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

 

Techniques to control the Money Supply

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

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

  1. 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

  1. 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

  1. Funding This is when the BOE issues more govt bonds and less Treasury Bills. This reduces the money supply because banks have less liquidity
  1. 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

 

Problems with controlling money Supply

  1. Goodhart’s law
  2. Banks can hold reserve cash above the required amount
  3. Not all reserve assets were under govt control
  4. Disintermediation. If bankers can’t get credit from one financial institution they will go to another
  5. Difficulties in selling bonds
  6. 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

  1. Goodhart;s law rationing did not apply to all financial institutions
  2. Banks may get around these restrictions
  3. credit rationing stifles competetition between banks
  4. Works against the free market

 

 
Finance Pages

Bank of England

Monetary System

Controlling Money Supply

Deposit Taking

Financial System UK

London Money Market

Monetary Policy

Setting Interest Rates