5.3Monetary policy and the money markets

We noted in Chapter 3 that while there have been changes in the functions of

central banks in recent years, one activity in which all central banks remain involved

is the operation of monetary policy. Monetary policy involves controlling the price

and quantity of money and credit with a view to achieving some desired objective

for the macroeconomy. Remember that it is bank loans which create money and

so the rate at which netnew loans (new loans made minusexisting loans repaid) are

created determines the rate of expansion of money and credit. Although there seems

in practice to be a large variety of techniques which can be used for this purpose,

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5.3 Monetary policy and the money markets

there are basically only two ways in which this rate of expansion can be inuenced,

and the techniques must fall into one or other category. Broadly speaking, the ow

of money and credit can be constrained by operating upon either supply or demand

conditions. That is by:

l	limiting banks’ ability to create loans;
l	limiting the demand for loans.

The traditional textbook example of restraining banks’ ability to lend involves

the central bank manipulating the quantity of bank reserves. Since loans and

deposits are assumed to be linked to reserves via a stable ‘bank deposit multiplier’,

a change in reserves produces a multiple change in loans and deposits. The modern

version of this technique is called monetary base control and we looked at it in

some detail in section 3.4.3. In the 1970s, the UK attempted to control the ow

of new loans more ‘directly’ using a device called the ‘supplementary special deposit

scheme’ (‘the corset’). Under the rules of the SSD scheme, banks were asked to

restrict the rate of expansion of their lending to a target range specied by the Bank

of England and the UK Treasury. They could adopt whatever method of ration-

ing they found most effective, but if their lending overshot the limits, they were

effectively ‘ned’ by having to hold additional (non-interest-bearing) deposits at

the Bank of England. Such direct controls have been out of fashion since the end

of the 1970s.

In section 3.4.1 we also noted that banks cannot make loans if people do not wish

to borrow. Thus, if the central bank can limit the demand for (net new) loans, it can

limit the rate of monetary expansion. The modern version of loan demand limita-

tion involves the use of short-term interest rates. Raising rates causes the demand for

new loans to diminish and reduces the rate of monetary expansion. There have also

been attempts at ‘direct’ control of the demand for loans. During the 1950s, for

example, attempts were made to limit the demand for credit by specifying minimum

deposit terms and maximum repayment periods for consumer credit. Again, such

direct intervention has been unfashionable for many years.

Monetary policy instruments:Variables which are directly under the control of the

monetary authorities.

In principle, then, monetary policy comes down to controlling either the avail-

ability of reserves (or monetary base) or the level of interest rates. Both of these require

day-to-day action by the central bank and so involvement with monetary policy is

inescapable.

Interest rates and the quantity of reserves are known as instrumentsof monetary

policy. As we said above, they are used with the intention of producing some desirable

macroeconomic outcome. This outcome is usually listed as one or more objectives.

For example, the desired outcome may involve some combination of values for the

rate of ination, the level of unemployment and the rate of economic growth. As we

noted in Chapter 3, the fashion in recent years has been to revise the rules whereby

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central banks operate in order to give them independence to pursue mainly one

objective: a low rate of ination.

Policy objectives:The ultimate goals or objectives of economic policy.

However, the connection between monetary conditions and the rate of ina-

tion (and the connection with unemployment and economic growth too, for that

matter) is indirect, it may not be constant over time, and it operates with a con-

siderable time lag. Thus, changing the instruments today in response to the current

rate of ination may be too late. Indeed, by the time any new settings start to

take effect, the rate of ination may have changed and we may nd the new instru-

ment settings pushing in the wrong direction. For this reason, central banks have

often operated with some intermediate targets. These are variables which respond

to instrument settings rather more directly and quickly, but have a predictable rela-

tionship with the ultimate objective. Thus, if one can keep an intermediate target

on track, this may be a good indicator that the ultimate objective will be at least

approximately achieved. During the 1970s and 1980s, the intermediate target in

most countries was the rate of growth of some measure of the money supply, and

policy instruments were adjusted to keep this within some target range. During the

1980s, however, the link between the quantity of money, the growth of spending

and the rate of ination broke down. Many countries, including the UK from 1986

to 1992, refocused attention on the exchange rate. Since 1992, the Bank of England

has dispensed with intermediate targets and has focused directly on the ultimate

objective of ination. ‘Ination targeting’ involves looking at a very wide range of

intermediate ‘indicators’ (rather than ‘targets’) in order to make a forecast of the

future path of ination on current instrument settings. The instruments are then

adjusted, if necessary, in the light of the forecast. An explanation of ination target-

ing in the UK is provided by Vickers (1998) and details of the way in which the Bank

of England Monetary Policy Committee arrives at its monthly decisions are given

by Budd (1998).

Intermediate targets:Variables which are affected directly by policy instruments and

form a reliable connection with the objectives of policy.

So far in this section we have suggested that central banks have a choice of

two policy instruments: the quantity of reserves and the rate of interest. In practice,

however, a general consensus has emerged among central banks that their powers

are limited to the setting of short-term nominal interest rates. The reasons for this

are mainly practical and can be summed up in the reasons for rejecting monetary

base control. We did this in Box 3.5. However, there is also a theoretical reason.

Operating on the quantity of reserves or the level of interest rates can be regarded as

policies drawn from each extreme end of a spectrum. It would be possible to employ

a mix of these instruments at different times.

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				5.3 Monetary policy and the money markets

Figure 5.2

To understand the difference involved in choosing between these instruments,

consider Figure 5.2. At one end of the spectrum, the central bank can set the quantity

of reserves and refuse to adjust it in response to any changes in demand. In this case,

the supply of reserves is shown by the vertical supply curve Sin the diagram and

1

the quantity of reserves is R*. Banks’ demand for these reserves is shown by the

demand curve, D. Notice that the demand curve is drawn steeply. Provided that

1

banks offer free convertibility between deposits and notes and coin (and we saw in

Chapter 3 that their ability to do this is crucial to condence in the system), their

demand for reserves is very inelastic. To begin with, we have an equilibrium position

at a (short-term nominal) rate of interest at i*. Suppose now that banks demand more

reserves. Remember: this could be because their clients are making net payments to

government or it could simply be that they have increased their lending (for com-

mercial reasons) and now need additional reserves to hold against the extra deposits.

The demand curve shifts outwards to D. Given the inelasticity of demand, interest

2

rates could rise very quickly indeed and to very high levels. i′is the example in the

diagram. Demand is inelastic because banks must be able to ensure convertibility.

And since their liquidity position is calculated when interbank settlements take

place at the end of each day, they need the reserves instantly. Faced with a shortage

of reserves, banks will bid aggressively for short-term funds. For every £1 gained

in customer deposits, there is an equal gain in deposits at the central bank. This one-

for-one gain raises the D/Dratio. But in a situation where reserves are in generally

bp

short supply, bidding for deposits will not solve the problem. What one bank gains,

another bank loses. But while attempts by individual banks to gain reserves will be

self-defeating, they will push up short-term rates sharply.

At the other end of the spectrum, the central bank may respond to the increase in

demand by providing additional reserves which completely accommodate the demand.

This it mustdo if it wishes the rate of interest, i*, to continue. Such a situation is

shown in the diagram by the supply curve S, drawn horizontally at the going rate

2

of interest.

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Chapter 5 • The money markets

Between these two extremes, obviously, it is possible for the central bank to

respond to a shortage by meeting some of the excess demand which will allow the

remaining shortage to bid up interest rates, but only to modest levels. We could

draw an upward-sloping curve in the diagram.

What this discussion reveals is that the central bank occupies a critical position

in the monetary system by virtue of its position as a monopoly supplier of liquidity

in the event of a system-wide shortage. In such a situation, it is genuinely a lender

of last resort.

Figure 5.2 tells us that the central bank can exercise this power just like any other

monopolist: it can x the quantity or it can x the price of what it supplies. Fixing

one determines the other, but this does not mean that the choice does not matter.

Firstly, it can x the quantity of reserves and let the price (the rate of interest)

adjust to shocks in demand. Alternatively, it can x the price, in which case it is the

quantity of reserves that will respond to shocks. Given the inelasticity of the demand

curve, xing the quantity is likely to result in sharp uctuations in price. In general,

central banks have come to the conclusion that it is likely to be less disruptive to

economic life in general to allow a certain degree of uctuation in the quantity

of reserves than to have interest rates moving sharply from day to day. This means

that the selected monetary policy instrument for most central banks is the rate

of interest. Central banks set the level of short-term interest rates which they hope

will produce the appropriate value for their intermediate target – the growth of

money, or credit, or asset prices, or the level of exchange rates – and provide whatever

quantity of reserves banks require in the light of the demand for loans. This demand

for loans will depend, among other things, upon the rate of interest which banks

charge to borrowers. This is not the same rate that the central bank targets, but it

is linked to it in such a way that changes in the ofcial rate are reected in the

loan rate. The ofcial rate is the price at which the central bank is willing to supply

reserves. The cost of reserves is part of the costs of production for banks. The rate they

charge on loans will be built up from the ofcial or ‘base’ rate by the addition of a

margin for prot and then a series of premia reecting the riskiness of the borrower,

the length of the loan and so on. The loan rate, in other words, is equal to the base

rate plus a ‘mark-up’. Provided the mark-up is constant, any change in the base rate

must be matched by a change in the loan rate.

The position of any monopolist is inevitably a powerful one, especially if it is

supplying something as crucial as the liquidity necessary to ensure the stability of

a country’s banking system. However, we must not get carried away with the idea

that because it has considerable power to bring about the rate of interest it thinks

appropriate, its choice of what is an appropriate interest rate is unconstrained. Even

an independent central bank is independent only of government inuence. It cannot

ignore the rest of the world. The constraints which central banks face in choosing

the appropriate level of interest rates are discussed in section 7.6.

Given their choice of the level of rates appropriate for the circumstances, central

banks set that level through their ‘ofcial’ operations in a country’s money markets.

Exactly how this is done and exactly which of the many short-term interest rates is

involved varies between countries. However, once again, there has been considerable

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