3.4 Constraints on bank lending

We turn now to the ‘base–multiplier’ model of money supply determination. All

it requires is some manipulation of terms with which we are already familiar.

Suppose that

MDC

pp

where M is the money supply, Dare bank deposits held by the public and Cis

pp

the public’s holdings of notes and coin. Suppose also that

BDCC

bbp

where Bis the wide monetary base, Dare bankers’ deposits (operational balances), C

bb

is banks’ holdings of notes and coin and Cis, as before, the public’s holdings of notes

p

and coin. Let that part of the monetary base held by banks be called ‘reserves’, R, so that

RDC

bb

and therefore

BR C

p

Suppose that banks operate with a desired ratio, a, of reserves to deposit liabilities,

‘the reserve ratio’

R/Da

p

and that the public holds a desired ratio, b, of notes and coin to its deposits, ‘the

cash ratio’

C/Db

pp

Then we can show that the relationship between the quantity of base money in

existence and the outstanding money supply depends numerically upon the magnitude

of the ratios aand b. Also we can show that a change in the supply of base will

cause a predictable change in the money supply, also dependent in size upon these

magnitudes. Firstly, the ratio of money supply to monetary base is

MDC

pp



BRC

p

Dividing through by Dgives

p

M	D/CC/D pppp 
B	R/DC/D ppp

Notice that D/D1, while C/Dis the public’s cash ratio b, while R/Dis the

ppppp

banks’ reserve ratio, a. Thus

M1 a



Bab

and therefore

M(1 b)/(ab) B

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Chapter 3 • Deposit-taking institutions

and

M(1 b)/(ab) B

The expression (1 b)/(ab) is sometimes represented by mand referred to as the

bank deposit multiplier.

Clearly, if the ratios aand bare stable, there is a precise relationship between M

and Band changes in Bwill have a totally predictable effect upon M. Equally clearly,

in these circumstances the quantity of Bwill be a constraint upon M. If the supply

of base is xed, banks cannot increase their lending without sacricing the ratio a.

Let us repeat, this is not a satisfactory account of the way in which the money supply

is determined in practice and the reasons for not basing monetary control techniques

upon it are given in Box 3.5.

3.5Building societies

The history, function and regulation of building societies distinguishes them quite

clearly from banks. They are, however, deposit-taking institutions and since 1989,

when M4 replaced M3 as the ofcial measure of broad money, their deposits have

been unambiguously ‘money’.

Building societies began, in the eighteenth century, as friendly or mutual societies

into which members made periodic payments to nance the building of houses in

their immediate locality. The origins are important because they help explain a

number of otherwise curious features of the societies. Their friendly society status

means that they have no shareholders in the normal sense of the term. A society has

no ‘owners’ but has ‘members’ who lend to the society by buying shares which are

in effect deposits. This partly explains why, although functioning for many recent

years in ways similar to banks, they have been exempt from regulations applying

to banks and were supervised by the Registrar of Friendly Societies rather than by

the Bank of England. Even now, under the FSA, the regulations applying to build-

ing societies are different from those governing banks. Their mutual nature also

explains why, until 1983, the Building Societies’ Association (BSA) was able to oper-

ate a system of ‘recommended (interest) rates’, a form of cartel which would have

been illegal for public companies. Their origins as providers of housing nance com-

bined with the advantages of mutual status also help explain why, in spite of rapid

growth, their business remains overwhelmingly concentrated in lending for house

purchase.

As we noted above, the societies’ deposits were rst admitted to the ofcial measure

of broad money in 1989. For most of the 1980s, the treatment of building society

deposits was something of a problem. Undoubtedly depositors themselves saw the

deposits as money. They could go into a building society branch and draw cash on

demand. For larger purchases they could obtain, also on demand, a cheque signed

by the manager payable to whomsoever they nominated. In the rst case, though,

it was the cash which was money, while in the second case careful examination of

the cheque would show that it was drawn on the building society’s bank. It was the

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