3.4 Constraints on bank lending

Box 3.5

Monetary base control rejected

Virtually every monetary economist believes that the CB [central bank] can control the

monetary base...Almost all those who have worked in a CB believe that this view is

totally mistaken. (Goodhart, 1994 p. 1424)

The base–multiplier model of money supply determination is presented in almost every

macroeconomics textbook as the only explanation of money supply determination.

Furthermore, it is impliedin all those texts which, lacking a formal model, still present the

money supply as a curve drawn vertically in interest–money space. And yet, as Goodhart

says, no central bank uses open market operations with a view to changing the size of

the base in order to achieve a multiple change in deposits. Even in 1981, at the ‘high tide

of monetarism’ when monetary targets were adopted universally, the Bank of England

considered explicitly moving to a system of monetary base control (MBC) and just as

explicitly rejected it. Why the model continues to dominate in textbooks when the real

world consistently rejects it is an issue we do not have time to discuss, but we can offer

a number of reasons for the rejection.

l

Firstly, MBC is a quantity control. In a pure system of MBC, supply would be xed(some positive interest elasticity notwithstanding) and uctuations in demand wouldhave to be absorbed entirely by price. If the authorities were trying to target the baseover very short periods, the uctuations in short-term interest rates could be extreme.The authorities are always reluctant to create situations in which interest rates may bevolatile. Targeting the base, averaged over a longer period, would ease this problemby allowing some day-to-day exibility in quantities, but so long as quantities are targeted rather than price, price must uctuate.

l

Secondly, while the base consists of liabilities of the central bank and one might expectthe central bank to be fully in control of its own liabilities, this is not always the case.Essentially, the central bank has to knowin advance what will happen to its liabilitiesin the course of ordinary transactions in order to supplement or reduce them. The mainproblem arises with Dwhich will change every time there are net payments between b the public and private sectors. Most central banks make daily predictions about theseows and inform banks and money markets of their plans to relieve shortages or to mopup excess liquidity. It is quite common for the nancial press to report the predictionsand outcomes. The errors are very large.

l

Thirdly, even if the central bank knewwhat effect spontaneous transactions were goingto have on the base, this does not mean that it could take the appropriate measures.Knowledge that the base was going to expand more rapidly than desired does notmean that the Bank can suddenly organise a bond issue in order to offset it. Again,this problem becomes more acute the shorter the targeting period. But even if the aim were to achieve an average rate of growth on a quarterly basis, frequent sales ofgovernment debt could be very disruptive to nancial markets. To ensure the sale ofthe correct quantity, governments would have to adopt a pure auction form of saleand thus would have to accept the market clearing price. Once again we are back tovolatile interest rates, this time at the longer end of the spectrum.

l	Fourthly, in some systems there would need to be major structural changes. Forexample, it is doubtful whether MBC is compatible with an overdraft system of

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Chapter 3 • Deposit-taking institutions

borrowing where banks agree maximum credit limits with their clients who then use

whatever fraction of the limit they need. In the aggregate, this is often of the order

of 50–60 per cent. A tightening of monetary policy would inevitably mean that rms

would want to use more of their overdrafts, and banks (unable to get reserves) would

then face the choice of either allowing the loans and breaching the reserve ratio

requirement or defaulting on their promises to borrowers. MBC would also require

governments to bank with the commercial banking system rather than the central

bank so that payments between the public and private sectors would not cause con-

tinuous and large uctuations in D.

b

l

Fifthly, there is an asymmetry in the operation of MBC caused by the fact that most bank assets are non-marketable. This means that an open market purchase of debt will increase D, Dand a(the banks’ reserve ratio – see below) as predicted pb and banks, being more liquid, can try to increase their lending. But a sale, causing a reduction in D, Dand a, requires banks to reduce loans. However, loans are not, as pg a rule, marketable. They can be reduced only by insisting on repayment (or refusing to renew). This is likely to prove very disruptive to trade, resulting in bankruptcies.

l

Sixthly, since cash pays no interest, then reserve requirements act as a tax on bank intermediation since they increase its cost. This occurs because the remaining, earning, assets have to earn a higher return to compensate for the zero return on cash (and what is often a below-market rate on operational balances at the central bank). This increases the spread between deposit and lending rates, which many would regard as the appropriate way of calculating the cost of intermediation. As with any tax, the supply curve is shifted to the left. Less intermediation is ‘bought’ and ‘sold’ and at a higher price than would otherwise be the case.

l

Finally, MBC raises doubts over the central bank’s lender of last resort role. As we have seen, bank deposits are convertible into cash on demand (albeit with interest penalties in some cases). However, the ows that we have discussed in this section could mean that perfectly well-run and solvent banks might nd themselves short of reserves. Would the central bank still offer the convertibility guarantee if such a shortage arose, as it well might, in a period of tight MBC?

Nonetheless, because it remains an extremely inuential view of the money supply

process, we need to know its essential features. In fact, we know how the central

bank could x the quantity of reserves if it so chose, so our main interest in this

model is the idea of some multiplier relationship between reserves and deposits.

Before we begin, notice that policy based upon this model is known as ‘monetary

basecontrol’ (not reservecontrol). This is because bank reserves and what is known

as the ‘monetary base’ overlap to a considerable extent. This can be seen by looking

back at Table 3.4, where the monetary base (M0) is shown to comprise notes and

coin outside the central bank (i.e. with banks and with the general public) plus banks’

deposits at the central bank. Using our earlier abbreviations, the monetary base 

DCC, while bank reserves comprise only the rst two, DC. If we assume

bbpbb

that the general public’s demand for notes and coin is stable (maybe a fraction of

their deposits, D), then in practice controlling the quantity of reserves amounts to

p

controlling M0, the monetary base.

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