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.
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:
. 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. Cash is then high powered money within the system. The money multiplier is 1divded by 0.01 or 100. So if the banks held £1 billion in cash, they would create a maximum of £100 billion in deposits. The money supply would then consist of any cash in circulation with the public plus £100 billion of bank deposit money.
One possible way in which a central bank can influence the size of the money supply is if it alters the size of the reserve ratio. From the example above, suppose the central bank issued a directive ordering banks in the future to keep 2% of their deposits in the form of cash. With only £1 billion in cash, banks could then hold £50 billion in deposits. The money supply would have fallen by £50 billion (£100 billion -£50 billion). So increases in the reserve ratio will lead to a reduction in the money supply, while falls in the reserve ratio, will lead to increases in the money supply.
The central bank can also restrict the supply of reserve assets in the banks. Suppose the central bank forced banks to deposit £1/2 billion of notes with it. They are then not allowed to include these deposits as part of their reserved assets. The bank will therefore see their holdings of reserve assets fall from £1 billion to £1/2 billion. They will be forced to then cut the amount of deposits held by the public from £100 billion to £50 billion. So restricting the availability of reserve assets to the bank will lead to a fall in the money supply.
Another policy instrument that the government may use is open market operations. This can affect the money supply through the power of purchase and sale of government stock. The central bank has a unique to centre bank notes or destroy them ate almost no cost to itself. For example, the central bank prints £1 million in notes and uses the money to buy financial securities such as government bonds from the general public. The public now holds fewer bonds but they hold £1 million more in bank notes. They are likely to deposit most of these in banks. Assume that the public deposits all their money into banks. If the reserve ratio is 1% and cash is the reserve asset, then £1 million of extra cash deposited in banks will enable then to create £100 million extra money through the credit multiplier.
The reserve is also true. If the central banks sells £1 million of its financial securities, the public will pay for these by withdrawing £1 million from the banks by issuing cheques to the central bank. The central bank will then present the cheques to the banks for payment in cash. The banking system will now lose £1 million of cash and therefore of reserve assets.
This process of buying and selling financial securities in exchange for high powered money is known as the open markets operation. In practice credit multipliers are nowhere near as large as in the examples, but open market operations are still likely to produce a multiple increase or contraction in the money supply.
Banks can still go bankrupt whilst still remaining perfectly sound financially, They only keep enough cash or other liquid assets to meet their day to day needs. They lend out the rest for a longer term. If all of the customers of a bank wanted their money back today, the bank would be unable to pay and therefore it would be technically bankrupt. To prevent this from happening, central banks act as lenders of last resort. When there is a shortage of cash in the financial system, the central bank will buy securities for cash. In the UK, ...
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Banks can still go bankrupt whilst still remaining perfectly sound financially, They only keep enough cash or other liquid assets to meet their day to day needs. They lend out the rest for a longer term. If all of the customers of a bank wanted their money back today, the bank would be unable to pay and therefore it would be technically bankrupt. To prevent this from happening, central banks act as lenders of last resort. When there is a shortage of cash in the financial system, the central bank will buy securities for cash. In the UK, discount houses are the channel through which the bank of England acts as a lender as last resort.
Banks will suffer no financial penalties for running short of liquid assets such as cash if the central bank is prepared to buy financial assets at their current market value. The current market value of assets such as treasury bills, commercial bills, and government bonds ids determined by the rate of interest. The higher the rate of interest, the lower the market value of outstanding bills and bonds. So if the discount rate (the interest rate which the central bank uses to calculate the price it will pay for bills and bonds) is equal to the current market rate of interest, the banks will not lose money if they are forced to sell assets to the central bank.
However, the higher the central bank sets the discount rate above market rates of interest, the greater will be the loss that banks face if they are forced to sell assets to the central bank when short of cash. So the higher the discount rate above market rates, the greater will be the banks' desired ratio of cash to total assets. With cash holdings, constant they can only increase this ratio by reducing their total assets and thus reducing the money supply.
Increases in the discount rate are also likely to increase bank base rates as well as other interest rates in the economy. An increase in the interest rates will reduce the demand for money. In equilibrium, the demand for money is equal to the supply of money. So in theory an increase in interest rates, with the demand curve for money (the liquidity preference curve) unchanged, can only be sustained if the money supply has fallen too. To achieve higher interest rates the central bank must be prepared to buy and sell financial assets such as bills and bonds on a day o day basis at the constant higher rate of interest. What the central bank cannot to do is choose both an interest rate level and a money supply level. Either it fixes the money supply and allows the rate of interest to find it's equilibrium level or it fixes the rate of interest and allows the money supply to adjust.
In the traditional sense of the term, funding refers to the replacement of short-term debt by a long-term debt. In modern monetary policy, changing the changing the structure of the debt can affect the government's intermediate targets.
Central banks have used a variety of other techniques in an attempt to control the money supply. For instance in the 1970's UK banks were subject to limits on growth of their deposits. These were called the supplementary special deposit scheme and nicknamed the 'corset', the bank of England imposed interest rate penalties an excessive deposit growth. Throughout the post-war period up to 1981, governments used hire purchase credit in the economy. During the late 1960's banks were told to give special priority to firms wishing to borrow money for exports. This was an example of how monetary policy was used to favour certain sectors of the economy at the expense of others.
In practice monetary policy is extremely complex and t is far from clear whether the central bank has any real control over monetary variables. Assume that the central bank is attempting to control the money supply by restricting the growth of bank lending. Potential borrowers then have tow choices. Either they don't borrow, in which case the central bank has achieved its policy objective, or they find another way of borrowing the money, for example through loan sharks. In practice both are likely to occur.
This encouraged banks and their customers to find new ways of borrowing and lending money, which would not appear on the officially controlled balance sheets of the banks. At the time, the banks got firms to borrow from each other. The bank put the two sides in contact and provided insurance cover to the lender in case of default by the borrower. The bank charged a fee for its work, and then lent out the money in the normal way.
This was an example of Disintermediation and it results in the measure of money supply being lower than the actual supply of money. Disintermediation becomes easier the more alternative forms of borrowing and lending are available. Disintermediation is an example of GOODHART'S LAW. Professor Charles Goodhart argued that if the authorities attempted to manipulate one variable that had a stable relationship with another variable, then that relationship would change or breakdown as behaviour adapts to manipulation. Controlling bank lending won't reduce the money supply, but will lead to a breakdown in the former stable relationship between bank lending and monetary growth as borrowers borrow outside the banking system.
Many monetarists have argued that the only effective way of controlling the money supply is through monetary base control. But there are a number of problems with this. First the central bank is likely to define the monetary base in very narrow terms. High powered money I likely to be defined as cash, or bank balances with the central bank. On any one day, banks are likely to find themselves with too much or too little high powered money. 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. The Keynesian economists often argue this. Even if the central bank could control the money supply, it might not choose to do so because of other policy constraints. These include:
* The money supply and the rate of interest
* The money supply, the rate of interest and the PSBR and
* The money supply, the rate interest and exchange rate.
Monetary policy has existed in the UK for many years. However, the UK has encountered many problems in the operation of monetary policy, including the ERM (exchange rate mechanism). These are described in detail, further on in the essay.
The conservative administration that came into office in June 1979 was, to start with at least, monetarist in its views. Its most important policy goal was the reduction of inflation and it believed that inflation was caused by excessive increases in the money supply. It therefore attached far more importance to money supply targets that the previous labour administration. Money supply targets (the intermediate target of monetary policy, along with the PSBR) were written by the Chancellor of the Exchequer Geoffrey Howe into the medium term financial strategy, first published with the 1980 Budget. A reduction in the money supply was to be achieved by:
:) Setting interest rates high enough to lower the demand for money;
:) Financing the PSBR without printing money by selling government debt to the non-bank sector;
:) Allowing the exchange rate to float, to prevent the buying and selling of foreign currencies from affecting the money supply.
Interest rates, the PSBR and the exchange rate therefore became the monetary instruments of government policy.
High interest rates were achieved through increasing Minimum Lending Rate in the discount market. Within five months of coming into office, the government increased MLR from 12% to 17%.
The government attempted to cut the PSBR by reducing government expenditure and raising taxes. Cuts in the PSBR were seen as essential, partly because it was feared that the PSBR would in practice be financed through printing money (despite the sale of the new debt to the non-bank sector), and partly because cuts in the PSBR were essential if interest rates were to be reduced from their record levels.
The absence of the government intervention in the foreign exchange market resulted in an increase in the value of the pound. The effective exchange rate index increased from 107 in the second quarter of 1979 to 127 in the first quarter of 1981, an appreciation of 19% in less than two years.
Unfortunately for the government, its policy instruments proved neither adequate nor suitable to the task of constraining money supply within the pre-set targets. In the early 1980's, the money supply grew at approx. twice the rate set by the government. In part, this can be explained by the government's desire to deregulate financial markets. In 1979, the government abolished exchange controls, controls on the amount of sterling that could be taken abroad for investment purposes. The corset was abolished in June 1980, leading to a sudden jump in the money supply as hidden money returned to the official banking system. There were therefore no quantitative controls on bank lending left. This led to an increase in bank borrowing, and therefore the money supply, as individuals and companies increased their borrowings to their 'free market' level. Increases in debt as a proportion of income rose throughout most of the 1980's fuelled by further measures such as the deregulation of building societies in 1985.
However, it came to be realized that there was no simple connection between the rate of interest, increases in the money supply and the rate of inflation. One explanation for this is that controlling the money supply through interest rates assumes that the demand for money is a stable function of income-which it cannot have been in the early to mid-1980's. Indeed, the demand for money must have considerably increased, indicating that the controls of the 1960's and 1970's had artificially depressed the demand for money.
By the mid-1980's, the government had effectively abandoned attempts to control the growth of the money supply, and in November 1985 abandoned M3 as an intermediate target.
The government was divided about whether or not the exchange rate should be used as a new intermediate target. The Chancellor of the Exchequer, Nigel Lawson, believed that fixing the value of the pound against the deutschmark would prevent increases in inflation resulting from devaluations of the pound. He also believed that fixed value of the pound would impose a discipline on the government and industry. To prevent devaluation, the UK inflation rate would have to fall to the level of German inflation rate. Governments therefore would be forced to set sufficiently high interest rates to reduce growth of money supply and therefore the level of inflation. Industry could not expect government to finance inflationary pay awards by increasing the money supply and then devaluing the pound to restore UK industrial competitiveness on world markets. Others, led by the prime minister Margaret Thatcher, believed that the UK should use interest rates as the main policy weapon to reduce the money supply and bring down inflation, and allow the exchange rate to find its own level.
In 1987, the Chancellor indicated that the pound would shadow the, deutschmark. For a variety of reasons the pound almost immediately began to rise against the deutschmark, and the Chancellor reacted by bringing down interest rates. By mid-1988, it became clear that inflationary pressures were building up again in the UK economy. The government decided to combat inflation by raising interest rates. But raising interest rates would also lead to a rise in the value of the pound against the deutschmark. The Chancellor lost the argument pegging the exchange rate and bank base rates were increased form 7.5% in May 1988 to 15% by October 1989 whilst the value of the pound increased from 3.00 deutschmarks in the second half of 1987 to nearly 3.25 deutschmarks in the first quarter of 1989. But by October 1990, the government, due to the pressure from its EU partners, reversed its policy of allowing the pound to float and joined the European Exchange Rate Mechanism, thus putting stability of the exchange rate as an intermediate target once again.
Britain's entry to the ERM was, in retrospect, a disastrous move. For those economists against Britain's membership, it was a disaster because it forced the Bank of England to keep interest rates too high a level. Bank base rates were cut in October 1990 to 14% and then came slowly down to 10% by May 1992. However, real interest rates increased over the period, from 3.6% in the third quarter of 1990 to 5.8% in the second quarter of 1992. The result was that the economy remained stuck in what became the longest recession since the 1930's. Critics of the ERM membership said that inflation had been defeated in 1990-1991 and there should have been a substantial relaxation in monetary policy when aimed at getting the economy moving again. Many proponents of Britain's membership of the ERM felt that the UK had entered at too high an exchange rate. The decision to go in at a very high exchange rate was based on previous thinking, which had led to the shadowing of the deutschmark in 1987. A high pound would force firms to cut costs and keep them low. If they didn't, they would lose business and could go bankrupt because they were in direct competition with low inflation German and French firms.
On 16th September 1992, 'Black Wednesday', the government's economic policies were shattered when the foreign exchange markets forced the pound out of the ERM. This proved to be the turning point for the success of government policy. It enabled the government to bring down interest rates rapidly, from their 10% level, before Black Wednesday, to 6% in January 1993 and to a low of 5.25% in February 1994. The economy quickly got moving again with much lower interest rates and a pound, which had been devalued by approx. 13%. The government was even prepared in 1993-4 to underfund the PSBR by £5bn by selling government stock to the bank sector, thus directly increasing the money supply.
Money supply growth during 1992 -5 remained very subdued. This was despite a pick up in the economy and a huge £46bn PSBR in 1993-4. In fact, the government and the bank of England increasingly discounted the evidence from money supply figures about what was going on in the economy at the time and what the future rate of inflation might be. M0 growth was erratic, with speculation that growth in the black economy at time of high unemployment was fuelling demand for high denomination notes. M4 growth was dampened because of subdued bank and building society lending. Investment till 1995 was low, and hence firms were not borrowing to expand. Consumers only began to increase their net consumer's debt in 1995. High real interest rates, previous indebtedness, high unemployment and a lack of confidence made all consumers cautious about borrowing. 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.
