The term monetary base denotes the total amount of a sovereign currency in circulation at a given point in time. A monetary base is made up of the combined value of all banknotes in circulation and sight deposits held at a central bank on behalf of commercial banks. These assets are known as base money. Other financial instruments such as Quasi money and book money are not normally included in a currency’s monetary base.
The size of a country’s monetary base directly affects inflation and deflation. A decrease in the amount of money in circulation leads to deflation, while an increase in the amount of money in circulation typically leads to inflation. A central bank or monetary authority may also choose to circulate new banknotes and coinage or to purchase commercial bank bonds in exchange for newly-created base money sight deposits in order to encourage inflation and deliberately lower the value a currency in relation to other currencies.
While a central bank may increase a monetary base by creating new base money to buy commercial bank bonds, commercial banks are not normally obligated to make use of those new sight deposits. A central bank can encourage commercial banks to put the new money into circulation by lowering the interest rate it pays to banks for their sight deposits, making the issuing of loans by commercial banks to the public a more attractive alternative to holding their reserves at the central bank. In some cases, central banks impose negative interest rates to force banks to put newly-issued base money into circulation in order to encourage inflation.
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