3.1 The Bank of England

position. But this only serves to increase ination again so that, over time, a policy-

maker with discretion to choosethe instrument settings will deliver a higher rate of

ination on average than would be the case if he were constrainedto minimise

ination.

On the face of it, both the theory and the evidence look sound. But there are

criticisms of both. The major one is probably that the empirical studies do not look

at other (non-central bank) factors which may play a part in a country’s predisposi-

tion towards ination. For example, in Germany, whose central bank was often

portrayed as the ideal model of independence, there is a widespread fear and dislike

of ination. This stems from historical episodes, in 1921–23 and 1948, when ination

wiped out the savings of millions of people and reduced transactions to barter.

Understandably, trade unions, employers and consumers are strongly opposed to

any development which might foreshadow rising prices, and this undoubtedly gave

the Bundesbank a relatively easy task, with or without independence. (It remains to

be seen whether the ECB, modelled on the Bundesbank, will enjoy such widespread

popular support.)

There are problems on the theory side too. Firstly, the benecial effects on output

and employment are purely temporary because agents are assumed to be well-informed

and realise that the higher money wages they are being paid to attract them into

work are quickly offset by rising prices. Realising that their real wage has not risen

they withdraw again from employment. Even so, the theory says that governments

have a continuingincentive to trick people into work by monetary expansion. This

suggests that agents can learn about the difference between real and money wages

but apparently cannot learn not to vote for governments that keep tricking them.

It seems that agents are quick to learn some things but not others. There is some

contradiction here.

Secondly, the incentives in the time inconsistency problem apply to allpolicy-

makers. Putting the decision in the hands of a central bank rather than government

in itself changes nothing. What is required is something additional, namely a central

bank that ignores the benets of surprise expansions. This is sometimes called a

‘conservative’ central bank. But it is not obvious why a central bank should nd it

easier to be ‘conservative’ than a politician who knows that surprise expansions do

not fool the electorate.

3.1.2Banker to the commercial banking system

Later in this chapter we shall emphasise that a country’s money supply is dominated

by bank deposits (notes and coin make up only a small proportion of the total).

Thus, while some bank deposits may be held as a form of saving, many deposits

(‘sight’ deposits in particular) will be held as their owners need them as a means of

payment. In the course of the average working day, customers of one bank will make

payments to other customers of the same bank, but also to customers of other banks

in the system. Payments between customers of bank A and bank B require some means

whereby funds can be moved between the two banks. This is done in most systems

by commercial banks holding their own accounts at the central bank. A payment

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Chapter 3 • Deposit-taking institutions

from customer A to customer B is then matched by the central bank debiting the

account of bank A and crediting the corresponding sum to bank B.

Furthermore, the willingness of the general public to hold bank deposits and

regard them as ‘money’ (something which we all take for granted today) depends

ultimately on the condence that deposits can alwaysbe converted to notes and

coin on demand. However, banks could not operate at a prot if for every deposit

(liability) they had to hold corresponding cash (assets), since notes and coin do not

pay interest. In practice, they hold only a small, carefully calculated fraction of cash

to deposits. (A verysmall fraction, as we shall see in the next section.) This opens up

the possibility, in theory at least, that a bank could nd itself in a position where

it could not meet an unexpectedly large demand for cash withdrawals. This could

cause a panic in which depositors generally tried to withdraw cash all at once and

banks, which were perfectly sound commercially, would nonetheless be forced out

of business. (The consequences of bank failure are discussed further under the

question of supervision below.) For this reason, the central bank occupies the role

of lender of last resort. Just as the general public can borrow from commercial banks,

so commercial banks can borrow from the central bank.

Lender of last resort:The ultimate provider of reserves to the banking system.

The Bank of England’s balance sheet is shown in Table 3.2.

Table 3.2Bank of England balance sheet, end 2005, £m

Banking Department
Liabilities and capital
Capital	14
Public deposits	615
Bankers’ deposits	3,117
Reserve and other accounts	21,095
	24,841
Assets
Government securities	2,126
Advances and other accounts	14,977
Premises, equipment, other securities	7,737
Notes and coin	1
	24,841

Issue Department
Liabilities
Notes in circulation	39,329
Notes in banking department	1
	39,330
Assets
Government securities	13,370
Other securities	25,960
	39,330

Source:Adapted from ONS, Financial Statistics February 2006, table 4.2A

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