Understanding The Money Supply and The Role of Central Bank Reserve Accounts - Part 1: Base Money

The MMT Perspective on Base Money and Why I Like to Take My Money in Liquid Form

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When I was first attempting to understand Modern Monetary Theory (MMT), the monetary base/money supply combo and commercial banking were the subjects that I found the most difficult. Before I could learn anything, there was always a mountain of jargon to look up—or climb over, if you prefer me to continue with the mountain analogy. Every sentence was like reading a foreign language: “Do you want to know about quantitative easing? Here are some strange words I’ve strung together that will clear that up for you.” Or not.

So, this article attempts to ease you in gently to the ‘monetary base’ stuff and the ‘how central banks interact with commercial banks’ stuff. We’ll start at the bottom—or the top—depending on your perspective. And we’ll do that by learning about base money and central reserves. I’ll leave ‘measuring the money supply’ explanations for part two of this subject area. It’s best we take one step at a time.

I Love to Categorise Money - Like an Economist

Economists categorise money based on how easily it can be used to buy things or pay for services—this is known as its 'liquidity.' For example, cash is considered very liquid because you can spend it immediately, whereas something like a savings bond is less liquid because you must sell it first before using the money to buy something.

I Prefer to Take My Money in Liquid Form

The most liquid form of money is called base money, sometimes referred to as M0, vertical money, high-powered money, or the monetary base. Base money consists of two types: currency in circulation and central bank reserves, both of which can be used immediately without any conversion or delay.

What Constitutes Base Money?

Central Bank Reserves

Central Bank Reserves are the deposits commercial banks hold at the central bank. In the UK, that’s the Bank of England. These deposits are held exclusively in digital form.

Physical Currency

Physical currency refers to the banknotes and coins in circulation, i.e., circulating among the public and businesses, as well as the physical cash held by commercial banks in their vaults and tills.

Both central bank reserves and physical currency are considered liquid assets. They do not need to be converted into something else before they can be spent.

What Causes Base Money to Expand?

Base money can be expanded as a result of government spending, the purchase of government bonds or other assets, and the Central Bank lending to commercial banks.

Government Spending

When the UK Government or the central bank pays for a service or new projects, for example a new fighter jet, the money always arrives at its intended destination via a bank account; i.e., it is paid into a commercial bank's reserve account at the Central Bank.

By ‘paid in,’ I mean the central bank types numbers into a computer using a keypad to add credits to the bank’s reserve account. As I said earlier, a reserve account is just the account that the bank has at the Central Bank. Just as you have an account at your bank, banks have accounts with the Central Bank.

The commercial bank credits the account of the service provider, i.e. the defence contractor. It does not move the money from the reserve account to the customer’s account—that money stays in the bank’s reserve account. And just as the Central Bank credits the commercial bank’s reserve account, the commercial bank pays the defence contractor by using a computer keyboard to type the required amount into the their account.

Quantitative Easing

When the central bank buys government bonds or other assets (e.g., corporate bonds or mortgage-backed securities) from commercial banks (the ‘secondary market’ as it’s called), it credits their reserve accounts with new money. This is called quantitative easing. Bank reserves have increased: base money has increased.

Central Bank Lending to Commercial Banks

In times of financial crisis or liquidity shortages, central banks provide loans to banks and financial institutions. This also increases base money. The most obvious example of this is the financial crisis of 2008. The collapse of Lehman Brothers and the ensuing financial panic caused a widespread liquidity shortage. Banks were reluctant to lend to one another due to fears of insolvency, so central banks stepped in to stabilise the financial system.

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Actions That Cause Base Money to Contract

Base money contracts as a result of the Central Bank selling government securities (securities is a term that covers various types of financial instruments) or physical currency being withdrawn from circulation.

The Central Bank Sells Government Securities and Does Not Reinvest the Proceeds

When the central bank sells government securities (i.e., government securities it previously purchased on the secondary market), banks purchase these securities using their reserves, which drains their reserves and reduces the monetary base.

Additionally, if the central bank allows the securities it had previously purchased to mature and does not reinvest them in new government securities (in the secondary market)—as the Bank of England did in 2022—this will, over time, reduce bank reserves. The maturing of securities does not have an immediate effect on bank reserves because the repayment of principal from the government is made directly to the central bank (as these were securities originally issued by the government). However, the decision not to reinvest by purchasing more securities will affect the long-term level of reserves in the system. With no fresh injection of reserves, those reserves gradually decrease due to normal banking operations, such as customer withdrawals, interbank payments or repayments of loans to the central bank.

This process, known as 'quantitative tightening' (QT), is a reversal of the quantitative easing activities that began in 2008. Through QT, reserves are gradually drained from the banking system, thereby reducing the monetary base.

Physical Currency Is Withdrawn from Circulation

The central bank can remove old, damaged, or obsolete banknotes and coins from circulation.

What Other Services Does the Central Bank Provide to Commercial Banks?

When Commercial Banks Need Physical Cash, They Get It from the Central Bank

When commercial banks need physical cash to fill up their ‘hole in the wall’ cash machines or to give to customers over the counter, they obtain that physical cash from the central bank. The commercial bank’s reserves are reduced by the same amount. The central bank is the only entity allowed to issue physical currency.

The physical cash comes from the central bank's vaults and is transported to the bank in a secure, armoured vehicle. Yes, that image in your head is correct: the money is delivered in those vehicles you see in the heist movies, where the driver wears a crash helmet and carries a hefty secure suitcase.

Central Bank Reserve Accounts Are Used to Settle Accounts Between Banks

The central bank provides a way to settle payments from one customer to another. For example, if your bank has given you a loan to purchase a new home and I’m selling mine, assuming you want to buy it, we need a way to complete the transaction.

If we both have accounts at the same bank, the bank just transfers the value of your loan into my account. And I give you the keys to your new house. End of story.

However, if we both use different banks, that’s when reserve accounts come in handy. Although the loan you got to buy my house was put into your bank account, that money is not transferred directly from your bank account into mine because, of course, I don’t have an account at your bank.

The Money Is Transferred Between Reserve Accounts

Instead, your bank uses its reserves to send the appropriate amount of money into the reserve account of my bank. Once my bank’s reserve account is credited, they update my personal bank account.

However, this update of my account is not done by transferring money from the reserve account to my account—these accounts remain separate; my bank’s reserve account remain credited with the additional value of your loan. As before, the bank uses a computer keyboard to type the appropriate amount into my personal account.

You No Longer Have an Asset in the Form of the Loan; You Now Have a Debt

Similarly, your bank has the cost of the loan debited from its reserve account. And the loan no longer shows as an asset in your bank account; it is now a debt, i.e., the debt you are expected to pay down with monthly payments of both the principal and the interest. Although you no longer have a financial asset, you have a physical asset, your new home.

Your mortgage debt is now the bank's asset because it expects to receive repayments from you over time. Your monthly mortgage payments will include both principal repayment and interest. The interest you pay over and above the value of the loan is the bank’s profit on the loan.

How Does This Affect Base Money?

These transactions do not affect the value of the monetary base. The total amount of reserves remains the same, and the amount of physical currency in the economy has not been affected.

In Summary

In this short article, you learned that:

• Economists categorise money based on how easily it can be used to buy things or pay for services. This is known as its ‘liquidity.’

• Base money means central bank reserves plus physical currency.

• Base money expands as a result of government spending, government purchase of government bonds or other assets, and the Central Bank lending to the commercial banks.

• Base money contracts as a result of the Central Bank selling government securities or physical currency being withdrawn from circulation.

• The Central Bank is the only source of physical cash and provides those physical notes and coins to commercial banks when they need them.

• Central Bank Reserve Accounts are used to settle accounts between banks.

In Part Two…

In part two of ‘Understanding Base Money, The Money Supply’ I will have a look at what we call, ‘the money supply’ and examine monetarist claims that "inflation is always and everywhere a monetary phenomenon.".

Do you agree? Do you disagree? I welcome your comments either way. Please comment below.

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Thanks,
Jim