M0 (monetary base)

The monetary base is the most liquid type of money circulating in the economy. The monetary base consists of physical money (coins, notes) and of the commercial banks' deposits with the central bank. The most important characteristic of the monetary base is that, under typical conditions, it can be converted into goods or services (or other currencies) almost immediately. In most cases, the supply of monetary base is controlled by the central bank that can expand it, for example by issuing more paper money.

The term derives from the fact that money created by the central bank is the ‘base’ upon which the larger monetary aggregates are pyramided in the fractional-banking system. The monetary base is also called ‘high powered money’, because in a simple money multiplier model, an increase in the monetary base can lead to a bigger proportional increase in overall money supply (broad money). Because of its ties with the general money supply, the monetary base plays an important role in the fundamental analysis of gold.

Gold and Monetary Base

The fundamental analysis of gold often emphasizes the importance of the relationship between the money supply and the price of gold. Even though the monetary base is not the biggest element of the money supply as a whole, it still is important as its aggressive expansion may cause the whole money supply to explode. Nowadays, (at the moment of writing this definition), we live in a world of fiat currencies. This means that the money we owe is not backed up by any physical asset but just by the commitment of our governments to recognize it as legal tender. Such a currency system allows central banks to print virtually unlimited amounts of money. In stable democracies, central banks are independent from the governments. This is a means of assuring that they will not print excessive amounts of money just to finance government spending. Whether this is reality, or just wishful thinking, is a different matter.

So, theoretically, central banks aim to avoid massive inflation – the rise of prices caused by an increase in the money supply. They should do so, because very high inflation may be harmful to the economy. If prices rise rapidly, it is extremely hard to compare prices of products and services in time. Such a situation hinders the process of long-term planning as it causes disorientation – not to mention that it eats up peoples’ savings. The instability harms the economy and limits its growth.

However, in the wake of the 2008 financial crisis, central banks have been under enormous political pressure to make many exceptions to the aforementioned rule (to avoid massive inflation). At first, exceptions were made to prevent the financial system from imploding, then to prop up the contracting economies. Since central banks succumbed to the desires of politicians, the monetary base and the money supply as a whole have been moving in one direction – up.

The fact that central banks are printing money means that everyone has more money, but it does not mean that everybody is better off. Why? As the amount of money in circulation is rising, people tend to feel that they have more money and they decide to spend it. This causes the demand for goods and services to rise. Retailers and producers notice that increasingly many people are buying whatever they produce. They decide to “check” whether people will continue buying if the price is “a little bit” higher. The prices rise and even though people have more money, they actually cannot buy more than before. So the citizens are not significantly wealthier than before. In short – money is also subject to the forces of supply and demand and excess supply means lower prices. A lower value of money means that you will need more of it to buy things and pay for services.

What does all of this have to do with gold? If the economy is struggling then the prices of stocks do not rise significantly (in real terms). This means that the stock market is relatively less profitable when compared with other markets. In such situations, investors usually switch from stocks to bonds. However, if the government is printing enormous amounts of money, investors start to lose their confidence. Most do not fear that the government will default on its debt but as inflation (especially if it’s really higher than reported…) is eating away at their gains from bonds they start to look for other assets that give greater returns. Some shift to commodities and assets perceived as wealth preserving. This is where gold and silver come into play. As more and more investors enter the commodities market, prices rise and precious metals soar.

Another way to think about this phenomenon is that when fiat (unbacked by gold or silver) money loses its value, people lose their faith in it and they turn to something that’s been money for many centuries – gold. This was actually one of the fundaments of the last gold bull (see the chart below).

As you can see, in the period between 2008 and 2011 the Fed more than tripled the amount of physical money. If you take into account the growing U.S. debt pile, then there is no wonder that investors are increasingly interested in precious metals.

We encourage you to learn more about gold – not only how it is affected by the monetary base, but also how to successfully use gold as an investment and how to profitably trade it. A great way to start is to sign up for our gold newsletter today. It's free and if you don't like it, you can easily unsubscribe.