Setting Targets for the Money Supply - Term Paper Example

 «Setting Targets for the Money Supply» Central banks keeping tight control over the money supply within their own respective countries was a notable feature of the majority of national economies before the Second World War. However supply side economics had been greatly discredited by the severe economic, political, and social consequences of the Great Depression (Smith, 2003 p.10). The New Deal introduced into the United States in the early 1930s was a forerunner of the demand side Keynesian economics that dominated Western economies until the middle of the 1970s. Then monetarism, or the tight control of the money supply in order to curb or control the level of inflation regained credence as the orthodox Keynesian economic policies were unable to prevent economic stagnation, rising inflation, and the slow re-emergence of high rates of unemployment (Smith, 2003 p.10). Even today there are various central banks that claim to be attempting to control the money supply within their respective national economies. For instance: “The Bank of England's two core purposes are monetary stability and financial stability. Monetary stability means stable prices - low inflation - and confidence in the currency and financial stability entails detecting and reducing threats to the financial system” (http://www.bankofengland.co.uk/monetarypolicy/index.htm) The majority of central banks such as the European Central Bank, the United States Federal Reserve, and the Bank Of England are tasked with controlling the level of inflation. The neo – liberal economists such as Joseph Hayek and Milton Friedman had argued for decades that controlling the money supply was the key to reducing the rate of inflation just as it had been done up to the 1930s. Governments and their central banks at that point believed that controlling the money supply, achieving low rates of inflation and balancing the national budgets were more important than low unemployment (Smith, 2003 p.10). In the late 1970s the arguments of these neo – liberal supply side economists gained a greater degree of economic and political credence. With the gaining of power by Margaret Thatcher and Ronald Reagan in the United Kingdom and the United States respectively many Western central banks were officially tasked with meeting specific and meaningful targets for restricting the money supply. The targets for managing the money supply often went hand in hand with other economic policies such as increasing interest rates, cutting government spending, and selling off parts of the public sector (Smith, 2003 p.10). For example in Britain the Bank of England was given the task of restricting the money supply in order to reduce the high level of inflation within the British economy at the behest of the Thatcher government. In reality it was the government that always had the final say in the control of the money supply and put political pressure upon the Bank of England to alter its interest rates in accordance with its desire to win general elections (Young, 2003 p. 100). It was not until 1997 that the Bank of England was given direct responsibility for managing interest rates, currency exchange rate levels, and also attempting to manage inflation rates during the early 1990s (Bannock, Baxter, & Davis, 2003 p.21). At that point, the Bank of England was not fully independent of interference from the British government when it came to the setting of interest rates, lowering inflation levels, or indeed the management of currency exchange rate levels with other major currencies such as the Euro and the American dollar. Aside from the British government, membership of the European Union has played a role in the Bank Of England’s decision-making processes in relation to interest rates and currency exchange rate levels in the last five years. The setting of interest rate levels by central banks is frequently regarded as being a more effective method of expanding or restricting the money supply than the more outwardly monetarist methods of reducing monetary expansion (www.bankofengland.co.uk/monetarypolicy/index.htm). At the beginning of the 2000s, it seemed that the United States Reserve Bank, the Bank Of England, and to a lesser extent the European Central Bank had managed to find an ideal economic balance. They all used interest rate levels to maintain low inflation levels, strong economic growth as well as a stable level of currency exchange rate levels without sticking to strict money supply targets (Bannock, Baxter, & Davis, 2003 p. 21). British governments had previously found it very difficult to achieve such economic balances for more than limited short –term periods if at all. British governments had either achieved higher levels of economic growth with increasing levels of inflation, or had controlled the levels of inflation at the cost of lower rates of economic growth. However governments and central banks across the Western world have found that monetarist money supplies were already less effective by the mid 1980s because people could acquire money through bank loans and foreign investment (Young, 2003 p.25). British governments were frequently tempted to lower interest rates before calling general elections, actions which were taken in order to promote higher levels of unsustainable economic growth and a feeling of improved prosperity for the majority of the electorate to increase their chanced of being re-elected. In fact other countries that adopted monetarist supply side economics such as France and Germany were far less committed to having their central banks restrict the money supply (Smith, 2003 p.10). In other words the French and the Germans never took the setting of tight money supply targets far less seriously than the Reagan and Thatcher administrations ever did (Smith, 2003 p.10). Ending the politically inspired cycles of boom and bust was one of the principle reasons for the New Labour government giving the Bank of England full autonomy. Ironically perhaps if the Thatcher government had stuck to tightly controlling the money supply the cycle of boom and bust might have already been broken, or at the very least altered (www.bankofengland.co.uk/monetarypolicy/index.htm). The Bank of England is no fully independent when it comes to setting interest rates to contain inflationary pressures and maintain the exchange rate stability of sterling in relation to all the major currencies (Bannock, Baxter, & Davis, 2003 p. 21). At the start of the five year period in 2002, the Bank of England and the New Labour government had continued to benefit from the high economic growth levels, declining inflation levels and lower interest rates that had begun under the previous Conservative governments (Smith, 2003 p.10). That period of economic growth had commenced ironically, enough after the Major government had been forced to withdraw from the ERM when currency speculation forced a drastic devaluation of the British pound (Bannock, Baxter, & Davis, 2003 p.21). Leaving the ERM meant that both the British government and the Bank of England no longer have to worry about raising interest rates to keep sterling at fixed levels in relation to the Euro (Nicholson, 2002 p. 36). Interest rate levels were low and the Bank of England was able to avoid increasing those base rate levels until 2006 as inflation remained low and within the targets set by the Bank of England’s monetary committees, and the pound was not at risk of being devalued. However things have worsened dramatically since then with the credit crunch severely affecting the global economy and possibly being the worst financial crisis since the Great Depression (www.bankofengland.co.uk/monetarypolicy/index.htm). However, the Bank of England had to raise interest rate levels for a variety of reasons, some domestic in origin, and other reasons international in their origin. The main reason for the Bank of England raising interest rate levels has been the higher levels of inflation caused by higher levels of consumer spending, higher house prices, and higher global prices for oil and natural gas. However the financial crisis in 2008 was so great that the Bank of England and other central banks have had to cut interest rates in order to prevent complete economic collapse or meltdown (Smith, 2003 p.10). The way in which the Bank Of England managed interest rates has had a strong influence upon the currency exchange rate levels between the British pound and the American dollar or vice versa has been closely linked with the comparative levels of interest rates within each country. The currency exchange rate levels have had important economic consequences, and just like the control of the money supply and interest levels can contribute to increasing or decreasing the rate of inflation. (Bannock, Baxter, & Davis, 2003 p.21). British governments were committed to maintaining the level of sterling at the levels agreed via the Bretton Woods arrangements. However, governments have not always been prepared to raise interest rate levels to maintain the GBP at agreed levels, as high interest rates were seen as detrimental to both economic growth and electoral success. Interest rate levels can be more effective in restricting or indeed increasing the money supply than efforts by central banks to put less money into circulation (www.bankofengland.co.uk/monetarypolicy/index.htm). Past devaluations of British sterling in relation to the American dollar have not been witnessed in the last five year period, as the New Labour government was determined to avoid the humiliation such events bestowed on previous Labour administrations. To a very large extent the strength of the British pound in relation to the American dollar is a significant consequence of the Bank of England being chiefly responsible for setting and moving interest rate levels up and down in Britain. That power and freedom of action allows the Bank of England to control domestic inflation levels as well as maintaining currency exchange rate levels at consistent financial values (www.bankofengland.co.uk/monetarypolicy/index.htm). The level of currency exchange rates between the leading world economies is in many respects highly important with interest rate levels experienced within different countries. Besides the confidence of international financial markets having an influence over the amount of paper, metal, and electronic money in circulation inside any specific country (Nicholson, 2002 p36). However, the high value of the British pound in relation to the American $ has not prevented the rate of inflation creeping upwards during the last five years. International instability especially in the Middle East has driven up the prices paid for crude oil and natural gas, thus increasing inflationary pressures in Britain since 2001. More expensive fuel and heating costs have been major contributory factors in the Bank of England moving to raise interest rates (www.bankofengland.co.uk/monetarypolicy/index.htm). The Bank of England might be able to set interest rate levels yet is incapable of influencing Britain’s foreign and defence policies, or those of its main ally, the United States (Smith, 2003 p.10). The Bank of England has not had to pay as much attention to currency exchange rate levels in the last five years as it might have done if the British government had decided to join the Euro. As it is the Bank of England has had greater freedom of action during this period as the New Labour government had effectively ruled out Britain joining the Euro in the next few years (www.bankofengland.co.uk/monetarypolicy/index.htm). There are several potential or actual challenges facing the British economy in the next ten years. The Bank Of England has concerns with regard to the viability of the financial markets within the UK during the next ten years, as does the British government and various financial institutions. These are concerns that seem to have a strong link with the challenges that face the British economy in the next decade or so. A major concern is that the Bank of England’s recent rises in interest rate levels will not quickly succeed in lower inflation rates which will in turn lead to further increases in interest rate levels (Smith, 2003 p.10). The higher interest rate levels become the more detrimental their affects will be on the performance of the British economy in the next ten years. Past experience has amply demonstrated that prolonged periods of high interest levels do indeed lower the rate of inflation. However, there have frequently been high social, economic, and political costs linked with such anti-inflationary policies. For instance, higher levels of unemployment, the further contraction of British industry, and increasing numbers of people having their homes reprocessed (Nicholson, 2002 p. 36). Another important, arguably vital challenge to the majority of the world’s most important economies within the next ten years relates to how the United States, China, and Japan’s economic and political relationships with the European Union alters during this period, and that would be beneficial or detrimental (www.bankofengland.co.uk/monetarypolicy/index.htm). The European Union has an increasing influence over the British economy, and that influence would increase still further if the British government decided that Britain should join the Euro (Smith, 2003 p.10). Such a decision would drastically alter the amount of power and influence that both the British government and the Bank of England have over economic policies. The Bank of England would have to set interest rate and currency exchange rate levels in accordance with convergence criteria set by the European Union. Eventually, the Bank of England would cease to exist once Britain had fully adopted the Euro (Bannock, Baxter, & Davis, 2003 p. 21). It that cases the money supply in as much as it can be will be controlled by the European Central Bank instead of the Bank of England or the British government. In many respects the attempts of central banks in the mid 1980s to control the money supply were in affect highly ineffective. Given the way that money can be sent anywhere across the globe instantly digitally and electronically the efforts of central banks now to control or restrict the money supply are even less likely to succeed. Bibliography Bannock G, Baxter R E, & Davis E, (2003) Dictionary of Economics, 7th edition, Penguin, London Nicholson M (2002), International Relations – A concise introduction 2nd edition, Palgrave, Basingstoke Smith D, (2003) Free Lunch –Easily Digestible Economics, Served on a plate, Profile Books, London Young H, (2003) supping with the Devils – Political writing from Thatcher to Blair, Guardian Books, London www.bankofengland.co.uk/monetarypolicy/index.htm Read More