Civil Engineering Reference
In-Depth Information
Control of Money Supply
The 1980s witnessed a shift in policy emphasis as some economists argued that
inflation, especially demand-pull inflation, seemed to be inextricably related to the
size of a nation's money supply. The glib explanation, popularised in the media, was
that 'too many pounds were chasing too few goods'. It is difficult to fully appreciate
the money supply argument until it is understood that 'money' in a modern society
not only comprises notes and coins but also holdings in bank accounts, savings
accounts and government bonds. We do not, however, need to be too concerned
with the intricacies of this method of control: it has dropped from favour as
governments throughout the world experienced too many difficulties in targeting
and controlling money supply. In 1977, the OECD published a table showing how
the 24 countries that were members of the organisation were using 23 different
definitions of money supply. In fact, there were four different definitions of money
supply used in the UK during the operation of the policy.
Interest Rate Manoeuvres
Since the 1990s, governments have tried to bring inflation under control using
interest rates. This is done on the understanding that the prevailing rate of interest
significantly influences spending decisions, and, in particular, affects the decisions
of both businesses and households on whether to borrow (that is, to incur debts)
to pay for consumption and investment goods. As interest rates become higher,
and more volatile, businesses and consumers generally become less confident about
making new investments and negotiating future contracts. That is, other things being
equal, higher rates of interest should encourage saving and discourage investment
and consumer spending. To follow one sequence, higher interest rates will tend to
increase the cost of financing house purchases, and so reduce demand and lower (or
slow the rate of increase of) house prices. In summary, therefore, changes to interest
rates have a strong influence on the level of spending in an economy.
As detailed in
Chapter 12,
the process of deciding interest rates begins with the
monetary policy committee (MPC). The MPC has full responsibility for determining
the rate of interest used by the Bank of England when dealing with other financial
institutions trying to raise funds in the money market. The official
base rate
is
sometimes referred to in monetary circles as the
repo rate
(which represents the
rate that a central bank is willing to lend funds to other banks). This phrase relates
to repurchase agreements (and sales) of assets such as government bonds between
the Bank of England and its counterparties in the money market. The eurozone
equivalent set by the European Central Bank is called the
refinancing rate
, and
the interest rate used by the Federal Reserve in America is called the
discount rate
.
At the introductory level you don't need to worry too much about the difference
between the American, British or European terminology: the important point is
that in each case the central bank sets a carefully considered unique rate of interest
that determines the rate at which it will lend short term to the banking sector.
Subsequently this determines the short-term rate of interest that banks charge each
other for loans. (This rate is sometimes called LIBOR, which is short for the London
interbank offered rate. The precise sequence is neatly captured in
Figure 14.3
.)
