There are 2 types of Monetary Policy:
1. Direct Control of the Money Supply: This was used in the early period of Demand Management, but hasn’t been used in the UK in the 1990s.
2. Influencing the demand for credit by using interest rates.
This is the main tool of current UK monetary policy
1. Monetary Base Control
This involves controlling the monetary base as opposed to broad liquidity
This can be done by imposing a statutory cash ratio on banks. The BOE can make banks deposit 10% of their bank balances with the bank of England , this will reduce the Money Supply.
Problems with Monetary base control
- Interest Rates would be volatile as attempts were made to keep the desired range of money
- BOE is a lender of last resort, therefore banks can always get enough cash
- Banks can keep cash surplus to their requirements so they will be unaffected by min reserve requirements
- Growth in MS unreliable
2. Controlling broad liquidity:
Focusing on broad liquidity allows the govt to use funding to be used a s method of controlling the MS.M3 was an important part of monetary policy until 1985
- Statutory liquidity ratio. If banks operate with a liquidity ratio of 10% then the Bank multiplier will be 1/0.1 = 10. If the gov’t increased this liquidity ratio to 15%, the bank multiplier would be 1/0.15 = 6
Before 1981 Uk banks had liquidity ratios placed on them, however they were removed in 1981 because of these reasons
- restrictions on banks is anti market and could lead to inefficiency
- Goodhart’s law. This states that it is very difficult for the BOE to control the banking sector, because when you regulate one part of the banking system this merely diverts business to another part which is unregulated
- Open Market Operations
If the Govt wants to reduce the money supply the BOE sells more securities. When people buy them they reduce their cash holdings. Thus there will be a multiple contraction of money.
Bonds are more effective than Treasury Bills
If the govt wishes to increase the MS it can buy bonds
- Funding This is when the BOE issues more govt bonds and less Treasury Bills. This reduces the money supply because banks have less liquidity
- Special deposits
Banks can be required to deposit a given % of their deposits with the BOE which can not be used until the BOE allows it
- THE Corset was a type of special deposit which made banks put a % of any increase in customers’ deposits in the BOE
Problems with controlling money Supply
- Goodhart’s law
- Banks can hold reserve cash above the required amount
- Not all reserve assets were under govt control
- Disintermediation. If bankers can’t get credit from one financial institution they will go to another
- Difficulties in selling bonds
- The effect on interest rates. If the BOE is committed to controlling the MS then ir will have to fluctuate, especially if demand in inelastic
Techniques to ration Credit
If BOE wanted to reduce supply of money without increasing ir then it would have to ration credit, The BOE tried to persuade banks to restrict their lending.
Or limit hire purchase credit. Also a reserve ratio will affect credit
Problems of rationing credit
- Goodhart;s law rationing did not apply to all financial institutions
- Banks may get around these restrictions
- credit rationing stifles competetition between banks
- Works against the free market