The concept of monetary base is a component of money supply, which is launched by the central bank into circulation. The term monetary base shows the nature of central bank money as a starting point for the creation of money by the banks.
Narrow money supply relates to a term formely used in the U.S. to identify currency kept by the non-bank entities as well as demand deposits of banks. Monetary base represents liabilities of the central bank to commercial banks. It is made up of deposits made by commercial banks at the central bank.
The term base money represents the dependence of an economy’s money supply on the central bank money.
Furthermore, it is dubbed as high powered money, because an increase in the monetary base, means the entire money supply can not rise to the same level. And that appreciation in the monetary base can be enlarged in respect of the supply of bank money, otherwise known as the money multiplier.
Monetary base is composed of various money supply components. These include from the minimum, that is, the volume of the prescribed mandatory deposits by banks at the central bank, as well as from the excess reserves, that is, the excess of the reserve requirements of voluntary deposits including cash holdings of commercial banks and non-bank sources (companies, households and public sector).
Open market operations constitute monetary policy tools which have a direct impact on the monetary base. Which is not only expandable but it is also possible to shrink it, via an expansionary policy or a contractionary policy respectively, but such actions are prone to risks.
Economic agents (non-banks) need central bank money for the payment function. Commercial banks need it because of the processing function by the reserve requirements. Both functions are fulfilled by the monetary base.
Central banks control the monetary base mainly through open market operations (including the main refinancing operations). For existing base money, the price level is influenced by the demand for it.
These institutions also possess the capacity to mold banking operations by controlling interest rates and modifying bank reserve prerequisites. Monetary base related determinations can generally influence the operations of the public sector, private sector and commercial banks.
Money market theory deals with the activities of providers of money. And a money based approach as well as credit theories are distinguished as the monetarist approaches of the money supply theory.