Monetary Policy - Monetary Policy Committee

Further work - The role of money

Money supply

It has always been argued by monetarists that 'inflation is always and everywhere a monetary phenomenon'. Textbooks also usually argue that the transmission mechanism works through policy-induced changes in the money supply. It is the excess demand or supply of money that then leads, via changes in short-term interest rates, to spending and price level changes.

The money supply does play an important role in the transmission mechanism but it is not, under the UK's monetary arrangements, a policy instrument. It could be a target of policy, but it need not be so. In the UK it is not, as we have an inflation target, and so monetary aggregates are indicators only. In the long run there is a positive relationship between each monetary aggregate and the general level of prices. Sustained increases in prices cannot occur without accompanying increases in the monetary aggregates. It is in this sense that money is the nominal anchor of the system. In the current policy framework, where the official interest rate is the policy instrument, both the money stock and inflation are jointly caused by other variables.

The monetary transmission mechanism

Suppose monetary policy has been relaxed by the implementation of a cut in the official interest rate. Commercial banks correspondingly reduce the interest rates they charge on their loans. This is likely to lead to an increased demand for loans and this will create new bank deposits that will be measured as an increase in the broad measure of money (M4). So the change in spending by individuals and firms that results from a monetary policy change will also be accompanied by a change in both bank lending and deposits. Increases in retail sales are also likely to impact on the narrow measure of money (M0), as there will be an increased demand for notes and coins in circulation.