Monetary Policy - Inflation - Cures

Theory 2 - Control of the money supply - just how much money is there?

The quantity theory of money suggests that control of the money supply will help in the fight against inflation. To say this is easy, but to do it is a lot more difficult. In the early 1980s, the governments set money supply growth targets for a number of years ahead to try to reduce inflation and influence people's expectations. The strategy was fraught with problems and the broad money measure targeted tended to go well outside its target range frequently. We now have an inflation target instead and use interest rates to influence money supply growth indirectly. However, there are various alternative techniques for controlling the money supply that have been suggested over the years.

There is more detail available on the development of monetary policy and the techniques that have been used in the past.

Monetary base control

Banks are only able to lend to people and firms if they have enough liquid money (cash and balances at the Bank of England) available to meet their liabilities. This is because the more they lend, the more money is required in the system. So, they have to have more than enough cash available to handle all requests for cash at a given time. After all you wouldn't be very happy if you turned up at your cash machine and it just said 'sorry'! This liquid money is referred to as 'base money'. The theory of monetary base control is that if you control the amount of base money available, you will limit the amount the banks can lend, and therefore limit the growth of the money supply.

There was a significant debate about using monetary base control in the 1980s, but it was felt that not enough was known about how stable the demand for base money was. It was therefore never implemented as a policy tool in the UK.

Direct controls on lending

Direct controls are regulations and requirements imposed on the banks and other financial institutions. They may take various forms, but usually set limits on the amounts the banks can lend. They are also often termed credit controls. They were used as a tool of monetary policy in the 1950s and 60s, but were dropped as the complexity and sophistication of the financial system increased. It would now be very difficult to use them, and there is little will to use them anyway. This is because it is widely acknowledged that they introduce all sorts of rigidities and reduce the amount of competition in financial markets.

Reserve requirements

In many countries, banks have to place a proportion of their liabilities as a reserve requirement with the central bank. These will often be non-interest bearing (pay no interest). The central bank could then use this reserve requirement to influence how much the banks could lend. If they raise the reserve requirement, then the banks would have to transfer money to the central bank and have less cash available to draw on when people wanted it. This would limit the amount they could lend as they would not be able to afford to generate new deposits. This would slow down the rate of growth of the money supply. Lowering the reserve requirement would have the opposite effect and would enable the banks to expand their deposits, increasing money supply growth.