Introduction
Interest rates can tell it all. As shown in figure 1, the Bank of England (BOE) can simply refer to implications of an action to interest rate in order to settle the required amount of money in circulation. To deal with this graph deeply, it is necessary to discuss the three main tools of BOE to control interest rates and then affect money supply. This discussion is supplemented with the explanation on how the level of money supply affects the GDP of the economy.
Monetary Tools
The first of these tools is altering cost of borrowing. The tool works by the action of the BOE to increase/ decrease the premium provided to banks (also called discounts) that need liquidity to operate. Since BOE issues rediscounting bills, gilt repos and straight loans to banks, altering the discounts on such financials against the market rate will influence the behavior of banks in borrowing from the government. As illustrated by figure 2, the market rate serves as the benchmark of BOE to increase/ decrease discount rate depending on the need of economy for more, fewer or prevailing money. If the adjustments are required, BOE will alter the current discount rate below market rate to increase money supply or above market rate to decrease money supply. The illustration is descriptive when banks are discouraged to borrow with high rate and encouraged when faced with low rate relative to market rate.
Money supply is affected because banks serve as borrower and lender of money in the economy. When it is discouraged to borrow from the government, it is faced with limited liquidity, and in turn, limited available funds to lend hindering money for private spending. They would also encourage deposits to resolve liquidity issues through higher interest income rates which make additional pressure to money supply reduction due to savings.
The second tool is closing open market operations or monetary base control. As illustrated by figure 3, open market operations aid the government in controlling money supply. The more government securities are sold in the open market, the more money is in the hands of government (less money available in the economy) while the reverse is also true. In contrast, the authority granted to BOE in closing market operations makes this simple illustration relatively complex. Closing open market operations requires banks to manage and monitor their BOE accounts in a daily basis as to provide interest rate proof from “overnight” shocks. As shown in the introduction, interest rate has its direct impact to money supply. BOE has decided to require banks to maintain an end-day or weekly balance of zero as for the former to forecast interest rate shocks especially during holidays when the economy performs an “abnormal” demand for money. Such pre-determination of banks’ accounts to BOE will award the latter more influence on long-term interest rates movement.
Money supply is affected because the previous unorganized sourcing of banks for BOE funds and BOE’s sourcing of funds in return are newly designed with greater formality. In effect, market operations that are used to be ambiguous due to several factors unknown to BOE are controlled. The invisible hand is somewhat lifted in favor of the common good. As a result, monetary decisions become real-time wherein money supply is relatively easy to set-up.
The last tool is called reserve ratio control. This tool works when BOE issues an order for banks to maintain a specific amount of assets in liquid form that can be accounted through balances in BOE, bills of exchange, certificates of deposit and money market loans. The available credit balance of banks available for lending is reduced since they have to keep a specified amount of their assets on-hold. As illustrated in figure 4, the increase/ decrease of reserve ratio of banks in turn decreases/ increases money supply in circulation because banks is limited on what it can lend previously. The discouraged lenders will then increase their interest rate for loans and increase their interest rates for deposits as to offset the effects of the increased reserve ratio.
Before 1981, United Kingdom required banks to deposit special deposit accounts to be held as frozen in BOE until there is an indication that the economy needs additional money and such amounts can be withdrawn available for lending operations. BOE has the purpose of controlling the amount of credit that the bank can offer in order for money supply to be controlled at BOE’s desired level.
Can the Bank of England Influence GDP?
Yes. With BOE having substantial influence, if not authoritative, in money supply and operations of banks, it can undoubtedly influence GDP. Since money supply is tagged with a lot of economic variables such as interest rates, inflation, exchange rate and international trade, monetary policy held by BOE has its way to use this related variables that will result to a determined economic environment. The more active the economy (economic boom), the more money supply is required to finance its operations. This supply will be used to buy raw materials and other factors of production. In effect, the amount of GDP the economy can produce depends on the availability of money the economy can provide to businesses.
This statement makes banks crucial as BOE dummies in aiding the government to obtain its economic targets including the level of GDP. As the intermediary of available money, banks are the primary source of financing/ augmenting of operations in the business sector. When it is forced to hold available liquidity in favor of BOE’s regulation, new/ current producers are hanged to continue their operations until contraction is lifted. The time lapse in waiting for funds including the risk of closure or discouragement to build ventures has then direct effects to annual output of firms in the economy. In contrast, when banks are not hindered to lend its liquidity, business prospects are obtained and strategies are deployed that results to higher output contributing to GDP in aggregate.
For the part of consumers, when banks lack liquidity, the former are motivated to save due to premiums in deposits. In effect, consumption is deferred in favor of future interest income gains. This will then have impact on consumption pattern since available money in the economy to buy goods/ services are limited. Thus, businesses are challenged to predict whether cessation of demand is an emergence of deferred demand or a real recession at hand making some shocks in GDP.
Conclusion
BOE is on top of monetary policy wherein banks serve as the implementation medium since they are fewer and easily controllable than when BOE confronts with individual economic actors. As relationship between the government and banks is considered mutualism, the control of money supply becomes efficient especially when the economy is targeting a specific indicator such as the level of GDP. Hidden in its three main tools lies the concept of interest rate manipulation to obtain the desired level of inflation, therefore, production (supply) and spending (demand) are efficiently managed. In doing this, banks is required or made to react to BOE policies in order for interest rates to be leveled with desired level of money supply in the economy.
Bibliography
Book
Sloman, J & Sutcliffe, M 2001, Economics of Business, 2nd Edition, Prentice Hall.
Electronic Sources
Bank of England; 2006; London; viewed on 8 May 2006; www.bankofengland.co.uk
Credit:ivythesis.typepad.com
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