Banks such as UK bank get the money that they lend from the deposits. The level of lending is usually dependent on the demand of the funds by the public and on the economic level of the state. When the demand for money is high, UK bank will have to check on the level of money that is circulation before it decides on how much to lend out (Sessa, 2011). It is done to reduce chances of having excess money supply into the economy that may result to the inflation. The bank can use various ways to ensure that the supply for money is properly controlled by the bank. The bank uses number of tools to ensure that the available liability is supplied to the public through a well controlled means to avoid excess money or shortage of money in the economy (King, 2012). The technique used by the UK bank is normally found to be difficult doing by most banks as their investors who use the money deposited at any time limit them. This paper is looking at how Bank of England is using its ability supply money by entirely relying on the liabilities to measure up with the changes in the demand that contributes in the effective change on the economic activities. It also tries to looks into the current policies used by the England bank if are consistent to the policies required.
Since the fall of UK on the Exchange Rate Mechanism (ERM) in the year 1992 September, the country resorted in using interest rates as monetary policy to control inflation. It is, however, a broad area and as monetary as a term suggests other forms of policy. The government uses monetary policy to control money supply in the economy, which was believed that would influence price level as well (Sessa, 2011). This method was the way of controlling inflation during the Thatcher’s monetarist experiment in early 80s.
The money supplied, and the exchange rate is closely linked. A good example is seen when UK is forced to have its exchange rate fixed at a given level, the rate of interest and that of supply of money has to be adjusted to be able to meet the desired goal of a fixed rate. Between 1990 and 1992, when UK was part of ERM, interest rate could not be controlled, and to a given level the money supply. As for Sessa (2011), the work of the government is to control interest rate, the exchange rate or money supply as controlling the three at once is very difficult.
Money Demand Verses Money Supply
The level of money that is in the economy is usually the result of the interaction between the banking sector and the money holding sectors such as individuals, households, non-financial corporations, and non-financial monetary intermediaries (Berlin, 2013). Broad money is the total of the currency in circulation and other close substitutes like bank deposits; it is the aggregate of spending and inflation. Identification on whether developments on monetary are because of money demand or supply are of equal importance especially when trying to assess how money, asset price, and wealth relate. If the level of money is properly assessed such that it is consistent with the level of income, interest rate, and price, the growth of money will be a reflection of the economic situation. Price stability risk resulting from economic growth would be very visible in money (Sessa, 2011). With appropriate observation, monetary developments are not a result of the historical relationship with interest rate, income, and prices, which makes it necessary to use monetary policy to respond to these underlying forces.
How monetary policy Works in England Banks
In an attempt to influence the overall expectation in the economy, Bank of England changes the official interest rate. Usually inflation result when the amount of money being spent grows faster than the level of output produced. It is then that the Bank of England uses the interest rate to control inflation (Berlin, 2013). The Bank of England sets the interest rate at which financial institution lent money. The rate settled on by the Bank of England has the overall effect on the interest rate that is set by building society and other commercial banks among other financial institutions on their borrowers and savers. The prices of the financial assets, like shares, bond, and exchange rates are affected by set interest rate. It in turn affects business and consumer demand in several manners. In the case where the rate is lowered or raised, the spending in the economy will be affected.
When the interest rate is reduced, borrowing by the public becomes more attractive while saving at the same reduce interest rate becomes less attractive; the attractiveness of borrowing by a reduced interest rate stimulates spending (Goodhart, 2010). Cash flow of consumers and firms is highly affected by when the interest rate is lowered; this is because the income received from savings and the interest payments on loans is reduced by the lower interest rate (Berlin, 2013). According to Papademos and Stark (2010), those who borrow money tend to spend more on the extra that they have than lenders do, therefore, the net effect of lowering interest rate by the cash flow route is meant to encourage high spending in aggregate. When the interest rate is increased, the opposite of this is true.
The other thing that the interest rate can do is to raise the asset prices such as houses and shares. Existing homeowners are able to extend their mortgages to finance their higher consumption when the there is higher house price. Household’s wealth, on the other hand, is raised by the higher share prices, which can boost their spending willingness. Changing the interest rate can also influence the exchange rate of a country (Goodhart, 2010). When there is an increase that is not in the rate of interest in UK that is related to the overseas, investors would be given higher returns on the assets in UK (Fama, 2010). In relation to the equivalents of the foreign currency, this makes sterling assets very attractive. When this happens, the value of sterling will be raised, the import prices will be reduced, and the demand for UK services and goods in a foreign country will reduce. Interest rates impact on exchange rate is seldom predictable.
Money supply and monetary policy
The behavior of central bank and banks are the origin of the money supply in UK. In this approach, the money supply is driven by the actions of the Bank of England. It is because monetary policy is used by UK bank to control outside money that is in the economy. The volume of money that is in circulation is calculated by a multiple of the monetary base, which is dependent on the money multiplier size (Berlin, 2013). When there is almost a zero nominal interest rate, it can be said that the Bank of England provides additional stimulus in the economy by providing Bank reserve to help in the increase the money supply by use of the money multiplier. It can be a point to what maybe the fundamental drawback of the framework of money multiplier (Goodhart, 2010). The approach assumes that money holding institution and banks will respond positively in the predictable way to in the adjustment of the monetary base by the Bank of England.
Monetary policy has an influence on the supply of money by the effect that it has on intermediary of the banks. However, the common major changes in the money supply that occur in the economy are dependent on how the UK banks conduct their business. In the duality of deposit issuance and lending Bank of England, full fills a number of functions. the deposits by the bank is formed by those who want money, banks deposit liabilities comprise the core monetary aggregates where banks play the role of a lender in the supply of broad money, and; therefore, changes in the behavior of banks will change the money supply in the economy. In the short-run, movements in output results to the demand for money and the banks will satisfy liquidity preference and interest rate. The business strategy will help the banks adjust the supply of money likewise to the credit with the changes in the interest rate. The economy can be affected by a change in money supply through the accessibility of credit in the economy and through the effect of liquidity on how asset portfolios are allocated (Cecchetti, 2011). The two channels complement each other though mutually exclusive.
Current Practices of the Bank of England
Even though there are policies that are set to check on volume of liquidity in the economy by the Bank of England, most of these policies do not work in the current economy. Most of the monetary policies are usually in writing but are rarely implemented. When monetary policy was developed, the intention was to help regulate inflation in the country by ensuring that the level of money within the economy is at a level that does not trigger inflation (Cecchetti, 2011). Currently, the policy is covering a wider perspective such as setting up the interest rate and the exchange rate, which has a direct effect on the asset prices as shares and stock. Since the problem of 2008-9, monetary policy has been improved to ensure that every measure prescribed in the policy is followed to the point.
Bank in UK has the power to lend and borrow from individuals and institution with the aim of ensuring that only healthy level money circulates in the economy depending on the state of the economy and the business circles. One major thing that the bank does is controlling the interest rate and the bank reserves to be use by commercial banks and other lending institutions. This is enshrined in the monetary policy where the interest rate is altered depending on the state of the economy and the volume of money in supply (Papademos & Stark, 2010). Unfortunately, the current practices by the Bank of England do not take into consideration on the policies intended to regulate the flow of money.
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Goodhart, C. (2010). “Money, Credit and Bank Behavior: Need for a New Approach,” National Institute Economic Review, (214), pp. F1-F10.
King, R. (2012). Money, Credit, and Prices in a Real Business Cycle. American Economic Review, 74. pp.363-380.
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Sessa, L. (2011). “Credit and Banking in a DGSE model of the euro area,” Journal of Money, Credit and Banking, Supplement to Vol. 42, pp. 107-141.