The Bank of England, the UK central bank, is banker to
the banks. Because it can print money it can never go bust. It acts as
lender of last resort to the banks.
The Bank conducts the government’s monetary policy. It affects the
monetary base through open market operations, buying and
selling government securities. It can also affect the money multiplier by
imposing reserve requirements on the banks, or by setting
the discount rate for loans to banks at a penalty level that
encourages banks to hold excess reserves.
There is no explicit market in money. Because people plan to hold the total
supply of assets that they own, any excess supply of bonds is matched by an
excess demand for money. Interest rates adjust to clear the market for bonds.
In so doing, they clear the money market.
A rise in the real money supply reduces the equilibrium interest rate.
For a given real money supply, a rise in real income raises the equilibrium
interest rate.
In practice, the Bank cannot control the money supply exactly. Imposing
artificial regulations drives banking business into unregulated channels.
Monetary base control is difficult since the Bank acts as
lender of last resort, supplying cash when banks need it.
Thus the Bank sets the interest rate not money supply. The demand for money
at this interest rate determines the quantity of money supplied. Interest
rates are the instrument of monetary policy.
Interest rates take time to affect the economy. Intermediate targets
are used as leading indicators when setting the interest rate.
A higher interest rate reduces household wealth and makes borrowing dearer.
Together, these effects reduce autonomous consumption demand and shift the
consumption function downwards.
Consumption demand reflects long-run disposable income
and a desire to smooth out short-run fluctuations in consumption. Higher interest
rates reduce consumption demand by reducing the present value of expected
future labour income.
Given the cost of new capital goods and expected stream of future profits,
a higher interest rate reduces investment demand, a movement down a given
investment demand schedule II. Higher expected future profits,
or cheaper capital goods, shift the II schedule upwards.
These effects of interest rates on consumption and investment demand are
the transmission mechanism of monetary policy.
