3.4.3The monetary base

In section 3.3.2 we saw that with xed reserves banks could increase their lending

only if they were prepared to operate at lower ratios of reserves: deposits. Until now

we have assumed that banks decide for themselves the appropriate ratio in the

light of their desire for prot and need for liquidity. The ratio is said to be a matter

of ‘commercial prudence’ and is said to be ‘non-mandatory’ to distinguish it from

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Chapter 3 • Deposit-taking institutions

the possible alternative, namely, that the ratio be written into banking law. A non-

mandatory ratio has operated in the UK for many years. This means that, strictly

speaking, banks could at any time increase their lending quite sharply provided they

were happy to incur the risk in so doing. However, under the current monetary con-

trol arrangements banks have agreed to advise the Bank of England in advance of

any signicant change in their decision to hold operational balances. Thus, we may

repeat that if the authorities decline to increase the supply of base money, banks are

constrained in the amount of lending they can undertake. To emphasise this point,

we can look briey at some of the steps that banks might think of taking in order to

circumvent the constraint. We shall see that they will not work.

Our rst thought might be that an individual bank which was short of base money

could raise the rate of interest it offered to depositors. It would gain deposits, matched

exactly of course by additional operational balances. Since operational balances were

previously only a very small proportion of deposits, this addition to both in the ratio

of 1:1 must raise the overall ratio. The bank is then free to expand its lending until

the ratio again falls to the critical level.

What is the difculty? It is that these additional deposits can come only from some

other bank. Any bank which loses deposits loses balances in equal measure and so

its ratio deteriorates. Thus, if the original problem was that the monetary sector as a

whole was critically short of base money, the attempt by individual banks to improve

their own position by raising interest rates will be self-defeating. The monetary

sector as a whole cannot gain balances by bidding for deposits. Let us consider an

illustration.

Exercise 3.2

Assume that the money supply is made up as follows and that the components pay the rate of interest indicated:

£bn	Interest rate % p.a.

Notes and coin in circulation with	the	public	50	0
Bank sight deposits			300	0
Bank time deposits (1 month)			200	5
Bank time deposits (3 month)			150	6
Bank CDs (3 month)			50	4
Building society deposits			250	7
			1,000

(a)	Calculate the weighted average rate of interest on money as a whole.

(b)	Assume now that banks begin to pay interest on sight deposits at 3 per cent p.a. What is the new weighted average interest rate?

Answers at end of chapter

Let us suppose that for each bank and for the system as a whole the reserve ratio

is 5 per cent or 1/20 and that each bank has deposit liabilities (D) of 1,000. Reserves

p

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