What is the Monetary Base?

This is a pretty fundamental question, crucial to understanding how money supply is created in an economy. Yet, I find that it isn’t answered clearly or rather completely, on many educational websites as well as in certain textbooks. So here’s my attempt at a lucid and comprehensive explanation. 

First things first, the ‘Monetary base’ is also called ‘High powered money’, ‘Reserve money’, ‘Base money’, ‘Money base’, ‘Central bank money’ or ‘M0’. 

Very simply, the Monetary base in an economy refers to the physical stock of currency (notes + coins) that is held by the public (this includes everyone except the Central Bank, all other banks in the country and the government) and the commercial banks.

More precisely, the Monetary base = Currency held by the public + Cash held by banks + Banks' reserves with the Central Bank. 

The Reserve Bank of India (RBI) defines it as: 

Monetary base = 1. Currency in Circulation +

                               2. Bankers’ Deposits with RBI +
                               3. Other Deposits with RBI

You'll see that while the terminology is a little different, RBI's definition is the same as the general one provided above. Before I talk about of each these components in detail, let’s take a quick peek at their quantitative significance. 

Monetary base (or Reserve money) Components for India (Rs Billion)

Source: RBI weekly statistical supplement, 4th Nov ’16


Source: RBI weekly statistical supplement, 4th Nov '16
We’ve used data for 28th Oct '16

As evident from the charts above, Currency in circulation comprises almost 4/5th of the Monetary base, while Bankers’ deposits with RBI comprise the remaining 1/5th. Other Deposits with RBI are ~1% of the base, and are therefore insignificant for the purpose of our discussion. That said, I’ll still touch upon them later for the sake of completeness.

1. Currency in Circulation

Currency in circulation = Currency with the public +
                                              Cash held by banks

This makes sense if you think about it. While the actual currency circulating in the economy obviously includes the currency held by the public (everyone outside of the banking system, the central bank and the government), it should also include the cash held by commercial banks, where the public has deposits. 

Ofcourse, if you have Rs 100 deposited in a bank, that does not mean that the bank has this Rs. 100 in physical cash. The bank has lent out most of your money to borrowers, and has probably just Rs 5 lying in cash to meet any sudden withdrawal requirements. But that’s a discussion for a subsequent post. 

Note: currency = cash; the terms are interchangeable 

2. Bankers’ Deposits with RBI (or Banks' Reserves with the Central Bank) 

Before I explain what Bankers’ Deposits with the RBI mean, I’m going to provide some much-needed context. 

So, by ‘Cash held by banks’ (part of Currency in circulation), I meant cash held by banks at their branches in order to meet daily withdrawal needs and maintain a cushion for other contingencies. But this is not the only reason why banks need to hold cash. They also need to satisfy the RBI’s Cash Reserve Ratio (CRR) requirement (most Central Banks in the world have this requirement). 

RBI’s CRR requirement stipulates that all banks need to maintain a certain % of their total deposits in cash with the RBI. Read my post CRR and SLR for details. The CRR currently stands at 4%. 

So let’s say a bank branch gets Rs. 20 lakhs in deposits in a day. Of this amount, Rs. 5 lakhs is consumed in meeting cash withdrawal and ATM replenishment needs. There’s Rs. 15 lakh left. Let’s assume the branch always keeps Rs. 10 lakhs in cash, in order to meet withdrawal requirements as well as maintain a little cushion. As a result, the branch will keep Rs 10 lakh at it's premises, and send the remaining Rs. 5 lakh to a “currency chest”.

A currency chest is a designated branch of a bank that collects cash on behalf of the RBI. Once cash is sent by a branch to the currency chest, it is deemed deposited with the RBI as on that day. This  amount is credited to the bank's (whose branch sent the cash) Current account with the RBI. Note: this cash counts towards satisfying the bank’s CRR requirement. 

With that background, I’m now going to explain what Bankers’ deposits with RBI refer to. Bankers’ deposits with the RBI are current account deposits that scheduled commercial banks hold with the RBI. When a bank deposits cash in a currency chest, this amount is credited to their current account. A bank usually maintains one Principal account, which is used to maintain CRR balances, and many subsidiary accounts with the RBI for inter-bank clearing, currency chest and other operations.

When you add up the balances in all these accounts, you get each bank’s total current account deposits with the RBI. The summation of all such deposits across the banking system, gives you total Bankers’ deposits with the RBI (or total banks' reserves with the RBI). As we’ve seen above, these deposits form 20% of the Indian monetary base. 

Finally, whenever banks are in need of cash, they withdraw currency from currency chests. When this happens, their current account balances with the RBI are debited by that amount. 

3. Other Deposits with RBI

This is a miniscule component of the monetary base (1% as on Oct 28th) and is usually ignored. It includes deposits held at the RBI by foreign central banks, foreign governments, international agencies such as the World Bank and IMF, and certain non-bank financial institutions (eg. primary dealers). 

Putting it all together

In conclusion, the Monetary base = Cash held by the public (i.e. cash held outside the banking system, the Central Bank and the government) + Cash held by banks (at their branches) + Banks' reserves with the Central Bank. 

This Monetary base is the total amount of physical cash available in an economy, and is quite literally the “base” on which the banking system of an economy creates the economy's money supply.