## Learning Outcomes

- Define the **monetary base** using AP-safe wording
- Identify the two parts of the monetary base: currency in circulation and bank reserves
- Distinguish the monetary base from **M1** and **M2**
- Explain why bank reserves count in the monetary base even though households do not spend them directly
- Apply the monetary base idea to Federal Reserve policy tools and money creation
- Avoid common AP exam mistakes about reserves, currency, and money supply measures

## AP Macroeconomics Syllabus

For the AP Macroeconomics, you are expected to understand how the monetary base is defined and measured, with a focus on the following syllabus points:

- Know that the **monetary base = currency in circulation + bank reserves**
- Identify that economists may also call the monetary base **base money** or **high-powered money**
- Explain that **bank reserves are part of the monetary base** but are **not** part of **M1** or **M2**
- Understand that the Fed can influence the monetary base more directly than broader money measures
- Distinguish between **currency in circulation** in the monetary-base sense and the currency measure used in money supply measures
- Explain how changes in reserves can lead to larger changes in the money supply through the money expansion process
- Recognise that open market operations, the discount rate, reserve policy, and interest on reserves affect the monetary base through reserves

## Test Your Knowledge

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, look more closely at that area during your revision._

1. What is the formula for the monetary base?
2. Are bank reserves included in M1 or M2?
3. Why are bank reserves counted in the monetary base if households cannot spend them directly?
4. How does the monetary base differ from M1?
5. If the Fed buys government securities, what happens first: the monetary base or M1?

## Introduction

Money measures can be confusing because economists use several different definitions for different purposes. On the AP Macroeconomics exam, students often know **M1** and **M2**, but miss a simpler point: the **monetary base** is a separate measure, and it includes **bank reserves** as well as currency.

This matters because the Federal Reserve does not control all forms of money equally well. It can affect the **monetary base** directly, especially by changing reserves in the banking system. Then, through lending and deposit creation, broader money measures may change later.

> **Key Term: monetary base**
> The total of currency in circulation plus bank reserves. It is also called base money or high-powered money.

### What the monetary base includes

The clean AP definition is:

$$
\text{Monetary base} = \text{currency in circulation} + \text{bank reserves}
$$

That is the formula you should memorise exactly. If an MCQ asks what the monetary base includes, the safe answer is **currency in circulation and reserves**.

> **Key Term: currency in circulation**
> Physical currency used in the economy rather than held by the U.S. Treasury or Federal Reserve Banks; in monetary-base measurement, this can include cash held in bank vaults.
>
> **Key Term: bank reserves**
> Funds banks hold as reserves, including cash in vaults and balances held at the Federal Reserve.

Why are these the two parts? Because both are forms of money linked directly to the central bank.

- **Currency in circulation** is physical cash
- **Bank reserves** are funds banks keep instead of lending out immediately

Together, these are the foundation for the banking system’s ability to create more money.

A useful way to think about this is cause and effect:

1. The Fed changes reserves or currency conditions
2. The monetary base changes
3. Banks may then make more or fewer loans
4. Deposits in the economy may rise or fall
5. M1 and M2 may change by more than the original reserve change

This is why economists sometimes call the monetary base **high-powered money**. A relatively small change in base money can support a larger change in broader money measures.

> **Key Term: high-powered money**
> Another name for the monetary base, reflecting that changes in it can lead to multiplied changes in the money supply.

Students often miss one subtle point. The monetary base is **not** the same thing as “all the money in the economy.” It is the central bank-related core from which broader money can grow.

> **Test Tip:** If a question asks which measure includes reserves, the answer is the **monetary base**, not **M1** or **M2**. This is a frequent AP trap.

### How the monetary base differs from M1 and M2

To answer exam questions well, you need to compare the three measures clearly.

- **Monetary base**: currency in circulation + bank reserves
- **M1**: currency + checkable and very liquid deposits
- **M2**: M1 + less liquid savings forms such as small time deposits and retail money market funds

The biggest exam distinction is this:

- **Currency** can appear in both the monetary base and M1
- **Bank reserves** are in the monetary base
- **Bank reserves are not in M1 or M2**
  > **Key Term: M1**
  > A money supply measure including currency, demand deposits, and other very liquid deposits.
  >
  > **Key Term: M2**
  > A broader money supply measure including M1 plus less-liquid savings forms such as small time deposits and retail money market funds.

Why are reserves excluded from M1 and M2? Because **M1 and M2 focus on money held by the public in spendable or near-spendable form**, while reserves are money held by banks.

This distinction is easy to blur because reserves are still real money in the banking system. But households do not use reserve balances to buy groceries or pay rent. Banks use reserves to settle payments, meet liquidity needs, and support lending.

A helpful comparison is below:

- If **you** hold cash in your wallet, that can count in M1
- If **your bank** holds reserve balances at the Fed, those reserves are not part of M1
- Both, however, are linked in the monetary base framework

That is why the monetary base only partly overlaps with M1. They share some currency, but they are not the same measure.

Students also confuse **checkable deposits** with reserves. They are different.

- **Checkable deposits** are liabilities of banks to customers and count in M1
- **Reserves** are assets held by banks and count in the monetary base

This difference matters because when banks create loans, deposits can rise even if the monetary base does not immediately change further.

> **Test Tip:** If a multiple-choice option says “required reserves are part of M2,” eliminate it immediately. Reserves are part of the **monetary base**, not the broader money supply measures.

### Why reserves matter if the public cannot spend them

At first, reserves may seem like an odd thing to include in a money measure. If households and firms cannot directly spend reserve balances, why count them at all?

The answer is that reserves matter because they determine how much lending and deposit creation the banking system can support.

Suppose the Fed adds reserves to banks. Banks now have a greater ability to make loans or buy assets. When banks lend, the proceeds usually become deposits somewhere in the banking system. Those deposits are part of the money supply.

So reserves matter not because consumers spend them, but because reserves are the banking system’s starting point for creating broader money.

This is the logic behind the money multiplier idea:

$$
\text{Money Multiplier} = \frac{1}{\text{Reserve Requirement}}
$$

And:

$$
\text{Change in Money Supply} = \text{Money Multiplier} \times \text{Change in Bank Reserves}
$$

Here is a worked example.

Assume:

- Reserve requirement = 10%
- Fed increases bank reserves by $5 million

Step 1: Calculate the money multiplier

$$
\text{Money Multiplier} = \frac{1}{0.10} = 10
$$

Step 2: Calculate the potential change in money supply

$$
\text{Change in Money Supply} = 10 \times \$5\text{ million} = \$50\text{ million}
$$

So a **$5 million increase in reserves** can support a **$50 million increase in the money supply** if banks fully lend and there are no leakages.

This is the key reason reserves belong in the monetary base. They are not mainly for consumer spending. They are there because they are the banking system’s raw material for money creation.

But notice the careful wording: this is a **potential** change. In reality, banks may hold extra reserves, or households may hold more cash instead of redepositing funds. That weakens the expansion process.

This also explains why the Fed often targets reserves first. It can inject or drain reserves directly through policy tools, and then the broader supply of money adjusts through banking behavior.

### How the Fed changes the monetary base

The Fed changes the monetary base mainly by changing reserves in the banking system.

There are four standard tools you need to connect to this idea:

- reserve requirements
- discount rate
- open market operations
- interest paid on reserves

Open market operations are the clearest example.

If the Fed **buys government securities**, it pays the seller, and those funds enter the banking system. Bank reserves rise. Since reserves are part of the monetary base, the monetary base rises first.

If the Fed **sells government securities**, buyers pay from bank accounts, reserves are drawn out of the banking system, and the monetary base falls.

Worked example:

Assume:

- Reserve requirement = 5%
- Fed buys $4 million of government securities

Step 1: Immediate effect

- Bank reserves rise by $4 million
- Monetary base rises by $4 million

Step 2: Multiplier effect

$$
\text{Money Multiplier} = \frac{1}{0.05} = 20
$$

$$
\text{Change in Money Supply} = 20 \times \$4\text{ million} = \$80\text{ million}
$$

So the sequence is:

1. Fed buys bonds
2. Reserves increase
3. Monetary base increases
4. Banks can expand lending
5. M1 and possibly M2 can increase later

Students often reverse steps 3 and 4. The base changes **first**. Broader money may change **afterward**.

The discount rate works through a similar channel. If banks borrow more from the Fed because the discount rate falls, their reserves rise. Since reserves are part of the monetary base, the monetary base rises.

Interest on reserves works by changing banks’ incentives. If the Fed pays more interest on reserves, banks may hold more reserves and make fewer loans. If it pays less, banks may lend more. At AP level, the key link is that reserves sit at the center of the story.

One more subtle point can appear in harder questions: the monetary base is more directly controlled by the Fed than M1 or M2. The Fed can add reserves, but it cannot force every bank to lend and every household to deposit funds in exactly the same way. That is why the base is the cleaner central-bank measure.

## Key Point Checklist

_This article has covered the following key knowledge points:_

- The monetary base equals **currency in circulation plus bank reserves**
- The monetary base is also called **base money** or **high-powered money**
- Bank reserves are part of the monetary base even though they are not directly spent by households
- **Bank reserves are not part of M1**
- **Bank reserves are not part of M2**
- Currency can appear in both the monetary base and M1
- M1 focuses on highly liquid money held by the public
- M2 includes M1 plus less-liquid savings forms
- The Fed influences the monetary base more directly than broader money measures
- Open market purchases increase reserves and therefore increase the monetary base
- Open market sales decrease reserves and therefore decrease the monetary base
- Changes in reserves can lead to multiplied changes in the money supply through bank lending

## Key Terms and Concepts

- monetary base
- currency in circulation
- bank reserves
- high-powered money
- M1
- M2


Definition, Measurement, and Functions of Money - Monetary base includes currency reserves