 
circulation outside a nation’s central bank and its Treasury, plus deposits held by deposit-taking 
financial institutions (hereafter referred to generically as “banks”) at the central bank.  More 
generally, the monetary base consists of whatever government liabilities are used by the public to 
purchase and sell goods and services, plus those assets used by banks to settle inter-bank 
transactions.  During certain specific historical periods when they were in circulation, measures 
of the monetary base also have included commodity monies such as gold and silver coin and 
bullion.  The components—currency and deposits at the central bank held by banks—often are 
referred to as base money.   
The monetary base has been defined by some authors as currency held by the public plus 
the cash reserves of banks.  Such definitions, even when correct, can lead to confusion and 
should be avoided.  A correct definition must include all base money held by banks, not solely 
the portion held to satisfy regulatory reserve requirements. 
Monetary Economics 
In monetary economics, the monetary base has several unique characteristics.  First, its 
components include the assets issued directly by a nation’s monetary authorities (Treasury and 
central bank) that are used by the private sector (the public and banks) to settle transactions.  
Transactions, of course, also may be settled by the exchange of privately issued bank deposits, 
but these have risk characteristics that differ from those of base money.  Second, the size of the 
                                                 
* Economist and vice president, Federal Reserve Bank of St. Louis. 
** Essay in preparation for the International Encyclopedia of the Social Sciences, 2
nd edition, Macmillan-Thomson 
Publishing, forthcoming. 
  2monetary base changes only if the monetary authorities take actions, actively or passively, to 
permit the change—the private sector cannot change the size of monetary base absent the 
cooperation of, and participation by, the monetary authorities.  Hence in monetary theory the 
monetary base, under the control of the monetary authorities, is the direct link between monetary 
policy actions and economic activity, including subsequent inflation.  As a practical matter, 
however, no central bank seeks to control the size of its monetary base exactly, fearing that so 
doing would sharply increase volatility of market interest rates. 
Supply and Demand 
Central banks control the supply of the monetary base by buying and selling assets.   
Purchases of assets, of any type, increase the monetary base when the central bank pays for such 
assets with currency or increased central bank deposit liabilities.  Similarly, central bank sales of 
assets, of any type, reduce the monetary base when the purchaser surrenders currency or central 
bank deposit liabilities in payment.  So long as the public willingly holds additional base money, 
the central bank is able to purchase assets and expand its size.  Historically, this has tempted 
governments with weak fiscal discipline to utilize the central bank as a purchaser-of-last-resort 
for government debt when private capital markets are unreceptive, often leading to hyper-
inflation (Fischer, Sahay, and Vegh, 2002). 
Demand for the monetary base includes the public’s transaction demand for currency and 
banks’ demand for base money to be used in their usual banking business and to satisfy statutory 
reserve requirements imposed on them by regulatory agencies.   
Cross-country comparisons of monetary base growth occasionally have appeared in 
international economics because central bank interventions to affect exchange rates necessarily 
are conducted by the purchase and sale of assets, altering the size of the monetary base.  When a 
  3central bank sterilizes the effects of its actions on the monetary base by offsetting the purchase or 
sale of one asset with the sale or purchase of another (buying, perhaps, a foreign-issued bond 
while simultaneously selling from its portfolio a domestically issued bond) such that the size of 
the monetary base remains unchanged, most studies have found little effect on exchange rates.   
Monetary Policy 
In all current economies, growth of the monetary base is an endogenous variable, that is, 
a variable determined simultaneously with other variables such as employment, output, prices, 
and market interest rates.  In modern times, only the Swiss National Bank has included among its 
monetary policy objectives a growth rate for the monetary base, although the Bank of England 
maintained a monitoring range during one interval (Rich, 1997).  Most of the world’s central 
banks conduct monetary policy by setting and manipulating the level of a short-term interest rate.  
In the United States, the Federal Open Market Committee implements policy by choosing a 
target level for the overnight federal funds rate (the interest rate charged by banks to each other 
for overnight loans of deposits at the Federal Reserve).  The federal funds rate is maintained 
close to the target rate each day by increasing or decreasing the supply of base money. 
Many empirical studies have examined linkages among growth of the monetary base, 
growth of broader monetary aggregates, and an economy’s inflation rate.  Over long periods of 
time, there is a clear positive relationship: absent significant structural or regulatory changes, 
prolonged inflation (and, especially hyperinflation) cannot continue without increases in the 
monetary base.  In most historical cases, excessive growth of the monetary base has reflected  
lack of fiscal discipline, not failure of monetary policy (Fisher, Sahay,and Vegh, 2002).  Sharp 
reductions in inflation such as occurred in the United States during 1979-1980 typically are 
accompanied by, and likely require, sharp reductions in the monetary base.  There is substantive 
  4disagreement regarding short-run relationships, however.  While some studies assert having 
found direct linkages between growth of the inflation-adjusted monetary base and inflation-
adjusted economic activity, other studies have found no reliable shorter-run connections.  In 
1988, Carnegie-Mellon University economist Bennet McCallum proposed a monetary policy rule 
in which the level of the federal funds rate target would be adjusted in response to growth of the 
monetary base.  After initial widespread attention, the rule’s impact on monetary policy has 
diminished in recent years. 
U.S. Currency Held Abroad 
In some countries outside the United States, large amounts of U.S. currency circulate 
freely and are used for the purchase and sale of goods and services.  It is common practice, 
however, for measures of the monetary base to exclude foreign-issued currency.  This practice is 
not without controversy.  To the extent that inflation is driven by total aggregate demand, foreign 
currency used in transactions matters. To the extent, however, that a country’s long-run inflation 
largely is caused primarily, or perhaps exclusively, by increases in its own monetary base, 
foreign currency is properly excluded.  Current empirical studies provide little guidance as to 
which is the more appropriate measure in these cases. 
For the United States, one additional issue arises.  Alone among the world’s nations, a 
large proportion of U.S. currency—more than half and perhaps as much as two-thirds—is held 
outside the United States (e.g., Anderson, Bordo and others, 2006, pp. 3-614 and 3-615).  Should 
this currency be excluded from the U.S. monetary base?  While experimental measures have 
been constructed that do so, no such measure has gained wide acceptance and none is currently 
published, despite Nelson’s (2002) finding that such a measure of the domestically held U.S. 
  5monetary base has been more closely connected to economic activity than other monetary 
aggregates. 
Changes in Reserve Requirements 
To be used as a longer-run measure of the stance of monetary policy, measures of the 
monetary base must be adjusted for the effect of changes in statutory reserve requirements.  The 
resulting series is referred to as the adjusted monetary base.  Increases in statutory reserve 
requirements, for example, tend to increase the quantity of base money demanded by depository 
institutions to satisfy the requirements, conditional on their level of deposits.  If no offsetting 
action is taken by the central bank, this increase is economically equivalent to the central bank 
reducing the monetary base itself.  To avoid sudden jumps in market interest rates due to changes 
in statutory reserve requirements, central banks have tended to match such increases in demand 
with increases in supply.  For further discussion, see Anderson and Rasche (2003).   
The Future 
  Two developments during the last decade portend a reduced future for the monetary base 
in monetary economics.  More specifically, these developments suggest a reduced demand for 
base money.  First, central banks worldwide have reduced regulatory reserve requirements to 
very low levels, attenuating banks’ demand for central bank deposits.  In the United States, 
although regulatory reserve requirements have not changed, banks since 1994 have used retail 
deposit sweep programs to sharply reduce their holdings of base money. (In a retail deposit 
sweep program, a bank reclassifies a transaction-oriented deposit subject to a high reserve 
requirement as a savings-oriented deposit subject to a low requirement.) Most banks that have 
implemented such automated sweep systems have reduced their required reserves to a level small 
enough to be satisfied by the vault cash and deposits at Federal Reserve Banks that they hold in 
  6the ordinary course of their banking business, thereby eliminating regulatory reserve 
requirements as a determinant of the demand for the monetary base (Anderson and Rasche, 
2001). In other countries, regulatory reserve requirements have been replaced with payments-
oriented requirements that generally allow banks to hold zero deposits overnight at the central 
bank. In the Euro area, the European Central Bank imposes a broad regulatory reserve 
requirement on most bank deposits at a three percent rate. This requirement must be satisfied 
solely with deposits held at the ECB; vault cash is not eligible. See Borio (1997) for a survey. 
 The second continuing development is the growth of electronic payments. In the absence 
of binding regulatory reserve requirements, demand for base money is driven by the need of 
households, firms and governments to initiate and settle payments. If electronic payments 
displace most currency and paper checks, then demand for base money might fall to such a low 
level that central banks would find control of its supply a weak lever by which to implement 
policy. The answer to this question remains uncertain. But, many economists have noted that tax 
payments play a central role. Most governments require that taxes be paid in base money.  In the 
United States, for example, tax payments to the U.S. Treasury must be settled in deposits at the 
Federal Reserve Banks—the Treasury accepts payments from households and firms drawn on 
banks only to the extent that such payments later are settled by the banks on behalf of their 
customers in deposits at the Federal Reserve Banks. Economists as diverse as Sir John Hicks 
(1969) and Michael Woodford (2002) have argued that this tax-payment function will assure a 
long-term role for base money in the economy. 
Data Availability 
In the United States, both the Board of Governors of the Federal Reserve System, 
Washington, D.C. and the Federal Reserve Bank of St. Louis publish monetary base data with 
  7and without adjustments for the effects of changes in statutory reserve requirements.  Data and 
details of the calculations and adjustments are available from those institutions. 
 
  8 
Bibliography 
Anderson, Richard G., Michael J. Bordo, Hugh Rockoff, David Wheelock and others 
(2006). “Monetary Aggregates,” in Historical Statistics of the United States: Millennial Edition, 
Susan B. Carter, ed., volume 3, Cambridge University Press. 
Anderson, Richard G. and Robert H. Rasche (2003). “A Reconstruction of the Federal 
Reserve Bank of St. Louis Adjusted Monetary Base and Reserves,” Federal Reserve Bank of St. 
Louis Review, vol. 85, number 3, September/October, pp. 39-70. 
Anderson, Richard G. and Robert H. Rasche (2001). “Retail Sweep Programs and Bank 
Reserves, 1994-1999,” Federal Reserve Bank of St. Louis Review, vol. 83, number 1, 
January/February, pp. 51-72. 
Borio, Claudio E.V. (1997). The Implementation of Monetary Policy in Industrial 
Countries: A Survey. Bank for International Settlements Economic Papers, No. 47, July. 
Fischer, Stanley, Ratna Sahay, and Carlos A. Vegh (2002). “Modern Hyper- and High 
Inflations,” Journal of Economic Literature, September, vol. 40, issue 3, pp. 837-880. 
Hicks, John (1969). A Theory of Economic History. Oxford University Press. 
McCallum, Bennett T. (1988). “Robustness Properties of a Rule for Monetary Policy,” 
Carnegie-Rochester Conference Series on Public Policy, vol. 29, pp. 173-203. 
Nelson, Edward (2002). “Direct Effects of Base Money on Aggregate Demand: Theory 
and Evidence,” Journal of Monetary Economics, May, vol. 49, issue 4, pp. 687-708. 
Rich, Georg (1997). “Monetary Targets as a Policy Rule: Lessons from the Swiss 
Experience,” Journal of Monetary Economics, June, vol. 39, issue 1, pp. 113-141. 
  9Woodford, Michael (2002). “Monetary Policy in the Information Economy,” in 
Economic Policy for the Information Economy, Craig S. Hakkio, ed., Federal Reserve Bank of 
Kansas City (proceedings of the 2001 Federal Reserve Bank of Kansas City Jackson Hole 
symposium), pp. 297-370. 
 
 
 
 
  10

A Reconstruction of the Federal Reserve Bank of St. Louis Adjusted Monetary Base and Reserves,” Federal Reserve Bank of St.

A Theory of Economic History.

Direct Effects of Base Money on Aggregate Demand: Theory and Evidence,”

Hugh Rockoff, David Wheelock and others

Modern Hyper- and High Inflations,”

Monetary Targets as a Policy Rule: Lessons from the Swiss Experience,”

Retail Sweep Programs and Bank Reserves, 1994-1999,” Federal Reserve Bank of St.

Robustness Properties of a Rule for Monetary

The Implementation of Monetary Policy in Industrial Countries: A Survey. Bank for International Settlements Economic Papers,

Monetary base

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Monetary base

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