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November 27, 2014 

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DEPRECIATION: A more or less permanent decrease in value or price. "More or less permanent" doesn't include temporary, short-term drops in price that are common in many markets. It's only those price declines that reflect a reduction in consumer satisfaction. While all sorts of stuff can depreciate in value, some of the more common ones are capital, real estate, corporate stock, and money. The depreciation of capital results from the rigors of production and affects our economy's ability to produce stuff. A sizable portion of our annual investment is thus needed to replace depreciated capital. The depreciation of a nation's money is seen as an increase in the exchange rate. This process is described in detail in the entry on the J curve.

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MONETARY BASE:

The combination of currency held by the nonbank public, vault cash held by banks, and Federal Reserve deposits of the banks. Also termed high-powered money, these are the three monetary components over which the Federal Reserve System has relatively complete control. Due to this control, the monetary base is often used as a guide for monetary policy. The monetary base differs from a relative monetary aggregate, M1, through the inclusion of vault cash and Federal Reserve deposits and the exclusion of checkable deposits.
The monetary base includes the three financial assets over which the Federal Reserve System (the Fed) as more or less complete control. They are (1) currency held by the nonbank public and in circulation throughout the economy, (2) vault cash held by commercial banks and currency out of circulation, and (3) Federal Reserve deposits that commercial banks keep with Federal Reserve Banks.

The Fed can control all three of these items as a means of implementing monetary policy. It controls the printing of paper bills (Federal Reserve notes), which is the primary component of currency in circulation and vault cash (U.S. Treasury coins are the other component). The Fed can specify exactly how many ones, fives, tens, twenties, fifties, and hundreds to print. If it does not authorize the printing, then the printing does not happen.

Even more important, the Fed has extensive control over Federal Reserve deposits. The Fed can change the total amount of Federal Reserve deposits of commercial banks through open market operations--the buying and selling of U.S. Treasury securities. Buying securities expands Federal Reserve deposits and selling securities reduces Federal Reserve deposits.

Three Blocks in the Base

The three components of the monetary base are currency in circulation, vault cash, and Federal Reserve deposits.
  • Currency in Circulation: This is the paper bills and metal coins that is held by the nonbank public, that is, in circulation throughout the economy. It includes Federal Reserve notes (paper bills) and U.S. Treasury coins (metal coins). The nonbank public consists of consumers, businesses (other than banks), and government agencies (other than the Fed or the Treasury Department). This is the currency that can be used to purchase goods, make payments, and complete transactions.

  • Vault Cash: This is the paper bills and metal coins that is kept in the bank, that is, in the vault. This cash is used, quite literally, to "cash" checks and otherwise to satisfy currency withdrawal demands of depositors. Note that vault cash is not part of the official M1 money supply because it is held by banks (not the nonbank public) and thus it is not in circulation.

  • Federal Reserve Deposits: This is deposits that banks keep with the Federal Reserve System to clear checks and assist in other banking activities. The Federal Reserve System provides banks with a range of banking services, including loans and deposits. Banks are not only required to keep deposits as a means of joining the Federal Reserve System, these deposits are used to process checks through the banking system.
The combination of currency in circulation and vault cash is the total amount of paper bills and metal coins issued by the government. The combination of vault cash and Federal Reserve deposits is bank reserves.

Monetary Policy

The monetary base is commonly used by the Fed as guide to monetary policy. Monetary policy is control of the money supply (both M1 and M2) as a means of stabilizing the business cycle and addressing the related problems of unemployment and inflation.
  • During a business-cycle contraction, the Fed implements expansionary monetary policy, which involves an increase in the money supply and usually a reduction in interest rates.

  • During a business-cycle expansion that generates excessive inflation, the Fed implements contractionary monetary policy, which involves a decrease in the money supply and usually an increase in interest rates.
The primary tool of monetary policy is open market operations. This involves the buying and selling of U.S. Treasury securities which are issued by the Treasury Department to finance the federal deficit. Once issued, these Treasury securities are regularly traded among financial investors through the "open market," much like corporate stocks are trade through the stock market.

The Federal Reserve System, including each of the 37 Federal Reserve Banks, buy and sell Treasury securities in the course of their daily business. However, the Fed is also inclined to do extra buying or selling as a means of conducting monetary policy. When the Fed buys or sells Treasury securities, payment is ultimately made with Federal Reserve deposits. When the Fed buys, commercial banks end up with more Federal Reserve deposits. When the Fed sells, commercial banks end up with fewer Federal Reserve deposits.

As these Federal Reserve deposits change, so too does the monetary base.

Demand-Driven Currency

While the Fed also has control over the printing of Federal Reserve notes, the total of currency in circulation and vault cash held by commercial banks is really "demand driven." That is, the Fed prints and supplies whatever quantity of paper bills that the public and the banks want to hold. The Fed DOES control the total amount of M1 money supply, but if people want to withdraw "cash" from their checking accounts of if commercial banks want to exchange Federal Reserve deposits for vault cash, then the Fed ensures that an ample amount of "cash" is available.

<= MONETARY AGGREGATESMONETARY POLICY =>


Recommended Citation:

MONETARY BASE, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2014. [Accessed: November 27, 2014].


Check Out These Related Terms...

     | vault cash | Federal Reserve deposits | currency | checkable deposits | bank reserves | fractional-reserve banking | M1 |


Or For A Little Background...

     | banks | banking | traditional banks | savings and loan associations | credit unions | mutual savings banks | thrift institutions | money | M2 | monetary economics | government functions | financial markets | liquidity |


And For Further Study...

     | money creation | Federal Reserve System | Federal Deposit Insurance Corporation | Comptroller of the Currency | central bank | monetary policy | bank panic | monetary aggregates | barter |


Related Websites (Will Open in New Window)...

     | Federal Reserve System |


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