This article defines monetary policy from the Economics perspective, describes the functions and forms of money and outlines the main measures of the money supply.
It explains the difference between nominal and real interest rates and describes the structure of interest rates using the UK as an example.
Additionally, explains the process of credit creation and calculates Credit Multiplier.
Finally, it describes the function of a central bank (e.g. The Bank of England) and evaluates the arguments for and against having an independent central bank.
Monetary policy
Monetary policy is concerned with the money supply, interest and the amount of credit available to households and firms.
These factors are controlled by the government and the central bank in order to manipulate the level of spending and investment in an economy.
Interest rates
When discussing interest rates it is important to distinguish between nominal and real interest rates.
- Nominal interest rate is the rate offered by the bank.
- Real interest rate is the rate adjusted for inflation. For example, the bank offers an interest rate of 8% on a savings account. The inflation rate however is 3%, therefore the nominal rate is 8% and the real rate is 5%.
Even though the central bank sets a base rate which influence commercial banks (those used by households and firms), there is no set interest rate when saving or borrowing.
Instead, the rate of interest will depend on a number of factors including:
- Risk. Possibility the customer cannot repay the bank.
- Duration. The length of the loan.
- Notice. The amount of time it takes to withdraw from an account. Current accounts can be used when you wish while funds in deposit account usually have a time delay and require application. For example, you inform your bank you wish to withdraw £1,000, but you must wait 2 weeks to receive your money.
- Competition. Competition between financial institutions.
- Minimum deposits. A fixed amount that must be in the account at all times.
Banks use deposits to lend money to individuals and businesses. Their profit is the interest they receive on these loans. Therefore the interest they charge on loans must be higher than the interest they offer for saving money within their bank.
Credit creation
Banks create credit through their reserves which are their holdings of deposits.
The central bank can dictate Cash Ratio (%) which is a percentage of all the money deposited a bank must keep as cash. The cash kept is not allowed to be lent to customers and is used for personal withdrawals and emergencies.
The percentage of deposits that do not need to be kept may be lent out to the banks’ customers. The government may wish to borrow emergency funds during a time of crisis, such as war, a natural disaster, to support a weakening currency, etc.
Let’s take a look at the process of credit creation.
- The Cash Ratio (%) set by the central bank is set at 20%.
- £100,000 is deposited by the customers.
- The bank must keep £20,000 deposited.
- The remaining £80,000 can be used for lending to individuals and companies.
- The cycle of lending and reserves leads to the concept of Credit Multiplier.
Credit Multiplier
The amount of credit available in the economy depends on the Cash Ratio (%). The lower the ratio, the more money is available to lend. Funds borrowed from one bank can be lent from another.
Let’s take a look at the process of Credit Multiplier.
- In the example above, £80,000 can be used for lending.
- After that amount of money has been borrowed, banks receiving the funds must keep 20% in reserve which is £16,000 in reserve.
- So they may lend £64,000 (£80,000 – £17,000).
- This cycle can continue 64 times, resulting in almost £500,000 deposits and £400,000 in credit
Credit Multiplier can be calculated using the following formula:
Credit Multiplier = 1 / Cash Ratio (%)
Credit Multiplier = 1 / 20% = 5
£80,000 * 5 = £400,000
Central banks
Since 1997, monetary policy in the UK has been controlled by an independent Central Bank which is called The Bank of England. Central Banks have various functions to play in an economy, including:
- Issuing notes and coins.
- Supervising the financial system.
- Managing the country’s gold and currency reserves.
- Acting as bankers to the government, such as managing national debt.
- Acting as bankers for the banking system, such as lending funds to them in emergencies.
These roles also see the central bank involved in the management of national gold reserve, loans to cover The Public Sector Net Cash Requirement (PSNCR) for government and cash loans to banks to make sure they have enough to cover demand from their customers. The Bank of England’s main task since it is independence was to control the rate of inflation.
The inflation system it uses is known as Consumer Price Index (CPI), which it calculates each month. The Bank has a group called Monetary Policy Committee (MPC) who uses Consumer Price Index (CPI) information to make decisions regarding the interest rate (bank base rate). If they feel consumer spending is too great, they will increase the interest rate and vice versa.
Central bank independence
As mentioned earlier, The Bank of England is independent of the government. The arguments both for and against such an organization are as follows:
A. Arguments for independence:
- Less vulnerable to political pressure to create booms before elections in an effort to be popular before a vote.
- Have greater credibility with the market because stability is a goal.
B. Arguments against independence:
- The decision makers of the central bank are not selected by the people (through voting) and are not accountable to the public.
In summary, banks control the creation of credit in an economy. This can be directly controlled by the central bank which can enforce reserve asset deposits. In general, the central bank is an overseer of a financial system and helps instigate monetary policy.
