Monetary policy after partial and final inconvertibility

We now come to monetary policy after semi- and final-inconvertibility of bank notes / bank deposits. The world had entered a new era; its economies were no longer constrained by a lack of money. By this time the Bank of England and many other central banks had much experience in the art of central banking. They had all the tools of central banking in place to effectively manage the growth rate in the money stock. The quoins of effective monetary policy were in place: centralized bank reserves, Bank rate, and the ability to make Bank rate effective (OMO).

However, this ability to effectively control money creation was put on hold for many years after 1931. Morgan informs us dramatically that: "During the nineteen years from 1932 to 1951 traditional monetary policy was deliberately thrown over." An era of cheap money and excessive money growth was to take place. The principal instigator, the cause, was government (and the related fact the central banks were subject to the dictates of government), and specifically the swelling budget deficits, which were largely financed by the banking sector, and specifically the central banks. As seen before, a CB purchase of an asset not only creates money it creates reserves (increases bank liquidity), ensuring low interest rates. Low rates were at times reinforced by Bank rate policy. During WWII at one stage ".the Bank of England announced it willingness to buy any Treasury bills offered to it on a 1 per cent basis"

As we have shown, a little time before 1931 (when there was partial inconvertibility), and certainly after 1931, a number of bouts of severe inflation in Europe were experienced, particularly after the World Wars. Morgan tells us that in these times: "The fact not generally appreciated was that.. .the money supply was accompanied by budget deficits which caused demand to outrun productive capacity"158 A new phrase emerged - hyperinflation - and the consequences were profound. There were calls to return to the gold standard. This was never to come about again.

However, following these bouts of severe inflation, the relationship between budget deficits (largely financed by the banking sector) and inflation came to be recognized, and so emerged an appreciation of the importance of the co-ordination of monetary and fiscal policy. Much later this was to be embodied in calls for the independence of central banks, which came about in the nineteen-eighties and -nineties (but only in a handful of countries).

After the Korean War (1950-53) monetary policy returned to "normality" in the sense that it was recognized that inflation was to be avoided and the cause addressed (the main one being large budget deficits financed in the banking sector). Central banks in the following few decades adopted specific economic objectives, which shifted from one period to another between: balance of payments stability, maintaining a fixed and stable exchange rate, low unemployment, high and sustainable economic growth, low inflation (or combinations of these). For example, in 1957 the UK Chancellor of the Exchequer, in announcing the appointment of the Radcliffe Committee stated: "...there is general agreement as to the objectives of monetary policy. This country stands determined to maintain a fixed and stable exchange rate. The primary requisite for this is that we shall be able and determined to avoid inflation at home. Equally, it is also agreed policy to avoid slumps and severe unemployment.... These objectives are not open to question."

Although the Bank of England had all the tools to implement monetary policy, as did many other countries, they were ineffectually utilized in the ensuing few decades - until it was realized that the adoption of an inflation target and success in this regard addressed all the objectives: that low inflation (meaning domestic demand was kept in check) created an environment that was most conducive to economic growth, low unemployment, and balance of payments stability. But this was to come later. In the decades before inflation targeting, the Bank of England, and many other central banks, flirted with monetary policy tools such as: a liquid asset requirements (of which the cash reserve requirement was a part) and variations in the ratio, quantitative bank loan ceilings, special deposit requirements, hire-purchase restrictions, and so on. None of them worked effectively.

The tone of monetary policy at this time was set by the 1957 Radcliffe Committee, and the essence of why monetary policy was not effective in the ensuing decades was a reluctance to allow interest rates to play the major role in curbing demand. The Committee stated that: "The Bank cannot restrain the lending operations of the clearing banks by limiting the creation of cash without losing its assurance of stability of the rate on Treasury bills.. .the Bank of England had chosen stability of the Treasury bill rate." This policy philosophy remained in place until the adoption of inflation targeting. Under inflation targeting the main policy instrument is interest rate management, which can only be executed if the KIR is made effective, and this can only be achieved if the banks are permanently indebted to the CB.

Even though the holy grail of monetary policy was discovered with inflation targeting, all is not well in the State of Denmark. This issue will not be belabored here, because this is a work on the mechanics of monetary policy; instead we now address the mechanics of monetary policy as applied today.

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