The Bank of England, the UK central bank, is banker to the banks. Because it can print
money it can never go bust. It acts as lender of last resort to the banks.
The Bank conducts the government’s monetary policy. It affects the monetary base through
open market operations, buying and selling government securities. It can also affect the
money multiplier by imposing reserve requirements on the banks, or by setting the discount
rate for loans to banks at a penalty level that encourages banks to hold excess reserves.
There is no explicit market in money. Because people plan to hold the total supply of assets
that they own, any excess supply of bonds is matched by an excess demand for money.
Interest rates adjust to clear the market for bonds. In so doing, they clear the money
market.
A rise in the real money supply reduces the equilibrium interest rate. For a given real money
supply, a rise in real income raises the equilibrium interest rate.
In practice, the Bank cannot control the money supply exactly. Imposing artificial regulations
drives banking business into unregulated channels. Monetary base control is difficult since
the Bank acts as lender of last resort, supplying cash when banks need it.
Thus the Bank sets the interest rate not money supply. The demand for money at this
interest rate determines the quantity of money supplied. Interest rates are the instrument of
monetary policy.
Interest rates take time to affect the economy. Intermediate targets are used as leading
indicators when setting the interest rate.
A higher interest rate reduces household wealth and makes borrowing dearer. Together,
these effects reduce autonomous consumption demand and shift the consumption function
downwards.
Consumption demand reflects long-run disposable income and a desire to smooth out
short-run fluctuations in consumption. Higher interest rates reduce consumption demand by
reducing the present value of expected future labour income.
Given the cost of new capital goods and expected stream of future profits, a higher interest
rate reduces investment demand, a movement down a given investment demand schedule
II. Higher expected future profits, or cheaper capital goods, shift the II schedule upwards.
These effects of interest rates on consumption and investment demand are the transmission
mechanism of monetary policy.
