High Powered Money

High-powered money is sometimes called the “monetary base.” It includes all cash, even vault cash at commercial banks, and commercial bank deposits at Federal Reserve Banks, which are redeemable in cash. These assets are called “reserves” because commercial banks hold them to honor checking account withdrawals during times when withdrawals exceed new deposits. New loans are also made out of reserves in the sense that a bank with no reserves would have no funds to loan out. The term “high-powered” is a reference to the fact that a $1 increase in the volume of high-powered money will cause the most narrowly defined measure of the money stock to increase by about $2.50.

High-powered money is important because it represents net wealth to the private sector. In contrast, checking account money, called demand deposits, represents an asset to the owner of the checking account, but represents a liability from the perspective of the bank, which owes that money to a customer on demand. The liability cancels out the asset, leaving a net effect of zero on the net wealth of the private sector. Commercial bank deposits at a central bank represent a liability to the central bank. However, a central bank is a government or quasi-government agency that is not considered part of the private sector.

The narrowest definition of the money stock, called M1, includes checkable deposits and circulating currency, but not vault cash at commercial banks. Because M1 includes checking deposits and excludes vault cash, it is possible for the supply of high-powered money to change without a change in a money stock measure such as M1. Normally, a 1 percent increase in the supply of high-powered money will lead to a 1 percent increase in M1, the most narrowly defined measure of the money supply in the United States.

The concept of high-powered money is important because central banks directly control high-powered money and exert only indirect control over measures of the money supply, which are influenced by the willingness of commercial banks to make loans out of reserves.