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Should the control of money supply be an essential part of macro-economic policy? Discuss two problems that havbe been encountered in the operation of monetary policy.

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Introduction

A. B. SHOULD THE CONTROL OF MONEY SUPPLY BE AN ESSENTIAL PART OF MACRO-ECONOMIC POLICY? C. DISCUSS TWO PROBLEMS HAT HAVE BEEN ENCOUNTERED IN THE OPERATION OF MONETARY POLICY IN THE UK OVER THE PAST DECADE. The government has the following policy goals: 1. Low inflation 2. Low unemployment 3. Balance of payments equilibrium 4. High economic growth. In order to achieve these goals the government has to use policy instruments such as controlling interest rates and money supply in the economy. The interaction of the demand for money with the supply of money determines the interest rates. The classical view believes that excessive increases in the money supply will lead to high inflation. Therefore they believe that they need to target money supply in the economy to achieve their policy goals. Monetary policy is the attempt by the government or the central bank to manipulate the money supply, the supply of credit, interest rates, or any other monetary variables to achieve the fulfilment of the policy goals. The way in which a government can assess its policy goals is through intermediate target. For example the number of vacancies notified in job centres could be used to judge whether the economy is in full employment or not. The government uses policy instruments to control monetary variables in the economy. Some monetary variables such as the rate of interest may be used by the government as a policy instrument as well as an intermediate target. One policy instrument is monetary base control, the control of high powered money in the economy. Banks have the power to create money, but there is limit to the amount that can be created. This is set by the amount of high powered money within the system and by the reserve ratio. For example, banks might need to keep 1% of their total deposits in the form of cash because customers withdraw cash on a day to day basis from bank branches. ...read more.

Middle

Because of the stock of high powered money is relatively small, these surpluses or deficits are likely to lead to large day to day fluctuations in short term interest rates. If banks are short of high powered money, they will need to borrow the money and this will push up interest rates, and vice versa. Sharp fluctuations in the short-term money market interest rates will be unsettling for financial markets as a whole. Secondly, there is doubt about the ability of the central bank to control the stock of high powered money. Assume that the central bank declares that banks must keep 1% of their assets in cash. The central bank then reduces the amount of cash in circulation, hoping to reduce the money supply by bringing about a multiple contraction in bank assets and liabilities. The banks may respond by tempting their consumers to place more of the cash in circulation with the banks. There is only one type of high powered money, which cannot be manipulated, in this way- balances by the banks with the central bank. If the central bank were to use this as a policy weapon, banks would have every incentive to devise deals which did not show up on their balance sheets i.e. engage in disinermediation. * Another problem with monetary policy is that money supply can be controlled through interest rates. The diagram below shows that the central bank wishes to reduce money supply MS1 to MS2. To achieve this it would have to raise interest rates from R1 to R2. But this assumes that the central bank knows the shape of the liquidity preference curve (LP). If it is more interest inelatisc than it thinks, then an increase in interest rates will not reduce money supply by as much as the central bank hoped. Moreover, if the liquidity preference curve is elastic then an increase in interest rates will lead to greater reduction in money supply. ...read more.

Conclusion

More importantly, mortgage lending was stagnant with the housing market stuck in a deep rut. On the other hand, by 1994 the economy was growing at above long-term average growth rates and there were signs that bottlenecks were already appearing in a few industries. International commodity prices were increasing along with many raw material prices. Consequently, the government began to put interest rates up again in September 1994, reaching 6.75% in March 1995. Since Black Wednesday, the short term rate of interest has been the key instrument of monetary policy, alongside a continuing commitment broadly to full fund the PSBR and allow the exchange rate to float without the Bank of England intervention. The Bank of England has continued to control short-term interest rates through open market operations in the discount market. It then allows other interest rates in the economy to be determined by market forces around that rate. On the whole, money capital markets are so inter-linked that increases in discount market rates will lead to increases in other interest rates in the economy and vice versa. Monetary base control has never been used in the UK. Quantitative controls were abandoned in the early 1980's. Open market operations are confined solely to the discount market and are used not directly to control the supply of money, but to control short-term interest rates. Overall, monetary policy can have many advantages, if implemented in the right way and in the right conditions. However, if government decide to implement monetary supply as a strong medium of intervention then problems may occur as stated above, where the UK suffered problems through the ERM and 'black Wednesday'. Monetary policy needs to be implemented in ways in which it will benefit the economy and help achieve the government's policy goals. However, governments have to realize that not all policy goals cannot be targeted at once, such as inflation and unemployment. This is clearly stated through Goodhart's law that if authorities attempt to manipulate one variable, which has a stable relationship with another variable, then the relationship will change or break down. ...read more.

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