The Bank of England

The Bank of England, usually known simply as the Bank, is the central bank of the UK. For historical reasons, it is divided into an Issue Department and a Banking Department, each with separate balance sheets which are shown in Table.

The Issue Department is responsible for issuing banknotes, and these are shown as liabilities in Table. To introduce notes into circulation, the Issue Department purchases financial securities: bills and bonds issued by the government, commercial firms, or local authorities. These are shown as assets of the Issue Department in Table. The exchange of high powered money for financial securities is called an open market operation. We return to this shortly.

The Banking Department acts as banker to the commercial banks and to the government. Public deposits and bankers' deposits are deposits by the government and the commercial banking system. Reserves and other accounts are deposits by central banks of other countries, by domestic local authorities, and by nationalized industries.

Assets are government securities (loans to the government) and advances. Advances are loans to the banks, and in the UK are issued through financial intermediaries called Discount Houses. Other assets include physical capital, buildings and equipment, and securities issued by private firms or local authorities.

In practice, the activities of the Issue Department and the Banking Department are carefully coordinated. Although much of Table resembles the balance sheet of a commercial bank, there is one crucial difference. There is no possibility that the Bank can go bankrupt. A £50 note is a liability of the Issue Department. Suppose you take it along to the Bank and say you want to cash it in for £50. At best, the Bank would simply give you 50 new £l coins. The unique feature of the central bank's liabilities is that it can create them in unlimited quantities without fear of bankruptcy.

Table. Balance sheets of the Bank of England, June 1989
DEPARTMENT	ASSETS	£b	LIABILITIES	£b
ISSUE	Government securities Other securities	14.0 0.7	Notes in circulation	14.7
Issue Department assets	14.7	Issue Department liabilities	14.7
BANKING	Government securities Advances Other assets	0.9 0.8 1.7	Public deposits Bankers' deposits Reserves and other accounts	0.1 1.3 2.0
Banking Department assets	3.4	Banking Department liabilities	3.4
Source: Bank of England Quarterly Bulletin.

This was not always so. In the days of the gold standard, notes could be cashed in for gold and the central bank might not have had sufficient gold to pay. Nowadays there is no such obligation. The Bank can always meet withdrawals by its depositors by printing new banknotes a little more quickly.

The Bank and the Money Supply

In this section we study the ways in which a central bank can affect the supply of money in the economy. The narrowest measure Ml of the money supply is currency in circulation outside the banking system plus the sight deposits of commercial banks against which the private sector can write cheques. Thus the money supply is partly a liability of the Bank (currency in private circulation) and partly a liability of commercial banks (chequing accounts of the general public).

In the last chapter we introduced the monetary base, the currency supplied by the Bank both to the commercial banks and to private circulation, and the money multiplier, the extent to which the money supply is a multiple of the monetary base. We saw that the money multiplier was larger the smaller the cash reserve ratio of the commercial banks and the smaller the private sector's desired ratio of cash to bank deposits.

We now describe the three most important instruments through which the Bank might seek to affect the money supply: reserve requirements, the discount rate, and open market operations.

Reserve Requirements

A required reserve ratio is a minimum ratio of cash reserves to deposits that the central bank requires commercial banks to hold.

If a reserve requirement is in force, commercial banks can hold more than the required cash reserves hut they cannot hold less. If their cash falls below the required amount, they must immediately borrow cash, usually from the central bank, to restore their required reserve ratio.

Suppose the commercial banking system has £1 million in cash and for strictly commercial purposes would normally maintain cash reserves equal to 5 per cent of sight deposits. Since sight deposits will be 20 times cash reserves, the banking system will create £20 million of sight deposits against its £l million cash reserves. Suppose the Bank now imposes a reserve requirement that banks must hold cash reserves of at least 10 per cent of sight deposits. Now banks can create only £10 million sight deposits against their cash reserves of £1 million.

Thus, when the central bank imposes a reserve requirement in excess of the reserve ratio that prudent banks would anyway have maintained, the effect is to reduce the creation of hank deposits, reduce the value of the money multiplier, and reduce the money supply for any given monetary base.

Text 27

Money and Modern Banking

In songs and popular language, 'money' stands for many things. It is a symbol of success, it is a source of crime, and it makes the world go around. Economists use the word more precisely.

Money is any generally accepted means of payment for delivery of goods or the settlement of debt. It is the medium of exchange.

Dog's teeth in the Admiralty Islands, sea shells in parts of Africa, gold during the nineteenth century: all are examples of money. What matters is not the physical commodity used but the social convention that it will be accepted without question as a means of payment.

We now begin our study of the role of money in the economy. We explain why society uses money and how money helps us to economize on scarce resources used in the transacting process. By the end of Chapter 24 we will understand how modern banks play a key role in determining the total quantity of money in the economy and how the government, operating through profit incentives or direct controls on the banking system, seeks to control the quantity of money in the economy.

Before embarking on this detailed look at financial markets, it may be useful to indicate where this path will eventually lead us. As macroeconomists, we are interested in how the financial markets interact with the 'real economy', the markets for output of goods and inputs of factors such as labour. We begin by showing the relation between money and interest rates. Then in Chapter 25 we show how interest rates can affect aggregate demand and hence the equilibrium level of output and employment. In Chapters 26-28 we examine the relation between money, prices, and output. By then we shall be in a position to discuss the major issues of unemployment and inflation. And in Chapter 29 we discuss the relation between money, interest rates, prices, and the exchange rate, showing how international competitiveness can affect the demand for exports and imports, and hence aggregate demand.

First, we must study the financial markets in some detail. We begin by asking why society uses money at all.