Monetary Base

Controlling Monetary Base: A chasm between theory and practice

Introduction

One unending and unresolved discussion among academic and policy circles is whether Central Bank can control the monetary base or not. The academic-side economists often view the central bank (hereafter CB) as an institution exogenous to the market, exerting a significant control over the monetary base (hereafter MB) and in turn over broad money as well. For example, in the omnipotent ISLM model, money supply is treated as an exogenous variable determined by the CB. However, the central bankers, who are the practitioners of monetary policy, are increasingly aware that this view is deeply flawed. As Charles Goodhart, a professor at the LSE and former member of the Bank of England's Monetary Policy Committee, observed (Goodhart 1994):

Virtually every monetary economist believes that the Central Bank can

control the monetary base....Almost all those who have worked in a

Central Bank believe that this view is totally mistaken.

This article aims to discuss the feasibility of MB control. First, we examine the complex nature of MB from the perspective of a typical CB’s balance sheet. After decomposing the MB, we go on to explore each item one by one and CB’s control over them. These discussions lead to a rejection of the notion of MB control.

The Complex Nature of MB

The best way to examine the nature of MB is to take a look at the aggregate structure of the balance sheet of a typical CB as follow,

Assets | Liabilities |

GS Government Securities | C Currency in circulation |

LCB Loans to Commercial Banks | R Reserves |

FX Foreign Exchange Reserves | GD Government Deposits |

LG Loans to Government | |

The first two items on the Liabilities side -- currency in circulation C and the total reserves of commercial banks R – constitute a nation’s MB, also known as high- powered money. Therefore, MB=C+R. This equation shows how MB is used but cannot provide a clue about...