Control of Money Supply and the Bank of England
Category : Money Supply
Control of Money Supply and the Bank of England
By definition, money pertains to any medium that enable trade or exchange of goods between people. The history of money dates back to the time when the barter system was still practiced. In this trade system, commodities are directly exchanged for other goods; for instance, farms animals are exchanged for fabric. Considering that commodities have different value, different countries developed standard values for each commodity for easier trade deals. These commodities are then valued according to their durability, divisibility and scarcity. Through this new practice, precious metals were introduced as the standard currency. It was during 400 BC when the Chinese used bronze, silver and gold coins to purchase goods. In some other parts of the world, gold nuggets, cowrie shells, copper, cacao bean, ivory and whale’s teeth were also used as money. Transporting precious coins can be dangerous as well as bulky; thus, traders would usually entrust their coins to goldsmiths in exchange of paper receipts. Eventually, the credibility of these paper receipts had become at par with the real coins, giving rise to another form of currency known as fiat or paper money.
As an important aspect of economy and trade, controlling the supply of money within a country is essential. Money supply refers to the total assets circulating that are acceptable in the trading of goods. This is primarily made up of cash and bank deposits. This has been explained through Fisher’s equation where MV = PT (M is for money supply; V is for velocity of circulation; P is the average prices; and T is the number of transactions). The supply of money is typically measured to monetary aggregates from M0 to M5. It is essential that money supply is monitored; otherwise, high amounts of money with too few goods available can cause upward pressures on prices, resulting to inflation. On intensive cases, inflation can negatively affect businesses in the country and lead to poor living conditions among the people. In UK, the Bank of England is in charge supply of money in line with its duty to protect its local economy. In this essay, the factors indicating the Bank’s control over the quantity of money will be discussed.
The Bank of England (BOE)
In 1694, the Bank of England was established as a joint stock company in return for a 1.2 million pound loan to the government. Aside from performing commercial activities, BOE is also expected to manage the accounts of the government and assist its funding requirements. Soon, BOE provided settlement services between banks as well as took the responsibility for maintaining the stability of the country’s banking system by means of acting as a lender of last resort. Over the years, the Bank’s central independence led to the development of the Bank of England in 1998. This in turn gave BOE the freedom to set its interest rate. However, the government set its inflation target to 2%; moreover, it is required that the operations of BOE must support the economic policy of the local administration (2002). The Bank of England Act indicates that BOE must maintain price stability and promoting the economic policy of the government by ensuring growth and employment. Along with this act is the utilization of the new monetary policy framework of UK. In addition, various measures are currently in use to monitor the country money supply (2001). The following section identifies these measures.
Measures of Money Supply and Control
Based on the IMF manual, the supply of money can be determined by combining the central bank’s current liabilities and the banking system’s deposit liabilities that are both held by the households, companies, non-profit organizations and public sectors outside the central government. This can be determined by standard monetary aggregates from M0 to M5. In the case of the Bank of England, two money aggregates are used to measure money supply. These are the base money (M0) and the broad money (M4).
Base money pertains to the currency that is in the hands of the public in addition to the reserves held by the commercial banks. The M0 is also known as the reserve money and monetary base, which is controlled by the central bank or monetary authority. On the other hand, M4 or L is M3 in addition to pension funds, treasury bills and negotiable bonds. This is also called very broad money that is used as a measure for fairly liquid assets. Generally, M4 covers most instruments traded in the money markets. Since the BOE is part of the European Union (EU), the Bank also used another monetary aggregate known as M3H. The purpose of this monetary aggregate is to coordinate the meaning of broad money within the union. This is basically made up of M4 in addition to British public entities’ foreign and sterling currency deposits in Britain’s monetary financial institutions and private sectors (). With the monetary aggregates used by the Bank of England, this indicates that BOE has a strong control over the quantity of money.
Another factor indicating BOE’s control for UK’s money supply is the presence of the Divisia money. This refers to the weighted average of money holdings from various groups or sectors wherein the weight of the money component is based on its usefulness in transactions. Examples of which are notes and coins that pay no interest and are generally useful for transactions. On the other hand, building society deposits require higher interest payments and are not as useful in transactions, resulting to a lower money component weight. This monetary aggregate is a part of BOE’s operations and has in fact been improved in 2004.
Specifically, changes involved the use interest rates instead of quotes. Rather than base the benchmark interest rate on local government bill rates, the interest rates are now calculated through the envelope techniques where the highest rate in the component series serve as the benchmark rate (2005). The implementation of these changes not only aims to enhance the appeal and accuracy of the Divisia money as a measure but also emphasizes the significant control of the Bank over the country’s money supply.
Finally, the integration of the new monetary policy in UK is observed through the main operation of the BOE. Specifically, this monetary policy aims to utilize a more transparent system, giving rise to open market operations. In this policy, the Bank targets a 14-day interest maturity rate. Considering that the reserve requirements are non-existent and all accounts must be settled by the end of the day, BOE create reserve shortages within the market in such a way that the entire system must come to the Bank for liquidity. BOE then sets the rate for the provision of liquidity to the market (2001).
In the beginning, the new policy framework seems to be doing its purpose. During the 1980s the average inflation was at 7% and about 4.25% over the 1990 to 1997 period. However, yearly RPIX inflation from May 1997 to March 2001 has been at 2.4% that is slightly below the target rate. Nonetheless, it should be noted that the introduction of the new monetary policy has made the inflation rate stable. In June 1995, the announced inflation target was at 2.5% or less; however, inflation expectation was still at four percent until 2005. Market measures of inflation sharply fell on May 1997, resulting to the development of the new monetary policy. Since then, expectations have fallen to levels that are slightly below the target, suggesting the strong faith the markets have for the new monetary framework.
Controlling the supply of money is generally an important responsibility of each nation so as to support continuous economic growth and development. In the case of UK, several factors have indicated the authority of the Bank of England over its money supply. These include the utilization of monetary aggregates, the inclusion of interest rate determination in the Bank’s operations and the development of the new monetary policy in the country that involves the open market operations. In addition, the role of the BOE in the country banking system indicates its ability to control the quantity of money. These include its ability to limit the amount of bank deposits banks can have, force up rates of interest to discourage customers from making loans as well as reduce the level of liquid assets. Considering that the BOE issues coins and notes, the amount of cash in the money supply can easily be controlled.
However, it should be considered that the major part of the money supply is not generated by the Bank of England. Since money is distributed to several holders, the Bank cannot have full control over all money holders. Moreover, the behavior of the retail banks as well as the customers cannot be manipulated by the Bank either. In conclusion, while the Bank of England may have a certain degree of control of over the quantity of money circulating in the UK economy, other factors limit this authority.