Monetary Policy: the challenge of interest rates

Published on October 29, 2015   21 min
0:00
My name is John Hearn. I'm a Senior Lecturer at the IFS University College, London. I'm going to talk to you about Monetary Policy: The Challenge of Interest Rates.
0:13
Monetary policy is defined as the central bank managing the overall level of aggregate monetary demand in the economy, using two main policy levers. Firstly, it can manage the volume of money, leaving interest rates to be determined by market forces. Secondly, it can manage the price of money, or what is usually referred to as the interest rate. And that is the challenge posed by this lecture. Before we move on, please note that both monetary policy and fiscal policy make up the government's demand management policies. Fiscal policy is defined in the same way as monetary policy, that is, managing the overall level of aggregate demand. And the only difference is in the levers used. Where fiscal policy makes its adjustments through spending, taxation, and borrowing, monetary policy makes its initial adjustment to the volume of money or the price of money.
1:10
To understand why interest rates were chosen exclusively as the main policy lever by almost all central banks around the world, you need to understand the structure of the money supply. This incorporates two main components. These are cash, which is notes and coins, and the money created by bank lending, which we're going to refer to as credit money. Most people find it easy to understand that cash is money, although they find it difficult to grasp that more than 90 percent of money is a claim on cash that could not be honored at one point in time if everyone demanded their money in cash. This means that the whole monetary system functions as long as everyone holding money is confident that they can access cash whenever they need it. A simple rule is to remember that all cash is money, but not all money is cash. That is why the monetary system of advanced economies is often considered fragile and liable to be damaged by shocks which affect confidence. In addition to this, we also need to understand how this money supply is converted into monetary demand.
2:28
The money supply is a stock concept. That is, at one point in time, it is fairly easy to measure total stock of money in the economy. Monetary demand, however, is a flow concept. It measures the number of times the stock of money is used on average over a period of time. We can represent the money supply by two concentric circles. In the center is cash or the stuff that is printed and minted by the central bank, and this probably accounts for less than 10 percent of the money in circulation in the more advanced economies. The other 90 percent has been created by bank lending and is represented here by credit money. The total money supply then can be estimated by adding up current or checkable accounts held at banks, and the total cash created by the central bank. To turn the money supply into monetary demand, we need to consider how many times on average, these units of money have been passed on in trade. Visually, this is easy to do by adding flow arrows to our concentric circles. In order to manage the size of aggregate monetary demand, it is necessary to control the size of the outer concentric circle and/or the velocity of circulation of that money, the speed it goes round. As it is almost impossible to control velocity, the central bank has two choices for controlling the money supply. Firstly, it can control the amount of cash in the economy. It has almost total control over this, if, of course, we exclude counterfeiting. Secondly, it can try to manage the total amount of bank lending in the economy.
4:20
In the 1980s, there was some debate about choosing either cash controls or lending controls. As there was a predictable ratio between cash and lending, the management of cash had been the main method of control. In the 1960s, this control had been made easier by central banks setting a ratio of cash to total assets for each main bank. In the UK banks have to keep 8 percent of their total assets in cash. By the 1970s, strict controls on cash had mainly been abandoned, and the rather loose connection between customer demand for cash and total bank lending was more difficult to estimate. So central banks decided to target the total amount of money in circulation by adjusting interest rates to restrict or encourage bank lending, and therefore, control the size of the credit money component of the money supply. Under a regime of interest rate policy, there was less concern of controlling the amount of cash in the economy.
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Monetary Policy: the challenge of interest rates

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