A policy on money: then

Introduction

As we know, money creation is a significant feature of the economic landscape. Without money creation the financial system and the economy cannot expand, except through productivity improvements. Money is created by bank lending and bank lending is controlled by the management of interest rates. However, in the past it was different.

In the distant past and up to the first half of the twentieth century, a number of phases in the history of money and money creation can be identified and each one is a little different in respect of money creation. Essentially, there was a natural brake on money creation (it was not always respected though, with dire consequences) and this was convertibility of bank liabilities into gold. This natural brake was abandoned in 1931, and in the short period after this hyperinflation was invented.

The Bank of England over more than two hundred years assumed the functions we now associate with central banking, and their lead was followed by many other countries. The tools of central banking forged over many decades were interest rates, open market operations and required reserves, which were ineffectually implemented in the early days of central banking.

Essence of monetary policy: managing interest rates

Monetary policy is the implementation of decisions made by the MPC that are aimed at achieving the objectives of high and sustainable growth, through the central bank's limited range of instruments, which is to manage money stock growth to a level consistent with the capacity of the economy to expand, in order to avoid inflation rising above an acceptable level. As mentioned earlier, if we take a cue from Britain, Europe and other Old World countries, an acceptable level of inflation is around 2% pa. At this level business's attention is not deflected from business. Thus, with low and stable inflation the economic setting is conducive to growing output (and the dreaded deflation - falling prices - is kept at bay).

With the existing monetary system in place in most countries, money creation drives a higher level of economic growth. Think about this carefully again: the "demanders of bank loans", the borrowers (individuals, companies and government) borrow with the purpose of spending - either on investments (in housing, plant and equipment, inventories, roads, harbors, etc.) or on consumption (new fridges, beds, lounge furniture, etc.). So underlying the demand for loans is higher investment and consumption expenditure. What makes up GDE? Consumption and investment spending does (remember GDE = C + I).

Figure 1: GDE and bank loan extension (yoy %)

So the demand for loans by the NBPS and government and its satisfaction by the banking sector influences economic growth? Yes, indeed. Take a careful look at Figure 1. It shows the year-on-year growth rates for nominal GDE (grey line) and bank loan extension for a particular country over almost fifty years on the same scale. The correlation (coefficient = 0.6) is obviously high, providing strong evidence of the statement. It will be seen that at times the growth rates in both the time series was excessively high (at one stage 35-40% pa). These periods were associated with high inflation periods (see later chart).

Now a vital question: how does the CB manage money stock (and, to a large degree through it, GDE) growth? The answer in the past was a series of tools which we will come to shortly. In these modern times it is interest rates (in most countries) and the target is prime rate (specifically in real terms) because this is the benchmark rate for bank loan extension, i.e. the benchmark rate at which loans are made to the NBPS. As we have seen, this rate is heavily influenced by the central bank's KIR. Chart 2 shows the powerful role that real prime rate plays in influencing GDE growth (over almost 50 years in the same country as in the previous chart). (Prime rate has been advanced by 12 months because of the lag in the effect of policy action.)

Figure 2: current GDE (yoy %) & real prime (adv 12 months)

Figure 3: real prim and CPI inflation (yoy %)

Figure 3 is also a telling one. It again shows the real prime rate but now includes inflation as measured by the CPI. The inverse correlation over almost sixty years is quite startling, again indicating the compelling force of interest rates.

The use of interest rates as the principal operational tool of monetary policy was not always the case. We now briefly go back to history to sketch the development of monetary policy over time, followed by the "models" of monetary policy followed today.