It is impossible to target both the money supply and the rate of interest. If you control one you have to let the other be as it will. Discuss

Authors Avatar

It is impossible to target both the money supply and the rate of interest. If you control one you have to let the other be as it will. Discuss

To discuss the above question we must firstly view the ways in which money supply can be controlled. In order to distinguish this we must first identify how it can be measured.

Money can be classified under two categories. High powered money (or monetary base) and broad money. Cash notes and coins that circulate outside the Country’s central bank is the narrow monetary base. The addition of banks’ balances with the central bank make up the wide monetary base, known in the UK as M0. However the monetary base system excludes bank deposits, which are the most popular source of liquidity for spending.

Therefore broad money is the measuring tool used by most countries in order to measure money supply. It consists of deposits at banks and building societies and is the means of selling most debts in modern society. The UK knows this as M4.

Until the 1970’s fiscal policy was seen as the main policy for controlling the economy. Monetary policy was only used to prevent excessive fluctuations in interest rates. However failure of the Keynes theory, as inflation and unemployment continued to rise rapidly, lead the Government to turn to monetary policy. The control of inflation was and remains one of the Governments main objectives and this lies with the purpose of the monetary policy. However since the independence of the Bank of England from the Government in 1997, interest rates are now decided by the Banks Monetary Policy Committee (MPC). The European Central Bank (ECB) also sets interest rates as well as targeting rates of inflation.

There are various techniques in order to influence and somewhat control the total money supply by affecting the credit amount that banks can create. The Central bank can provide extra money to banks. They may also set their interests rates below that of market rates in order to encourage and allow banks to borrow at a cheaper rate. This allows the Central bank to control liquid assets and if need be, cut back the amount provided to reduce the money supply. Open-market operations is another example. This is the sale or purchase by banks of Government securities (gilts or treasury bills) in the open market. If it sells more securities it will reduce the money supply as people pay with cheques drawn on banks. Open-market operations can also be used to control short-term interest rates. For example if the Monetary Policy Committee wish to raise interest rates, it will use open-market operations in order for their stated interest rate to be the equilibrium rate. They sell treasury bills to financial institutions that have to then borrow from the bank. They borrow through a sale and purchase agreement (repo), where they sell the bank gilts and buy them back after a fixed length of time. The difference between sale and repurchase prices will be set by the bank to reflect its chosen rate of interest.

Join now!

The model below illustrates demand for money (L) and the effects on interest rates (I) when supply of money (M) changes.

Market rate of interest at its equilibrium (I) lies where total demand of money (L) is equal to supply of money (M). This is known as the liquidity-preference theory of interest and originates from the Keynesian theory. If the interest rate was greater than at point (I) there would be an excess of supply of money. This would push interest rates back down towards equilibrium. Similarly if interest ...

This is a preview of the whole essay