The Impact of Monetary Policy on Expenditure, with Particular Reference to the United Kingdom

International Monetary Fund. Research Dept.
Published Date:
January 1969
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VERY BROADLY, there are two problems connected with the use of monetary policy for stabilization purposes. The first one is, How reliable is the relationship between monetary instruments on the one hand and the money supply and the rate of interest on the other? The second one is, How reliable is the relationship between the money supply and the rate of interest on the one hand and aggregate expenditure on the other? This paper will be largely concerned with these two questions, with particular reference to the United Kingdom.1

Part A begins with a general discussion of the determinants of the money supply and is followed by an examination of the effect on the money supply and interest rates of changes in the main monetary instruments available to the authorities. Part B will deal mainly with the effects of changes in the money supply and/or interest rates on aggregate expenditure, discussing first the theoretical considerations and then the empirical evidence.


I. The Determinants of the Money Supply

The determinants of the money supply may be explored in terms of a number of simple relationships.


M = total money supply,

H = base money,

R = cash reserves of the banking system made up of notes and coins and of deposits with the central bank,

C = currency holdings by the nonbank public,

D = total bank deposits.


These two equations are definitional, the first defining money as the sum of currency and bank deposits, the second defining base money as the sum of currency and reserves.

Two behavioral relationships are now assumed:

The first supposes that nonbank currency holdings are a function of the money supply; the second supposes that bank reserves are a function of bank deposits.

Equations (1), (2), (3), and (4) may be combined to yield2

This equation may be interpreted in the following way. The money supply is a function, first, of base money (H); second, of the currency ratio (c); and third, of the bank reserve ratio (r).

The main sources of changes in base money are external transactions, budgetary transactions, open market operations by the central bank, and advances to the private sector (in the United Kingdom, to the discount houses). In the United Kingdom any changes in base money owing to external transactions tend to be effectively offset by open market operations. If we assume that the Treasury and the central bank coordinate their economic policies, then the only element in base money strictly outside the control of the authorities is represented by the advances to the private sector. In our discussion of open market operations we will in fact examine in some detail the extent to which these advances constitute a slippage in monetary control. We conclude then that while those advances do create certain difficulties it is still reasonable to assume that base money is controlled by the authorities.

The currency ratio is determined by the behavior of the public; the bank reserve ratio has normally two elements: one element, the legal reserve ratio (r1), is determined by the authorities; the other, the excess reserve ratio (r2), is determined by the behavior of the banking system. It follows then in general that at any time the money supply is partly under the control of the authorities (through the base money, at least the unborrowed portion and the legal reserve ratio) and partly under the control of the nonbanking public (through the currency ratio) and the banking system (through the excess reserve ratio). Hence, the monetary authorities may be said to be able to control the money supply if either of two conditions holds:

(1) c and r2 are reasonably stable, so that a change in either H or r1 will have a predictable effect on the total money supply.

(2) Variations in r2 and c are offset by corresponding changes in H or r1. Suppose, for example, that the authorities wish to maintain the money supply constant in a given period, and suppose that c were to rise in the period; then, from equation (5), there would be a tendency, other things being equal, for the money supply to fall as a result of the rise in c; but the authorities can always prevent this fall in the money supply by appropriately raising H or lowering r1. Monetary management of this type is conceivable if c and r2 change in predictable ways or, alternatively, if H or r1 can respond rapidly to unpredictable changes in c and r2.

In the United Kingdom the bank reserve ratio is made up of the special deposit ratio, determined by the authorities, and the excess reserves ratio, which is conventionally set at 0.08. In fact, the banks have adhered closely to the 8 per cent cash convention, which means that r2 for all practical purposes may be treated as a constant.3 On the other hand, c has fluctuated from year to year. The degree of variation in c is an indication of the extent to which the money supply might be outside the control of the monetary authorities. A simple example will illustrate this particular point. The mean base money in the United Kingdom between 1961 and 1967 was about £3,391 million; r could be taken as approximately 10 per cent, made up of a 2 per cent special deposit ratio and an 8 per cent excess reserve ratio. The mean of c for the period was 20.2 per cent. The largest deviation from the mean of c in the period occurred in 1962, when the ratio was 19.1 per cent. Equation (5) may be used to calculate two values of the money supply—one where c is equal to 0.202, and another where c equals 0.191 (in both instances, r = 0.1 and H = £3,391 million). The difference between the two values may provide some idea of the possible size of the error in controlling the money supply. In 1962, for example, the difference represented something like 3.6 per cent of the money supply, this money supply calculated on the basis of a c value of 0.202. This error is substantial, but it must be remembered, first, that it represents the maximum deviation from the mean in the period and, second, that the error in bringing about a given money supply may be minimized by anticipating changes in c or by quickly offsetting these changes.4

When allowance is made for currency demands by the nonbank public, the multiplier (1/r (1—c) + c) is approximately 3.6, which is considerably below the deposit/cash ratio, which is around 10. In other words, on average a change in base money in the United Kingdom of £ 1 million will result in a change in money supply of something like £3.6 million.

Crouch’s work has some bearing on the issues raised so far. In an earlier paper,5 he estimated the following equation from annual U.K. data for the years 1947–60 (standard errors shown below coefficients).6

M in this equation represents money supply; c0 was derived from the formula c0=C—0.2M, where C represents total nonbank currency holdings; and H stands for base money. The coefficient for H is an indication of the relevant multiplier, which is not much different from the 3.6 suggested above. The expression c0 in effect represents “autonomous” demands for currency, i.e., the differences between total demand for currency and demand based on the total supply of money (the ratio assumed here of 0.20 is not very different from the mean ratio for the period 1961–67). One way to interpret the equation, in line with our own results, is to treat c0 as the element in the explanation of the supply of money that is largely outside the control of the authorities.

In a later and more ambitious paper, Crouch dealt with this problem differently.7 In the first of two models of the U.K. monetary sector, he estimates three equations, explaining, respectively, the supply of bank reserves (R), the demand for nonbank currency (C), and the supply of bank deposits (D). The three equations were

where S1 represents the Bank of England security portfolio, S2 represents special deposits, and Y, income.

The first equation explains the supply of bank reserves in terms of security operations by the Bank of England (S1), the special deposits held with the Bank of England (S2), and the demand for currency by the public. Equation (2) is a distributed lag function, explaining currency demands in terms of current and past income levels, with declining weights attaching to income, the earlier the period. It makes good sense to explain currency holdings in terms of income, since the main motivation for holding currency would be to effect transactions.8 If currency demands in fact move closely with income, the behavior of the currency/money ratio would then correspond to the behavior of the income/money ratio (which to some extent is predictable over a cycle). Finally, equation (3) explains the level of deposits in terms of the supply of bank reserves with a multiplier that approaches 12.5.

It is illuminating to compare the United Kingdom with the United States as regards some of the issues raised above. In the United States the behavior of the money supply has been extensively analyzed, and the literature is now quite large.9 As in the United Kingdom, there is some disagreement as to whether the part of the base money represented by “borrowings” from the central bank ought to be treated as being determined by the behavior of the banking system or whether, alternatively, it should be viewed as being determined largely by the decisions of the central bank (through the interest rates it charges on loans). If we take all base money as being controlled by the monetary authorities, then the authorities in the United States are in a position to influence the money supply by varying the base money and/or by varying the required reserve ratios. In addition to changes in base money and changes in reserve ratios, the money supply in the United States may be influenced by three other factors: changes in the currency ratio, changes in the excess reserve ratio, and shifts between time and current deposits. The last two are sources of instability in the money supply that do not exist in the United Kingdom. It has been shown that the excess reserve ratio is sensitive to changes in interest rates; it is therefore not a constant;10 at the same time a shift by the public from time to current deposits will absorb some reserves of the banking system (since reserve ratios are higher on current than on time deposits) and lead, other things being equal, to a contraction in the money supply. How much of the behavior of the money supply in the United States can be explained in terms of policy variables (base money and reserve requirements) and how much in terms of the behavior of the banks and the public remains an unsettled issue. Brunner and Meltzer have argued vigorously the view that a good part of the behavior of the money supply can be accounted for by policy variables alone;11 but other studies impute an important role to the behavior of the banks and the public.12 In this connection, Cagan’s work is particularly interesting.13 He finds that, in 18 reference cycles between 1877 and 1954, changes in the currency ratio explained something like 50 per cent of the cyclical variations in the growth rate of total money (including time deposits). Thus, in the United States the currency ratio alone is a more important element in the behavior of the money supply over the cycle than base money.

II. Monetary Instruments in the United Kingdom

In the United Kingdom the monetary instruments available to the authorities are the following:

  • (a) Open market operations

  • (b) Changes in the bank rate

  • (c) Changes in the special deposit ratio

  • (d) Changes in the “liquidity ratio”

  • (e) Funding

  • (f) Ceilings on advances

  • (g) Hire-purchase restrictions

A discussion of the impact of each of these instruments follows. Although in fact at various times many of the instruments have been changed simultaneously (e.g., a, b, f, g), the discussion will consider the effect of each instrument in isolation.

Open market operations, base money, and deposits

An active controversy has proceeded for some years now on the effectiveness or otherwise of open market operations in the context of institutional arrangements in the United Kingdom.14 In this section an attempt will be made to examine some of the relevant issues and to synthesize the extensive literature on this question. To simplify the discussion that follows, and to keep the discussion in line with the literature, it is assumed through most of the section that c = 0, so that no complications arise from currency demands by the nonbank public. This assumption effectively means that variations in base money are absorbed only by the banking system. Our procedure will be to set up a simple model and then to modify the model in various ways in order to assess the impact of open market operations under alternative assumptions.

We begin by making the following assumptions:

(1) The monetary authorities sell short-term securities to the nonbank public (the banking sector includes the discount houses).

(2) Bank cash is maintained rigidly at 8 per cent of deposits, and liquid assets (including cash, call loans to the discount houses, and bills) are maintained rigidly at 28 per cent of deposits. We simplify slightly by disregarding the existence of a special deposit ratio.

(3) The Bank of England charges a penal rate for loans to the discount houses. A penal rate is generally taken to mean a rate in excess of the treasury bill rate.15

(4) The discount houses are in “disequilibrium” (with marginal costs in excess of marginal revenue) as long as they are in penal debt to the Bank of England and therefore will take some steps to liquidate the debt.

(5) The discount houses are able to liquidate any penal debt with the Bank of England by a combination of the following: (a) increasing borrowings from the nonbank public, (b) shifting some of their treasury bill holdings to the nonbank public—either by direct sales or by lowering their bid price at the weekly tender, (c) reducing their holdings of commercial bills, (d) selling short bonds to the nonbank public.

Table 1, Situation 1, shows the commercial banks in initial equilibrium. Now we suppose that the Bank of England sells 10 units of short-term bonds to the nonbank public. Cash and deposits of the banking system fall by 10 units, as shown in Situation 2. The liquidity ratio is now below 28 per cent, and the banks must now take steps to restore their cash and liquidity ratios.16 In Situation 3 we represent the banks as being in equihbrium again. Deposits will have fallen by about 35.7 units (10 × 100/28). The question now is whether the banking system as a whole, including the discount houses, is in full equilibrium. The banks are shown as having called in 7.1 units from the discount houses. By assumptions (3) and (4), the discount houses will then be in disequilibrium. By assumption (5), the discount houses will take steps to liquidate the debt of 7.1 with the Bank of England. Any of the possible lines of action under assumption (5) will result in a reduction in the cash deposits of the banking system by 7.1 units. In Situation 4 the banks are again out of equilibrium, and the discount houses are in equilibrium. Once again, to restore their liquidity ratio, the banks will need to call in more loans from the discount houses. The new position is shown in Situation 5, but here again the discount houses are out of equilibrium. Once again then the discount houses will act in such a way that the cash and deposits of the banks will fall by a further 5.1 units (not shown in the table). It is clear that since full equilibrium requires that both the banks and the discount houses be satisfied with their portfolio position, the end result must be the position shown in Situation 6 in the table. Here deposits have fallen by 125, which represents 12.5 times the original sale. What is interesting about this end result is that cash obtained indirectly from the Bank of England by the banking system is not permanent in the sense that steps will soon be taken to return the cash to the Bank of England.17 The result therefore would have been nearly identical if we had represented the banks as, in effect, selling the bills to the nonbank public in the process of adjustment.

Table 1.Impact of Open Market Operations of the Bank of England on the Equilibrium of Commercial Banks in the United Kingdom
Call loans, etc.200200192.9192.9187.8…..175
Investments and advances720720694.3694.3676.0…..630

The effect on interest rates may be dealt with briefly. The original sale of short-term bonds will probably have raised the yield on bonds; to the extent that banks liquidate some of their security holdings, the effect on the yield of bonds is strengthened directly. If the discount houses shift treasury bills to the nonbank public, some direct pressure will be exerted on the bill rate. These results are of course consistent with expectations that a drop in the money supply tends to be accompanied by a rise in interest rates.

We must now proceed to modify the assumptions and to examine some of the consequences. Suppose, first, that banks hold a liquidity ratio in excess of the prescribed minimum of 28 per cent. (We assume throughout that they hold 8 per cent cash.) It is easy to demonstrate that the final equilibrium level of cash and deposits shown in Situation 6 will be the same, although, of course, the dynamics of adjustment will be different. On the assumption that the banks cannot obtain permanent additional cash, therefore, the drop in deposits must again be 12.5 times 10. The only modification in this case is that a larger burden of adjustment will fall on the liquid assets of the banks and a smaller burden on investments and advances. Where excess liquidity is substantial, the whole burden could fall on liquid assets without contravening the 28 per cent requirement. We conclude then that, irrespective of the liquidity ratio of the banking system, open market operations will be successful in permanently reducing base money, notwithstanding institutional arrangements whereby banks can indirectly replenish their cash base, provided that assumptions (3), (4), and (5) hold.

We now retain assumption (2) and examine more carefully assumptions (3), (4), and (5). Suppose now that assumption (3) does not hold. Then assumptions (4) and (5) will also not apply. Assumption (3) may be relaxed in the extreme example by supposing that the Bank of England accommodates the discount houses (or banks) at the “back door” at “market” (nonpenal) rates.18 In effect, any rate that does not raise marginal cost above marginal revenue is nonpenal. Under these conditions, Situation 3 in Table 1 will represent the final full equilibrium for the banks and the discount houses. The discount houses, by definition, will have no incentive to take any further action. In this instance, then, some permanent cash can be absorbed from the Bank of England. It is interesting that here the relevant multiplier (i.e., the change in deposits divided by the initial open market sale) is 100/28, or about 3.5, and not 12.5 as in the previous example. In principle, though, the same ultimate reduction in deposits can always be achieved by engaging in a much larger initial open market sale (e.g., in this case, just under 36).

One interesting problem raised by this particular model is the following: The objective of back-door accommodation is to prevent any disturbance in the bill rate, but at the same time deposits are allowed to fall from 1,000 to 964.3, putting some of the burden of adjustment therefore on investments and advances. If only advances are allowed to fall and advances directly affect expenditure, it is conceivable that the rate of interest will not be affected but, to the extent that short-term bonds are sold, the yield on bonds will tend to rise. Hence, where securities are sold by the banks, as is normal, the model assumes that the authorities will allow a rise in the bond rate while vigorously maintaining the bill rate unchanged.

If the liquidity ratio is in excess of the prescribed 28 per cent, deposits may fall by only 10 units. Banks would obtain the required cash to satisfy the 8 per cent requirement, but, since they are holding liquid assets in excess of the prescribed minimum, no further action will be necessary.

Now retain assumptions (2) and (3) and relax assumption (4). It has been argued by some that the discount houses may borrow at a penal rate, yet need not view themselves as being out of equilibrium; hence, they would not be anxious to take steps to liquidate the penal debt. Jasay, for example, argues that there is an implicit agreement between the banks and the discount houses according to which the discount houses agree to maintain some debt at a penal rate as part of a general package deal that embraces a number of arrangements within the banking system.19 If we accept this line of reasoning, then again Situation 3 in Table 1 may represent full equilibrium in the banking system.

However, in these circumstances it is always open to the monetary authorities to reinforce the original sale of securities to the nonbank public by affecting further sales of securities equivalent to any cash made available at penal rates. In other words, if the discount houses are unwilling to take steps to absorb bank cash by liquidating their debt, the monetary authorities can always bring about the same ultimate result by an active open market policy. A policy of this type by the monetary authorities has come to be known as “netting” of open market operations.20

Now retain assumptions (2), (3), and (4) but relax assumption (5). This is an interesting case, because here one is involved in saying that the discount houses are anxious to get out of debt but are inhibited by difficulties in implementing any of the four steps indicated under assumption (5). They may be reluctant to unload their limited stock of short-term bonds. They may not be able to obtain any sizable nonbank funds, the scope for reducing their commercial bill holdings maybe quite limited, and, finally, most important, the nonbank market for treasury bills may be thin and relatively inelastic to changes in the bill rate. To the extent that these restrictions apply, an uneasy equilibrium may settle in Situation 3. But here again the monetary authorities may pursue a policy of netting their open market operations and thus ensure that Situation 6 is ultimately realized.

Finally, note that assumption (1) has been retained up to now. Would the results be different in any way if we supposed that the monetary authorities began the process by selling treasury bills to the discount houses?21 We will not develop this case in any detail. For example, where the banks hold no spare cash, as is normal, the discount houses will finance the purchase of new treasury bills by penal borrowing, but they will then take steps to liquidate this debt, and in the end deposits will have fallen by 12.5 times the initial sale of bills. If, however, assumptions (3), (4), and (5) do not hold, there may be some difference between security sales to the public and sales of bills to the discount houses. For example, if the discount houses take no action to repay the debt, then the bank may experience no change in cash or deposits.22

We may now briefly summarize our results. We concluded that if the discount houses are accommodated at a penal rate and if, either at the initiative of the discount houses or at the initiative of the monetary authorities (“netting” operations), cash equivalent to penal borrowings is absorbed, then the relevant multiplier is 12.5; i.e., the drop in deposits will equal 12.5 times the original sale. This result also holds irrespective of the state of bank liquidity. If borrowing is nonpenal, liquidity ratios are rigidly maintained, and sales are made to the nonbank public, the relevant multiplier is probably 3.5. If there is excess liquidity, in these conditions, the relevant multiplier is probably 1.

A number of different models have been examined, each model incorporating a particular set of assumptions. Clearly, a most important question concerns the empirical relevance of the alternative assumptions. Unfortunately, on this point nothing very conclusive can be said. First, it is a fact that the liquidity ratio has on frequent occasions been in excess of the prescribed minimum. Second, it is also a fact that the Bank of England has at various times accommodated the banking system at non-penal rates. Third, it remains a matter of some controversy whether the discount houses make an active effort to liquidate debt at penal rates. On the whole, what evidence is available appears to be consistent with the postulate that penal debt does represent a disequilibrium situation.23 Fourth, there is also considerable disagreement as to the empirical relevance of our assumption (5). Since treasury bills represent the most important asset held by the discount houses, the public’s elasticity of demand for treasury bills at different interest rates becomes a particularly critical consideration. On this point there is now evidence to indicate some flexibility in the public’s demand for treasury bills.24

To conclude, then, our discussion of open market operations, it is a reasonable hypothesis that base money is in the main controlled by the monetary authorities in the United Kingdom,25 provided, of course, that the authorities are prepared to accept corresponding changes in the yields on securities. Perhaps the most significant result is that the change in base money is not a simple accompaniment to open market sales. Sometimes an “active” netting policy on the part of the authorities may be required. In every instance the dynamics of adjustment is complicated, with changes occurring stage by stage to bring the result to an ultimate conclusion.

In this section, we excluded altogether currency demands by the non-bank public. When currency demands are allowed for, the relevant multiplier (i.e., the change in deposits divided by the initial sale of securities)26 is considerably reduced, to something like 2.9, which means that an open market sale of one unit will on average reduce deposits by something like 2.9 units and not by 12.5 units as suggested in the simplified examples in this section.

The bank rate

Consider a rise in the bank rate with no accompanying open market sales. A number of rates conventionally tied to the bank rate will also rise. For example, the rate on bank advances has been, for most customers, about 1 per cent above bank rate subject to a minimum of 5 per cent; the basic call loan rate is about 1 to 1¾ per cent below bank rate, while the deposit rate is about 2 per cent below bank rate. With higher call money rates and also the threat of higher penal rates,27 the discount houses will lower their bid price on bills at the tender; at the same time, with higher rates on deposits now offered, the nonbank public will require a higher yield on bills. Hence, the bill rate may be expected to rise. The rise in the bill rate in turn is likely to spread to the bond rate as well as to other rates in the economy. Some rates will adjust only slowly, so that in the short term some funds may switch between different assets; e.g., building society share rates may rise only after a lag during which building loans may decline.

This is an interesting outcome, because it means that interest rates in general may rise, and the bank rate therefore may exercise a deflationary impact, even without any fall in the money supply.28

It might be thought that the rise in the bank rate might itself be responsible for a fall in the money supply, but it is difficult to envisage a reliable mechanism that could bring about such a result. For example, it may be argued that a rise in the bank advance rate might reduce the demand for advances and the fall in advances might reduce deposits, but this argument is weak in at least two respects. First, if the market for advances is a disequilibrium one, with demand in excess of supply at the going interest rate, an increase in bank advances is a more likely outcome, with the banks switching from investments to advances to take advantage of the higher rate. Second, even if the public were to reduce their advances and if deposits also fell, the banks would now be holding excess cash and would be anxious to expand their investments.

A second example of possible causation running from the bank rate to the money supply may be more interesting. Consider a case where the discount houses are in debt to the Bank of England, yet they have taken no measures to liquidate the debt. The higher bank rate will become applicable after a lag and will increase the cost of carrying debt. It is conceivable that the discount houses will now have an incentive to sell securities and to repay some of this debt. These sales and repayments will then influence the money supply in ways suggested earlier.

In a recent contribution, Walters suggests a mechanism whereby a rise in the bank rate might actually increase spending. “. . . the higher rates of interest will encourage those who hold money balances to put them to work—to invest them in financial institutions, in hire purchase debt, etc. The higher interest rate will tend to increase the supply of credit. Now if many of those who seek credit are not deterred by the higher rates of interest (and this argument runs through much of the evidence in the Radcliffe Report) and if their spending is primarily limited by the quantity of credit they can obtain, the raising of Bank Rate will actually increase spending.”29 This sequence of events would appear to depend on two assumptions, both of which may be open to question. First, it seems to rely on the unsupported notion that, notwithstanding a rise in the deposit rate, there will remain a net incentive to shift out of money balances. Second, it also assumes that there is an excess demand for funds from a number of financial institutions and that the increased availability of funds will now absorb part of the excess demand.

Special deposits

Since 1959 the Bank of England has had the power to require the banks to hold with it in cash a certain percentage of their deposits. The required percentage has varied on a number of occasions since 1960 from 0 to 3. These special deposits, which are not counted as liquid assets, earn a return that is quite close to the return on treasury bills. From the beginning the Bank of England decided that the cash required by the banks to accommodate the special deposit requirement would be provided by the Bank by the purchase of treasury bills. It appears that the authorities did not anticipate that the special deposit scheme would have any marked effect on the level of deposits but hoped that the pressure on bank liquidity as a result of a rise in special deposits would induce the banks to restrict their advances. We will, in what follows, briefly examine the likely effects of a rise in the special deposit ratio.

Suppose that the initial position of the banks is as shown in Table 2, Situation 1, where the special deposit ratio is assumed to be 0.01; the banks are shown as holding exactly 8 per cent of deposits in cash and 28 per cent of deposits in liquid assets. It seems clear that if banks hold liquid assets in excess of 28 per cent then a rise in the special deposit rate is almost certain to have no effect whatsoever on cash, deposits, or investments and advances. In this instance the banks will simply exchange excess liquid assets (treasury bills) for cash, which would then be used to meet the special deposit requirement. Suppose now that the special deposit rate rises to 0.02. It is worth considering two alternative solutions corresponding to different reactions by the banking system. We would expect the banks in the first place to obtain cash by selling some of their bills. The banks will then be short of liquid assets. They may respond in one of two ways: they could first reduce their deposits and investments and advances to accommodate the lower level of liquid assets. This is the solution shown in Situation 2a. One can envisage this solution coming about in the following way. As investments and advances and deposits fall, “excess” cash is created. This excess cash is then lent to the discount houses who in turn either “pay off” some debt with the Bank of England or, alternatively, buy up treasury bills from the Bank of England operating through the back door. In this way, some cash would be lost to the banking system.

Table 2.Impact of Changes in Special Deposit Ratios by the Bank of England on the Equilibrium of Commercial Banks in the United Kingdom
Liquid assets200193.3200
Special deposits1019.320
Investments and advances710676.8700

More likely, however, they can make up for the loss of liquid assets by selling investments and advances (10 units) and buying bills from the public (10 units)—Situation 2b. In this case deposits will be unchanged.30 To the extent that advances fall, the objective of the monetary authorities might still be satisfied. It has been argued, however, that the major part of the adjustment is likely to fall on investments and not on advances, and indeed that advances may even increase following a rise in the special deposit ratio.31 The rationale here is that since the liquid asset ratio plus the special deposit ratio must now rise, the mean return on the banks’ portfolio will have fallen; the banks then will have an incentive to substitute higher earnings assets (advances) for bonds, or at least to minimize the drop in higher earnings assets.

If bonds are liquidated and bills are bought, at a given level of deposits, the term structure of interest rates may change. With given supplies of short-term bonds and bills, a fall in the demand for bonds and a rise in the demand for bills will tend to raise the bond rate relative to the bill rate. Hence, we conclude that the most important effect of a rise in the special deposit rate is likely to be a change in the term structure of rates and not a reduction in the level of advances. These effects appear to be different from those intended by the authorities.

The liquid asset ratio

The Bank of England has powers to vary the liquid asset ratio of the banking system. The prevailing rate is 28 per cent. The effect of a rise in the liquid asset ratio is almost identical to the effects of a rise in the special deposit rate. The level of deposits is likely to remain unchanged with a switch from investments and advances to bills. Again there will be an incentive to minimize the switch out of higher earnings assets (advances), and the term structure of rates is likely to move in favor of bonds.


In general, funding involves any lengthening of the average maturity of the public debt. More particularly, in the U.K. context, the notion of funding is usually associated with a reduction in the floating debt matched by an increase in the availability of bonds. As a general principle, a policy of funding the public debt, particularly during inflationary periods, appears to have received a good deal of official support in the postwar years. The desirability of funding has been based on a number of considerations. One important argument was that the reduction in the availability of liquid assets to the banking system would force a contraction in deposits (deposits, on this view, being determined by the supply of liquid assets).32 Other arguments used in defense of funding were that funding itself entails a higher rate on longer term bonds, which may have a stabilizing effect during inflation; that a lengthening of the average maturity of the debt will make it more difficult for the private sector to sell securities to finance expenditure; that a given change, in whatever direction, in the interest rate will have a larger impact on capital values, the longer the debt, and this might influence expenditure on consumption and investment either directly or indirectly through its effect on lending by financial institutions; that a smaller floating debt means less continuing concern over the finance of maturing securities.

If funding was desirable in principle, it was thought that there were many practical difficulties in implementing such a policy. The difficulties were that raising long-term rates might not result in an increased demand for bonds if rates were expected to rise further; that it was important to maintain orderly markets, and therefore there were limits to acceptable fluctuations in rates; that a deliberate policy of forcing up rates at the long end represented an act of “bad faith” toward holders of securities in general; finally, that funding increases the cost of servicing the public debt.

A proper appraisal of all these arguments would involve an extended discussion of the principles of debt management that is beyond the scope of this paper. It will be sufficient in this section to examine the validity of the first argument only, i.e., the case for funding as a means of monetary control.

A strong case against this particular argument has been advanced recently by Crouch.33 He argues that a policy designed to reduce the floating debt and to release more bonds will almost certainly leave the money supply unchanged and will raise long-term rates relative to short-term rates. There are several routes by which this outcome may be brought about. One mechanism suggested by Crouch is the following: the discount houses will maintain their holdings of bills simply by raising their bid price at the tender; this will leave a reduced supply of bills for the nonbank public, which will now use its increased cash to buy the more attractive bonds being offered. In the new equilibrium the banks are unaffected, the discount houses hold the same portfolio (with bills now carrying a lower return), and the public has replaced its bills with bonds. Crouch finds, in fact, that on the occasions when funding did take place, something like these results could be observed.

Whether a change in the structure of rates in favor of long-term rates is a desirable outcome will depend on the assumptions made about the state of the economy and the responsiveness to particular changes in rates. Consider an economy that is experiencing both inflation and balance of payments difficulties; suppose that both short-term rates and long-term rates influence expenditures but the long-term rate operates with a long lag that may be destabilizing. Under these conditions the change in the structure in favor of long-term rates will be clearly undesirable. Under a different set of assumptions a policy of “defunding” (buying long and selling short) may be desirable. Consider an economy with balance of payments difficulties and a high rate of unemployment; suppose now that the short-term rate has little effect on expenditures but has a strong effect on short-term capital flows; suppose also that long-term rates are stabilizing. Then raising short-term rates and lowering long-term rates (assuming the policy is feasible) may improve the balance of payments and conceivably may raise the level of economic activity. (This was the rationale of “operation twist” in the United States.)

Prescribing limits on advances

In the United Kingdom in the postwar years banks have been requested to limit their advances at various times. Suppose that advance limits are prescribed without corresponding limits on deposits. In this case banks can maintain their level of deposits by switching out of advances and into other assets, e.g., investments. It was argued elsewhere that even if this happened some net deflationary impact was still possible, i.e., the deflationary effect of the fall in advances exceeding the expansionary effect of the increased security holdings.34 On the whole, banks would be expected to minimize their loss of earnings so that if they were holding excess liquid assets, they might well shift out of these liquid assets into the higher earning investments.35 Interestingly, this would result in a change in the term structure but this time the change would be in favor of the bill rate, i.e., a rise in the bill rate relative to the bond rate.

Hire-purchase restrictions

Hire-purchase terms have been changed frequently in the postwar years. It is sufficient here to note that there is evidence that these changes have had strong effects on the demand for consumer durables.36

III. Conclusions

In the main, after allowing for the dynamics of adjustment and given certain fairly plausible assumptions respecting the reaction behavior of the discount nouses and the monetary authorities, we concluded that base money could be controlled by means of open market operations. The relation between base money and the money supply, on the other hand, is open to an element of unpredictability owing largely to the behavior of the public’s demand for currency; but, on average, the margin for error here is likely to be small. It is not unreasonable, therefore, insofar as the United Kingdom is concerned, to argue that the money supply is effectively under the control of the authorities (which, of course, Keynes always took for granted).

The most reliable conclusion about the bank rate is that it influences the general pattern of rates in the economy, even when no other change in policy (e.g., supporting open market operations) has taken place. The special deposit rate and the liquidity ratio operate in similar ways. A rise in either is likely to leave deposits unchanged and to raise the bond rate relative to the bill rate. Neither policy is likely to make any substantial impact on the level of advances, and this raises the question whether these instruments serve any particular purposes desired by the authorities. The objectives of a funding policy are uncertain, but here, too, we find that the main outcome is a rise in the bond rate relative to the bill rate with virtually no effect on the money supply. Any restriction on advances without a restriction on deposit growth is likely to leave deposits unchanged and to increase the banks’ holdings of securities, but even this outcome could conceivably exercise a net deflationary effect. Changes in hire-purchase terms for consumer durables are likely to have strong effects on the demand for consumer durables.


I. Theoretical Considerations

The theoretical considerations to be discussed are as follows:37

  • (a) The transmission mechanism—general

  • (b) The interest rate transmission mechanism

  • (c) The role of nonbank financial intermediaries

  • (d) The role of lags

The transmission mechanism—general

The transmission mechanism defines the way in which monetary changes may make their impact on expenditure. It is useful to distinguish five channels through which monetary policy may operate: an interest rate effect, a real balance (or wealth) effect, a “credit rationing” effect, a “quantity theory” effect, and an “announcement” effect.

An interest rate effect

The interest rate effect is the most familiar transmission mechanism. Monetary policy, in this context, is concerned with two questions: first, the extent to which the rate of interest will respond directly to changes in the money supply and other government actions and, second, the extent to which expenditure will be responsive to the rate of interest. These two questions are taken up in some detail in the section on the interest rate transmission mechanism, pages 459–66.

A real balance (or wealth) effect

The sum of base money and interest-bearing government debt represents part of the wealth of the private sector. If the monetary authorities engage in open market operations, one of the main instruments of policy, interest-bearing debt, is exchanged for base money and there is therefore no change in the wealth of the private sector. It is possible, however, for base money to change without any corresponding offset in the holdings of interest-bearing debt: this would happen, for example, if base money changed as a result of external or government operations. A change in the money supply originating in this way will normally change the net worth of the private sector, and this may directly influence household expenditure on consumption.

A “credit rationing” effect

Suppose that there is an excess demand at the prevailing interest rate on bank loans and that banks ration the available supply of loans to their customers. Then an increase in credit rationing (with a corresponding reduction in the supply of money) may for a number of reasons result in a direct reduction in expenditure on consumption, inventories, or fixed investment. Lenders in general may apply more rigid credit standards to particular types of borrowers, with the result that these borrowers are unable to obtain marginal funds whatever the interest rate that they are prepared to offer. Borrowers may have a strong preference for bank credit; they may be lethargic in seeking alternative sources; capital markets may be unsophisticated, so that alternative sources are not readily available; finally, the terms of credit available outside the banking system may be “intolerable” (strictly a back-door interest rate effect). On the whole, one would expect the credit rationing effect to be weak in countries where capital markets are sophisticated and relatively strong in countries where capital markets are undeveloped.

This raises the possibility that the composition of the reduced money supply may have a significant bearing on expenditure. Suppose that banks have the option of reducing their deposit liabilities by liquidating government securities or bank loans of equal value. If they sell government securities, they absorb “idle” balances, and the rate of interest will rise. On the other hand, if they reduce their loans, potential borrowers may not have easy access to the idle funds now available.38 Put differenüy, if the change in income is a function of the change in the money supply, the coefficient of the change in the money supply is itself a variable, depending on the source of the change in the money supply.

A “quantity theory” effect

An excess supply of money in Keynesian economics disturbs the bond market and lowers the rate of interest. A broader view is to allow for the possibility of a direct substitution between money and goods.39 If the public holds an excess supply of money it may decide to exchange money for capital goods, consumer durable goods, and even nondurable consumer goods, and so directly increase its expenditure. In this way monetary policy may make a broad and direct impact on expenditure, an impact that is not dependent on interest rate effects. This direct effect is supposed to be distinct from any direct effects from changes in “wealth” or “credit rationing” discussed earlier.

Friedman’s writings appear to support this direct transmission mechanism. In his work with Meiselman, he acknowledges that the first impact of a change in the money supply from open market operations “may be on goods rather than securities.”40 In the same work he also outlines a more complicated mechanism by which money ultimately influences expenditure. His starting point here is an open market purchase by the central bank, which releases more cash to the public. At first, the cash is used to purchase fixed-interest securities, so that the price of all securities rises. In due course the excess cash finds its way to riskier securities, equities, secondhand real capital assets, and consumer durables. Friedman then argues that the rise in the price of existing assets (capital or durable) relative to new assets will create an incentive to produce new assets, and in this way expenditure will rise. Thus in the end the stimulus to expenditure is provided by price differences between old and new assets.41

A direct mechanism is also implicit in Friedman’s work on the demand for money.42 According to Friedman, real money balances are determined by real permanent income, with rates of interest playing a negligible role. If the money supply is increased, expenditure on goods and services may increase directly until the equilibrium relationship between real balances and permanent income is restored. This relationship is complicated by the fact that measured income may be different from permanent income, so that in the short term, fluctuations in the ratio of money to income are possible even though the ratio of money to permanent income is relatively fixed.

An “announcement” effect

A change in monetary policy may create additional uncertainty in households and businesses about the near future. Households may revise their expected earnings downward, and businessmen may feel less confident about their future sales. In both instances, current expenditures on consumption and investment may fall off.

This general discussion of the transmission mechanism may be summed up in this way. On theoretical grounds we may expect real aggregate expenditures to be a function of the following variables that are influenced by monetary policy: the rate of interest, real balances, bank credit (a credit rationing effect), the money supply (a quantity theory effect), the degree of uncertainty (the “announcement” effect).

The interest rate transmission mechanism

The control of the rate of interest

In the short term, the rate of interest may be influenced by a number of considerations: current and past values of the ratio of money to income (or, more generally, income and the money supply); expectations with respect to future short-term or long-term rates; the expected rate of price change; changes in the weights of particular sectors with different liquidity needs relative to their transactions; changes in the distribution of income (with different factor incomes having different liquidity needs); financial changes and innovations that may influence the demand for money; changes in controlled rates (e.g., the bank rate) tied to other rates in the system. If we isolate the role of the ratio of money to income (the Cambridge ratio) and assume that all other influences are constant, we can trace a relationship in the short run between the money/income ratio and the rate of interest. This relationship, assumed to be nonlinear, is shown in Figure 1. In order to induce the public to hold a lower ratio of money to income, a higher rate of interest will need to be offered. Moreover, the lower the ratio, the larger will need to be the rise in the rate of interest in order to bring about a given fall in the ratio. The lower the Cambridge ratio, then, the larger will tend to be the rise in the rate of interest for a given reduction in the money supply; in this limited sense, a low ratio is favorable to monetary policy.

Figure 1

The crucial question for monetary policy is the extent to which the authorities are able in the short term to manipulate the rate of interest. Other things being equal, there are three ways in which the rate of interest may be directly sensitive to government actions: First, and most important, by changing the money supply. Second, by changing “controlled” rates in the system (e.g., a change in the fixed deposit rate relative to “outside” rates will increase the demand for fixed deposits and will result in a switch away from other claims or securities). Third, and most difficult, by operating on expectations with respect to future rates. If the authorities can induce an expectation that rates in the future will be higher, current rates may also rise. Whether the monetary authorities will in fact be successful in making an impression on the rate of interest will depend critically on the weight and dominance of the other influences (not responsive to direct government policy), some of which were listed at the beginning of this section. For example, if the Cambridge ratio-interest rate schedule is relatively stable in the short run, a change in the money supply will tend to bring about a predictable change in the rate of interest. If, on the other hand, the schedule is relatively unstable and shifts rather erratically in the short period, then a change in the money supply may be consistent with a whole range of interest rates.43

So far we have considered the extent to which the monetary authorities are able to bring about a change in interest rates in general. We saw in PART A that monetary actions frequently have effects on the term structure of rates. The theory underlying the term structure is briefly discussed in the Appendix. A change in the term structure of rates as such may change both the composition of expenditure and the total of expenditure. Suppose that the long-term rate rises relative to the short-term rate; then investments financed by long-term capital will be harder hit than expenditures financed by short-term borrowings (e.g., for inventories and consumption). Suppose now, to take an extreme example,44 that the short-term rate rises and the long-term rate falls, then the effect on total expenditure will be determined by the interest elasticity of demand of short-term and long-term rates.

Interest rates and expenditure

It is convenient in considering this question to distinguish two ways in which the rate of interest may influence expenditure. The first is by bringing about changes in the market values of existing debt securities (and perhaps equities); the second is by changing the cost of borrowing (interest costs). We will refer to the first effect as a valuation effect and the second as a direct interest rate effect. A discussion of each of these follows.45 The discussion of the direct rate effect will be limited to investment demand.46

The valuation effect

The question here is the effect of changes in the market value of financial assets on expenditure. The change in valuation from a given change in the interest rate will be larger, the longer the life of the securities in the hands of the public. From this point of view the longer and the more widespread the debt held, the more significant will tend to be the valuation effect. To the extent that households and businesses hold marketable assets, their expenditure on consumption and investment could be directly affected. In addition, changes in the valuation of securities held by financial intermediaries could influence the willingness of these institutions to make loans. The effect on financial intermediaries is considered later; here we examine briefly the valuation effect on households and businesses.

Consider first the situation where there was no question of liquidating securities for expenditure in the relevant time period. Suppose that the rate of interest should rise. Holders will experience a fall in the current market value of their assets; but since the sale of assets was not relevant, they will be less concerned about the current market values than about expected market values when a sale was anticipated. Clearly, if the assets are expected to be held to maturity, the change in valuation will not influence current expenditure. If the assets might be disposed of before maturity, the expected value will depend on expected interest rates and the life of the assets at the time disposal is anticipated. In general it can be said that the more synchronized the time pattern of expenditures and maturities, the weaker will be the valuation effect on expenditure. The point here is that in the case being considered it is clearly misleading to look at current market values when the relevant consideration is market values expected at some future date.

Consider next the situation where liquidation for expenditure is relevant. It is possible that the drop in valuation will induce some postponement of expenditure, this postponement being more likely, the more that interest rates were expected to fall shortly. If the expenditure is in fact carried out, the value of the expenditure may drop as a result of the fall in valuation. In this case, however, it is conceivable that there may not be a net fall in the value of expenditures if the buyer of the assets, now enjoying a windfall improvement in the terms of his purchase, correspondingly raises his current expenditure.

The rate of interest and investment

We will deal briefly with some of the considerations that have been thought to be relevant in determining the response of investment to a change in the rate of interest. First, other things being equal, long-term projects are generally thought to be more responsive to the rate of interest than short-term projects. This is usually explained on two grounds.47 One is that interest payments represent a smaller proportion of amortization charges, the shorter the life of the project; the other is that the present value of an investment yielding a flow of receipts is more sensitive to a given change in the rate of interest, the longer the expected life of the investment. The latter explanation in particular has not gone unchallenged.48 Second, the greater the risk and uncertainty attaching to a project, the weaker will tend to be the interest rate effect. If the required margin for risk and uncertainty is large, a given change in the rate of interest will represent only a small proportion of this margin. Third, a rise in the rate of interest may produce no change in the real rate of interest if it is accompanied by an equivalent rise in the expected rate of inflation. It is conceivable that periods of rising rates of money interest are also conducive to expectations of an acceleration in the rate of inflation. Fourth, it is sometimes argued that if changes in the rate of interest could be passed on by businesses, this might weaken the effects of monetary policy. Since, however, businesses are affected quite differently by a change in the rate of interest, it is difficult to see how, at least in the short run, this shift in the rate of interest could eventuate.

Fifth, the weight of internal funds in the finance of investment may be significant in determining the effect of the rate of interest (see Figure 2). DD1 represents the amount of internal funds (depreciation and retained profits) available to the firm. The rate of interest (D) earned on internal funds is assumed to be lower (by D1G) than the minimum rate imputed to external funds (G). This difference may reflect a gap between the firm’s lending and borrowing rate or, alternatively, it may reflect the firm’s reluctance to incur additional debt. The interest cost of external funds is shown as a function of the size of external funds. This can be explained either in terms of the firm’s unwillingness to incur additional debt or in terms of the lender’s unwillingness to continue to provide loans at a fixed rate of interest. MEC1, MEC2, and MEC3 represent three alternative positions of the marginal efficiency of capital schedule (each schedule showing the expected gross return at different levels of investment). Suppose now that the rate of interest rises, and suppose that we disregard valuation effects (considered earlier). If the imputed rate of interest on internal funds is not correspondingly raised (the horizontal line DD1 continues to apply), then investment will be unresponsive for both MEC1 and MEC2. If the rate of interest on internal funds is written up (line DD1 shifts to EE1, then investment in case 1 may be affected but investment in case 2 will remain unresponsive. If the firm operates at MEC3, the investment will be affected in the normal expected way (with the rate of interest line shifting upward from F1 to F2). It follows, therefore, that the more that firms operate in the discontinuous portion of the schedule, the larger the gap between the internal and external rates of interest, and the less the inclination to raise internal rates in line with external rates, the weaker will tend to be the interest rate effect.

Figure 2

What this shows is that a fall in internal liquidity effectively raises the weighted cost of capital to business. Since businesses tend to become relatively illiquid and to depend more heavily on external finance in the later stages of a boom, the effective weighted cost of capital would rise in this phase of the cycle. If, in addition, the market rate of interest is allowed to rise, the effects on the cost of capital may be magnified.

Sixth, it is also argued that the higher the rate of tax on profits, the lower will tend to be the response to a given change in the rate of interest.49 If the rate of tax is 25 per cent, the profit rate 10 per cent, and the rate of interest 2 per cent, the net profit rate will be 6 per cent. If the rate of interest rises to 4 per cent, the net profit rate falls by 1½ percentage points to 4½ per cent. If now the rate of tax is 50 per cent, a rise in the rate of interest from 2 to 4 per cent will lower the net profit rate by only 1 percentage point, from 4 to 3. In the form in which this argument is generally presented, it is incorrect. Suppose that t is the rate of tax, MEC the marginal efficiency of capital, and R the rate of interest, then the net profit rate will be (1—t) (MECR), where (MECR) represents the gross rate. It is true that the larger the t, the smaller the change in the net profit rate from a given change in the gross rate, but as long as the net rate is positive, the incentive to invest will remain. If the gross return is negative, no tax applies. Therefore, any project that was considered worthwhile at the lower tax rate must continue to be worthwhile at the higher tax rate. However, the argument could have some validity when risk, uncertainty, or income concepts for tax purposes are introduced.

Seventh, business sensitivity to the rate of interest may also depend on the techniques used to appraise investment projects. For example, it may be that the “payoff criterion” (requiring the receipts of an investment project in the first two to five years to cover the initial outlay) makes investment less sensitive to the rate of interest than, for example, a “discounted cash flow” technique.

Eighth, since government and public utility investment tends to be largely immune to monetary policy, the greater its weight in total investment, the less will be the impact of monetary policy.

Before concluding this section, a word should be said about Tobin’s approach to the question of the cost of capital.50 He argues that the true cost of capital is represented by the equity yield, not the bond rate. It is the relation between the equity yield and the marginal productivity of capital that determines the rate of new investment.51 If monetary policy is to make an impact on expenditure, therefore, it must influence the equity yield. Monetary policy generally operates by changing the relative supplies of money and government bonds. The question then is how policies of this type may alter the equity yield. Tobin assumes the existence of three types of financial assets—money, bonds, and equities. He further supposes that while money and bonds are close substitutes, neither is a good substitute for equities. Consider now three types of monetary policy. First, an increase in the supply of interest-bearing debt as a result of an excess of government expenditures over tax receipts. In this instance the interest rate on bonds will rise and the equity yield will fall. The fall in the equity yield will be brought about by an attempt to shift out of bonds into equities. Here then we have a result that is contractionary in terms of the bond rate but expansionary in terms of the equity yield. Second, an open market operation that increases the supply of bonds and reduces money. Here both the bond rate and the equity yield will rise. Third, a reduction in the supply of deposits brought about by a change in reserve requirements. Again the end result will be some increase in both the bond rate and the equity yield. It does seem, then, that the most pronounced divergence between the Keynesian approach in terms of the bond rate and the Tobin approach in terms of the equity yield occurs in the first case, with the other two types of monetary policy yielding movements in the two indicators in the same direction.

The role of nonbank financial intermediaries

In recent years there has been considerable discussion of the situation in which nonbank financial intermediaries may weaken the effectiveness of monetary policy. It is useful to distinguish two major ways in which these intermediaries may be in a position partially to offset the impact of monetary policy.

First, during a credit squeeze they may raise the rate of interest that they pay on their liabilities relative to the rate of interest on time deposits,52 attract more funds from the public, and expand their lending. Finance companies, building societies, and savings institutions are examples of intermediaries capable of behaving in this way, in theory. In effect, these institutions act as intermediaries in channeling “idle” funds to final spenders. These activities may reduce the effectiveness of monetary policy in one of two ways. One way is to represent funds loaned by financial intermediaries as creating a direct effect on expenditure. This would be the counterpart of the credit rationing effect for the banking system. Essentially, this is an argument that would have some force in the short run (e.g., if in a particular period the flow of funds through certain intermediaries were stopped) and where capital markets are unsophisticated.

Another way is to represent the financial intermediaries as permitting a given transfer of funds to the spender with a smaller rise in the interest rate than in the absence of intermediary financing. The more liquid the claims created by the intermediaries and the greater the substitutability of their credit for bank credit, the greater the ease with which funds are channeled to final spenders. In terms of Figure 1 the existence of intermediary finance lowers the interest elasticity of the Cambridge ratio-interest rate schedule in the relevant range, so that a given percentage reduction in the money supply results in a smaller percentage increase in the rate of interest than otherwise.53 This would complicate the problem for monetary policy only if there were certain costs involved in bringing about larger percentage changes in the money supply, e.g., the effect on bank profits or discrimination against the banking system.54

Second, certain financial intermediaries (e.g., life insurance companies, superannuation funds) cannot expand their lending by creating new liabilities in the short run. They may, however, still be destabilizing to the extent that they switch between government securities and private securities during a squeeze. In this respect, banks behave in ways quite similar to financial intermediaries: by switching they do not create money but simply act as intermediaries in transferring “idle” funds from surplus to deficit units. Again, this switching operation might be represented as directly affecting expenditure or lowering the interest elasticity of the schedule in Figure 1.

If financial intermediaries were destabilizing in any of these ways, the monetary authorities could take a number of possible steps to deal with the situation. One might be to impose ceilings either on the rate of interest on intermediary claims or on the rate of interest at which they could lend to the public. In the latter instance, switching out of government securities would also be discouraged, since they would not have the incentive provided by the higher rate on private loans. Another step might be to impose secondary reserve requirements on both the banking system and those intermediaries in a position to engage in switching. Again, lending by financial institutions could be attacked directly by imposing ceilings on their loans.

In general, central banks are anxious to avoid resort to direct controls; for this reason they have tended to rely on two indirect methods of influencing intermediary lending. One is to raise the rate of interest on time deposits and so discourage shifts into intermediary claims. Intermediaries could of course respond by raising their rates further to attract funds but in the end the higher rates will tend to depress expenditure. A second indirect method is the “locking-in” effect. The argument here is that a rise in the rate of interest on government securities, engineered by monetary policy, might discourage switching by banks or insurance companies.55 This discouragement will tend to be the more pronounced, the more rigid the rate of interest on private securities, the greater the reluctance to take capital losses, the greater the concern over portfolio liquidity, and the greater the expectation that the rate of interest will fall again shortly. On the other hand, if the rate of interest on private securities is flexible upward, and the demand for funds is relatively inelastic to the rate of interest, switching is not likely to be discouraged. More important, switching need not necessarily entail losses by these institutions. Banks can switch government securities that are currently maturing or that have a very short life; insurance companies can divert a larger proportion of the new inflow of funds into private securities.

In the end, many of the questions raised here can be settled only by empirical work. To what extent do financial intermediaries actually create claims that are close substitutes for money and increase their lending during a credit squeeze? Is switching accelerated by a credit squeeze? Does the interest rate on intermediary claims show a relative rise during a squeeze?

The role of lags

A most important issue is the length of the lag in the implementation of monetary policy. In general, the shorter the lag, the greater the likelihood that policy will be stabilizing; a long lag means that policy continues to make a significant contribution into the relatively distant future when conditions that originally provoked the policy change may have materially altered. There are several types of lag involved. The “inside” lag is made up of a “recognition” lag (i.e., between the need for a change of gear and the recognition of the need) and an “action” lag. The “outside” lag, which is the length of time from the policy action to the impact on production, may be broken down into a number of distinct lags: a bank reaction lag; a “financial intermediary” reaction lag; a lag in decision taking by households and business units; a production lag that makes its impact felt over several periods.

Given the number of lags involved, the “average” lag is bound to be variable depending on the specific conditions of a monetary change. For example, the lag may be shorter if banks restrict loans rather than reduce their holdings of securities; monetary policy will vary in its impact on different components of expenditure, and each component will have its own “production” lag (see below); bank and financial intermediary reaction will vary. For example, with banks where overdraft limits (approvals) are granted, there will be an element of inflexibility in the response of loans to a restrictive policy; a “bills only” policy will operate with a different lag from a policy that makes a direct impact at all ends of the market.

Given a decision to change expenditure, the distribution of the production effect (or lack of effect) over time will depend on the type of expenditure affected. One component of expenditure would have a shorter lag than another if, say, over six months a larger percentage of the “total” effect had been realized. Consumption and inventories may have short lags in this sense and residential investment a somewhat longer lag, while equipment and commercial construction may have the longest lags. Consider now the situation in which monetary policy makes its impact only on expenditures with the longest lags and in which these lags are too long for effective stabilization. Then the case against discretionary monetary policy for stabilization would be strong. Consider now the situation where monetary policy makes its impact on the whole range of expenditure. In these conditions it becomes uncertain whether monetary policy will have a net stabilizing effect. If destabilizing results are more likely from the long end of the market and stabilizing results from the short end, then there may be a case for concentrating on the short end of the market (an active short-term rate policy) and maintaining the long end relatively stable over cycles. (The feasibility of this solution is another matter.)

II. Empirical Evidence

In this section we review some of the empirical work that throws light on the ways in which monetary policy makes its impact on expenditure. This review is presented in five sections:

  • (a) The interest rate transmission mechanism

    • Interest rate determination

    • Interest rates and investment and consumption

  • (b) The role of other liquidity variables in investment and consumption

  • (c) Quantity theory studies

  • (d) The role of nonbank financial intermediaries

  • (e) The significance of lags

The interest rate transmission mechanism

Interest rate determination

If the interest rate is the important transmission mechanism, one critical question, as we have seen, is the extent to which the interest rate is controllable by the authorities. There are a few studies of the determination of the long-term rate in the United Kingdom, and some of the relevant equations are given below. In the equations following, r = long-term rate; y = income; m = money supply (bank deposits plus cash holdings by public); rb = bank rate.

Kavanagh and Walters56

Logarithmic form (1926–60)

First difference logarithmic form (1926–61)

Ford and Stark57

Logarithmic form (1948–63)


Logarithmic form (quarterly, 1955–62), two-stage

First difference logarithms


Linear form (1947–61)

First difference logarithms

The equations are not comparable, partly because they cover different periods and partly because they are estimated in different forms (logarithmic, linear, semilogarithmic). Whether the ratio of money to income is used or income and the money supply are used as separate variables, the equations demonstrate that a Keynesian-type interest rate theory is useful. Ball’s work suggests that the bank rate also plays some independent role in determining long-term rates, as one might expect on theoretical considerations.60 The implications of using the lagged value of the long-term rate (in Ball and Ford and Stark) to represent the influence of expectations are important for monetary policy. The impact of a given change in the ratio of money to income on the rate of interest will be considerably larger in the long period than in the short period. A new permanent ratio of money to income will in the long period generate a new equilibrium long-term rate, but the impact will be felt gradually over a number of periods. Walters’ equations on the other hand carry a rather different implication. They suggest that a rise in the money supply will lower the rate of interest sharply in the same period and then raise it by roughly five sixths of the fall in the next period.

Equations using the levels of the variables reflect the longer term relationships between the independent variables and the long-term rate. For policy purposes, first difference equations may be more revealing. They indicate the extent to which the rate of interest may be changed on a year-to-year (or quarter-to-quarter) basis by manipulating the policy variables. The results are disappointing. The R2 are quite low usually, suggesting that changes in the rate of interest in the short run are relatively independent of changes in the money supply. The inclusion of the change in the bank rate improves the fit, and to the extent that changes in expectations can be manipulated by the authorities, the rate of interest in the short run may not be altogether outside the control of the authorities.61

For the United States there is convincing evidence that the rate of interest is a significant variable in the demand for money.62 A change in the money supply, therefore, would be expected to alter the rate of interest, but the short-term relationship between the money/income ratio and the rate of interest also appears to be unstable.63

Interest rates and investment and consumption

Fixed investment. To the writer’s knowledge there is no recently published econometric work on the significance of financial variables on expenditure decisions for the United Kingdom. The last econometric work appears to be the original and the revised Klein (and others) quarterly model of the U.K. economy.64 In the original model (1948–58) the rate of interest (the debenture yield) had the right sign but was insignificant in the investment equation; in the later version (including the years 1959 and early 1960, and new data) the rate of interest was significant, with the size of the coefficient increasing 10 times; but even in the later version the coefficient was very low, indicating a rather weak response to the rate of interest.

For the United Kingdom the main evidence comes from survey studies. There were early surveys (the 1938 Oxford inquiry), but the more recent ones are the 1956 Oxford survey of 876 small and medium-sized manufacturing firms and the inquiries by the Federation of British Industries (FBI) in 1957 and the Association of British Chambers of Commerce in 1958, the last two submitted as evidence to the Radcliffe Committee. The main conclusion of the 1956 Oxford survey was that only a small percentage of the sample (less than 5 per cent) was affected by the higher cost of money but that a much higher percentage (12 per cent) said that they were affected by the inability to obtain credit (credit rationing). A sizable number (about 10 per cent) also said that they were influenced by the anticipated effect on sales (announcement effect). The Radcliffe Committee concluded after studying the two inquiries and other submissions that “changes in rates of interest only very exceptionally have direct effects on the level of demand.”65 But this firm conclusion was almost certainly too harsh. A more careful reading of both inquiries and some submissions suggests that the rate of interest may certainly have played a fairly significant part in decisions. For example, in the FBI inquiry, about 12 per cent (179 firms) considered a change in the bank rate a major factor in decision taking; 37 per cent answered in the affirmative the question “Does your judgment of the profitability of new investment vary according to the prevailing rate of interest?” In the inquiry by the Association of British Chambers of Commerce, although only 4 per cent attributed reductions in their turnover on investment programs to the higher cost of money, another 16 per cent had been influenced in their reductions by the tightness of credit. Another survey, by the Birmingham Chamber of Commerce, revealed that 74 out of 610 respondents were influenced in their investment decisions specifically by the higher interest rates. (Finally, there is considerable evidence from other witnesses—the British Engineers’ Association, the Country Landowners Association, the Association of Investment Trusts, the Association of Municipal Corporations, the Scottish Chamber of Commerce—that the rate of interest had been significant.)66 One can only conclude then that the Radcliffe Committee did not satisfactorily establish that the rate of interest was unimportant in investment decisions.

For econometric evidence on the importance of the rate of interest, we must turn to U.S. studies.67 There is now quite convincing econometric evidence that the rate of interest is important in investment.68 There is no point in laboriously going over the many recent studies that attach some weight to the rate of interest; it is sufficient to list some of these studies in a footnote.69 If then the rate of interest plays a significant role in the United States, can it be inferred that the same would be true for the United Kingdom? The onus would seem to be on the skeptics to indicate in which way institutional conditions are so different in the United Kingdom, e.g., in terms of our earlier theoretical discussion of the role of the rate of interest in investment, that the results would be expected to be different.

Inventories. The Radcliffe Committee was even more skeptical of the effect of the rate of interest on inventories: “. . . we have found that stocks of commodities are extremely insensitive to interest rates. . . .”70 While this result too is open to some criticism,71 there is general agreement that the rate of interest probably plays a lesser role in inventory than in fixed capital decisions. The U.S. evidence in this area is ambiguous, some finding the rate of interest significant while others (probably a larger number) finding it insignificant.72

Consumption. Until recently the rate of interest was thought to be quite unimportant in consumption decisions. Two U.S. studies, published in 1967, have found the rate of interest significant in consumption.73 We may, therefore, be entering an era where the rate of interest will begin to play a role even in consumption functions.

The role of other liquidity variables in investment and consumption

The rate of interest is not the only liquidity variable found to be significant in studies of investment and consumption. A brief review of these other liquidity variables is therefore important.


We have already seen that one of the findings of the U.K. surveys was that the unavailability of credit was frequently at least as important as the “cost of credit.” For the United States, a recent econometric study has found the bank supply of loans to be significant in both inventory and fixed investment functions.74 Another liquidity variable frequently found to play some role in investment is a measure of business internal liquidity;75 this reflects the preference for internal funds in investment decision taking.


Some investigators have found real money balances (made up of the cash base and interest-bearing government debt as a component of private wealth) to be significant in consumption decisions.76 Another variable sometimes appearing in estimated consumption functions is “credit terms” available to households; this has been shown to be of particular importance in the United Kingdom for expenditure on consumer durables for which credit terms have been frequently changed by the authorities.77 Mention should also be made of the fact that the Federal Reserve-MIT econometric model has also now identified a significant wealth (capital value) effect on consumption.78

Probably the most persistent liquidity variable used in U.S. consumption studies is “liquid assets,” usually defined to include public cash, deposits, savings, and some other close money substitutes.79 However, there is considerable disagreement as to the interpretation that should be placed on this variable. Some have treated it as a proxy for wealth, and others as reflecting the ability of households to make consumer purchases; since the variable includes the money supply it could also represent a credit rationing effect; again it may also stand in for a quantity-theory type effect.80

Quantity theory studies

We have seen that one possible rationale for using liquid assets in expenditure functions (in particular, consumption functions) is a “quantity-theory” type effect. Apart from studies using money balances in expenditure functions, two other types of study are relevant in appraising the significance of a “quantity theory” effect. One relates income directly to the money supply in current and earlier periods. For the United Kingdom the work of Walters81 and Crouch82 is relevant. Walters relates income to the money supply in the current and five previous quarters (in level and first difference forms) in the years 1955–62. Many of the coefficients are insignificant with some quarters showing positive and others negative coefficients.83 For the level equations the coefficients sum up to +1.7, suggesting a six-quarter elasticity of well over 1 for income with respect to money.84 Crouch, in his monetary model, has estimated the following equation for quarterly data for the years 1954–65 (y = income, D = public cash + deposits):

According to this equation, income is a function of deposits in the previous quarter and all earlier quarters, with declining weights attached to the earlier periods (assuming that the coefficient for yt–1 can be taken seriously as reflecting a distributed lag function). Interestingly, although Crouch’s equation is essentially different in construction from Walters’, the long-run elasticity of income with respect to deposits (measured at the means) is 1.80, a result quite similar to Walters’.85

Most of the empirical work on the relevance of a quantity theory effect in the United States has been inspired by Friedman. Reviewing the historical behavior of money and income, Friedman finds that the amplitude of income has been considerably greater than the amplitude of money. He explains this difference in amplitude in terms of his permanent income hypothesis: Money balances are adjusted to permanent income, and the amplitude of permanent income is considerably less than the amplitude of measured income. The rise in velocity in the upswing and the fall in velocity in the downswing are taken as evidence of the powerful effects of money.86 He estimates in fact that the elasticity of income on average with respect to money approaches 2, so that a 1 per cent increase in the money supply has tended to raise income by something like 2 per cent.87 One difficulty with this analysis is its relevance to the postwar years. The high elasticity of income with respect to money is the result of severe fluctuations in measured income. Since in the postwar years cycles have been considerably milder than in the prewar years, the elasticity of income will presumably have fallen well below 2. Indeed as cycles are eliminated and differences between permanent and measured incomes disappear, the elasticity of income will be less than 1. This is because Friedman treats money as a luxury good in the long run, with desired money holdings rising at a faster rate than income.

Another group of studies inspired by Friedman is concerned with comparing the long-term relative efficiency of Keynesian and quantity theories in explaining the behavior of income. Friedman and Meiselman initiated this exercise for the United States for the period 1897 to 1958.88 They concluded that, in the main and taking the period as a whole, the behavior of consumption is better explained by money than by “autonomous” expenditures (the latter representing the Keynesian explanation of “induced” expenditure).89 On the whole they tended to play down the role of autonomous expenditures and took the view that money tended to be the most important determinant of expenditure.90 A number of doubts were subsequently raised about these results.91 For the United Kingdom, Barrett and Walters applied rather similar tests for the period 1891 to 1962 including a number of subperiods.92 They defined autonomous expenditures as the sum of private domestic investment, government expenditure, and the excess of exports over imports. Over the whole period, autonomous expenditures appear to provide a slightly better explanation of consumption than money; but for certain sub-periods (e.g., before World War I) this result is reversed. The final conclusion, which is not surprising, is that “both money and autonomous expenditure have been important factors in the determination of aggregate consumption.”93 A typical equation for the most recent subperiod (1948–63) using both money and autonomous expenditure is the following (c = consumption, a = autonomous expenditure, m = money supply):

The author has himself experimented with equations of this type for the United Kingdom, and it may be useful to report the results of the best equation estimated in first difference form from annual data for 1951–67.

Money here is narrowly defined to exclude deposit accounts, and A represents the sum of government expenditures, investment in fixed capital, and exports. The explanatory power of the equation is good for first differences. Autonomous expenditures in the same period are insignificant and have the wrong sign. One surprising result is that autonomous expenditures operate with a longer lag than money.

Three brief comments on the Friedman and Meiselman type of tests are in order. First, few types of expenditure can be unambiguously classified as either “induced” or autonomous of income. Private domestic investment, treated as autonomous in these studies, is obviously related in a complicated way to the behavior of income (e.g., an accelerator-type function). Consumer durables and the external balance are also partly induced and partly autonomous. Second, sophisticated Keynesianism does not imply a simple relationship between “autonomous” expenditure and consumption of the type tested in these studies. Third, where the money supply and autonomous expenditure are both quite significant, as in the above function, this can easily be shown to be consistent with a simple variant of Keynesianism. For example, all expenditures (which make up income) are a function of income, the rate of interest, and autonomous expenditures. The rate of interest in turn is determined by income and the money supply. In this simple scheme, income is then determined by autonomous expenditure and the money supply (a reduced form of a simple Keynesian system).94

A recent study for the United States by Anderson and Jordan has aroused considerable interest and comment.95 Anderson and Jordan regress changes in income against an indicator of monetary policy and an indicator of fiscal policy. The study is very much in the spirit of the original Friedman and Meiselman contribution, since it is designed to appraise the relative merits of a monetary model against a Keynesian-type model (this time represented by fiscal policy instead of autonomous expenditures). Their own results showed, first, that monetary policy exerts a larger influence on economic activity than fiscal policy; second, that the response of economic activity to monetary policy is more predictable and reliable than the response to fiscal policy; third, that there was no evidence that fiscal actions were quicker acting than monetary actions. These results, then, were strongly monetarist and attributed rather weak effects to fiscal actions.

Later work for the United States, particularly by de Leeuw and Kalchbrenner, threw some doubt on these results.96 These authors questioned the assumption that money was truly exogenous, since it also responded to movements in income. More important, they ran regressions for alternative indicators of monetary and fiscal actions.97 The most striking difference was obtained with a different indicator of monetary policy:98 now monetary policy becomes substantially weaker and fiscal policy much stronger and more reliable. A similar study has also been applied to the United Kingdom recently.99 If we take this study seriously, the results for the United Kingdom turn out to be the exact opposite of those obtained by Anderson and Jordan. Fiscal policy now performs better and with a smaller lag.

The role of nonbank financial intermediaries

The only fairly comprehensive study of financial intermediaries in a period of monetary restriction in the United Kingdom is by Clayton.100 His method is to examine the actual behavior of a number of institutions that are potentially destabilizing. He finds that building society interest rates tend to be sticky, so that in restrictive periods the flow of funds to these institutions is actually slowed down. The interest rate that finance companies pay on deposits tends to be a fixed margin over the bank rate; since the commercial bank deposit rate is also tied to the bank rate, the absolute margin between the bank deposit rate and the finance company rate is constant. This means that as interest rates rise there is in general no incentive to move into finance company deposits.101 Turning to insurance companies, he does find some actual switching out of government securities in restrictive periods. He also finds that investment trusts may have been destabilizing because they had switched substantially from fixed-interest securities into equities; but since the fixed-interest securities were, in the main, private issues, it is not clear that this would necessarily have been destabilizing.

Another, more abstract and far less satisfactory, way to attack the problem is to examine the extent to which the growth of money substitutes by financial intermediaries may have affected the demand for money. Other things being equal, one would expect, for example, that if these money substitutes were at all significant, they would help to explain the behavior of interest rates in the postwar years, i.e., a broader concept of liquidity that embraces these money substitutes ought to provide a better explanation of interest rate movements than a narrow bank concept of liquidity.102 There is some evidence from studies by Ball103 and Ford and Stark104 for the United Kingdom that money substitutes have not played a significant part in interest rate determination; however, this evidence should not be taken too seriously.105

The evidence for the United States on this question is far less relevant for the United Kingdom. First, the types of institution involved are different in the two countries. Second, arrangements and conventions respecting interest rates offered on intermediary claims will be different in the two countries. Third, in the United States reserve requirements are lower for fixed than for current deposits, and this fact is important in analyzing the effects on the supply of loanable funds of shifts from deposits to intermediary claims. For what it is worth then, in the United States detailed studies of financial institutions do not reveal any marked destabilizing behavior.106 The evidence also suggests that money substitutes need not be explicitly allowed for in studies of the demand for money.107

The significance of lags

The Radcliffe Report suggested that monetary policy might be too slow to be useful for short-term stabilization.108 Unfortunately, there has been virtually no research on U.K. lags to permit some judgment on this question. The only research that has any bearing on this issue at all is not very helpful; nevertheless, a brief review of the evidence will be given.

A typical method of estimating the “inside” lag is the following: Consider the equation Pt = aW + bX + cY + dZ + ePt–1, where P is the monetary instrument, W, X, Y, and Z represent policy targets, and Pt–1 is the distributed lag variable for the policy targets. A recent study by Fisher applies this method for the United Kingdom, using a number of monetary instruments and policy targets.109 The targets that are significant in some of the equations are the price level, international reserves, and unemployment rates. The e coefficient is large (between 0.6 and 0.9), indicating that much of the response is delayed.

Walters has also tried to measure the “inside” lag by relating money (m) to prices (p) and the deficit in the balance of trade (d).110 The two relevant equations for quarterly data 1955–62 (in logarithmic form) are

It is extremely difficult to extract any meaning from these equations: the signs are different (the first equation, for example, implying that the government increases money as the level of prices rises and the deficit increases); many of the coefficients are insignificant; other possible indicators of government policy (e.g., unemployment rate) are left out.

A direct measure of one “outside” lag is suggested by the Klein (and others) econometric model. In the investment functions, the debenture yield, which as we saw was significant in the later version, appears with a four-quarter lag. In a study by Walters referred to earlier, income is related to the money supply in the current and five previous quarters, but many of the coefficients are insignificant, and some coefficients are positive while others are negative.111 Crouch’s equation for income and money, given earlier, suggests that income is a function of money in the previous and all earlier periods.112

For the United States there is now considerable empirical literature but the position remains somewhat unsettled. Kareken and Solow113 and Brunner and Meltzer114 estimated the total inside lags (recognition and action) to be in the vicinity of 9 months, on average.115 On the other hand, some writers, including Hendershott,116 Wiles,117 and Havrilesky118 all estimate the lag to be considerably less than that (from zero to 2 to 3 months).

The “outside” lag is more complicated, with lags varying depending on the type of expenditure, e.g., inventories, residential construction, and plant and equipment investment. Kareken and Solow looked at the lag from changes in free reserves to changes in bank interest rates, and then from changes in bank interest rates to inventory investment. The first lag proved to be quite long (with about one fifth of the effect on interest rates occurring after six quarters),119 and the second averaged (meaning 50 per cent of effects felt) about 8 or 9 months. The average lag for the change in the bond rate to the change in producer durable equipment turns out to be between 14 and 18 months, about twice as long as the inventory lag. (No estimate is given of the time it takes for the bond rate to respond.) Kareken and Solow concluded that plant and equipment investment, while probably ultimately responsive to monetary policy, changes too slowly to be of any use for countercyclical policy of the postwar variety. Mayer’s study arrives at only a slightly less pessimistic result.120 He concludes that “monetary policy is too inflexible to reduce the fluctuation of industrial production by more than about 5 to 10 per cent on the average.”121 Ta-Chung Liu also finds the monetary lags to be somewhat long in his econometric model of the U.S. economy.122 Two experiments carried out by Liu are relevant for us. In one experiment he traces the effects of a maintained increase in the short-term rate of interest (effectively controlled by the monetary authorities) on gross national product (GNP). He finds that the maximum effect does not eventuate until eight quarters later. In another experiment he supposes that a given error in actual GNP (excess or deficiency) is fully corrected by adjusting the interest rate in the next quarter. It turns out that this policy increases the severity of fluctuations and thus worsens the situation. Friedman’s own work also supports the “long lag” hypothesis.123 He finds that the lead of the money series over business (national bureau reference figures) has tended to average between 12 and 16 months.124 Several recent writings also support the “long lag,” although there are significant differences in detail between these studies.125 It is difficult then to escape the conclusion that, insofar as fixed investment is concerned, the lag may be somewhat on the long side.126

III. Conclusions

We saw in the theoretical discussion that monetary policy may make its impact in a number of ways. There is some empirical support for each transmission mechanism discussed: the rate of interest, real balances, bank loans, “announcement” effects, and a direct money supply effect. If more recent studies are to be taken seriously it would seem that monetary policy makes its impact not only on investment but also on consumption. It still seems, however, that the direct interest rate effect on investment remains the most effective, the most unambiguous, and the least controversial of the transmission mechanisms. The major problem connected with monetary policy is no longer whether monetary changes impinge on real variables but rather the time it takes for this impact to be felt. In this area, more work remains to be done before any more definite evaluation of monetary policy is possible.


A Brief Note on the Term Structure of Rates

There is some evidence to suggest that the long-term rate is approximately a mean of expected short-term rates plus a liquidity premium that is larger, the longer the maturity of the security.127 If we also accept the view that expectations will not be uniformly held (i.e., that expectations are diverse),128 then it can be demonstrated that the term structure may change in favor of long-term rates for any of the following reasons.

1. If the supply of long-term bonds increases and an equivalent supply of short-term bonds or bills is withdrawn.

2. If, with a given supply of long-term and short-term securities, the public’s preference for short-term securities increases at the expense of longer term securities.

3. If there is an autonomous upward change in expectations respecting future short-term rates, e.g., the expectation that future short-term rates will be higher than previously anticipated.

4. If longer term securities are considered less liquid, perhaps because their values have been allowed to be more volatile. In this instance, a higher liquidity premium will be required to carry longer term securities.

The cases discussed in the text are consistent with these theoretical expectations. Funding represents an example of case 1 above,129 while a rise in special deposits or a rise in the liquidity ratio represents an example of case 2 above. It is conceivable that the monetary authorities may be able to raise long-term rates relative to short-term rates by influencing expectations of future rates in accordance with case 3 above. Again, a more flexible rate policy may raise the desired liquidity premium in line with case 4 above. In accordance with the general theory of expectations, a rise in the bill rate (brought about by a rise in the bank rate) will raise the longer term rate to the same extent only if all relevant future bill rates are expected to be higher by the increase in the current bill rate; in other words, all future bill rates are written up by the amount of the increase in the current bill rate.

Les répercussions de la politique monétaire sur les dépenses, en particulier au Royaume-Uni


Cet article se compose de deux parties. La première traite des rapports entre les instruments monétaires d’une part et la masse monétaire et le taux d’intérêt d’autre part. La seconde étudie les rapports entre la masse monétaire et le taux d’intérêt d’une part et les dépenses globales d’autre part. Les deux parties examinent ces problèmes en se référant tout particulièrement au Royaume-Uni.

Dans la première partie est étudiée la question du contrôle de la masse monétaire au Royaume-Uni. Une question importante dans ce cas est celle de savoir si les emprunts à la Banque d’Angleterre représentent un obstacle grave au contrôle. Cette première partie examine également les effets sur la masse monétaire, les taux d’intérêt et la structure des taux d’intérêt résultant de l’utilisation des instruments monétaires à la disposition des autorités au Royaume-Uni.

La seconde partie examine le mécanisme de la transmission de la politique monétaire et ensuite étudie en détail les données relatives à cette question. Cette étude porte notamment sur le rôle des intermédiaires non bancaires ainsi que sur les décalages dans l’action de la politique monétaire. Les données de fait confirment nettement l’opinion selon laquelle la monnaie a des effets significatifs sur l’activité économique, mais elles ne dégagent pas de certitude en ce qui concerne en premier lieu la manière dont la monnaie exerce ses répercussions et en second lieu la répartition de ses effets entre les différents éléments des dépenses.

El impacto de la política monetaria sobre el gasto, refiriéndose en especial al Reino Unido


Este artículo consta de dos partes. La primera parte se ocupa de la relación entre, por un lado, los instrumentos monetarios y, por el otro, la oferta monetaria y el tipo de interés. La segunda parte trata de la relación entre, por un lado, la oferta monetaria y el tipo de interés y, por el otro, el gasto agregado. En ambas partes se examinan esos problemas refiriéndose en especial al Reino Unido.

En la primera parte se aborda la cuestión del control de la oferta monetaria en el Reino Unido. Es importante averiguar si los préstamos tomados en el Banco de Inglaterra representan un obstáculo serio a dicho control. También se examinan en la primera parte los efectos sobre la oferta monetaria, los tipos de interés, y la estructura de los tipos de interés como resultado de la utilización de los instrumentos monetarios de que disponen las autoridades del Reino Unido.

En la segunda parte se estudia el mecanismo por el que se transmite la política monetaria y luego se examinan en detalle los datos relativos a dicho proceso. También se habla de la función de los intermediarios no bancarios y de los desfases en la marcha de la política monetaria. Los datos analizados apoyan firmemente la opinión de que el dinero ejerce un efecto significativo sobre la actividad económica; pero aún no está claro, primero, la forma en que el dinero ejerce ese impacto y, segundo, la distribución de los efectos entre los distintos componentes del gasto.

Mr. Argy, Acting Chief of the Financial Studies Division of the Research Department, is a graduate of the University of Sydney, Australia. He has been a lecturer at the University of Auckland, New Zealand, and a lecturer and senior lecturer at the University of Sydney. He has contributed several articles to economic journals.

Both questions are, of course, important in appraising the role of monetary policy for stabilization. If the relationship between instruments and the money supply and interest rate is weak or, alternatively, if the relationship between the money supply and interest rate and expenditure is weak or very much delayed, then monetary policy would be an unreliable instrument of policy.

H = cM + rD and M (1–c) = D. Then H = cM + r (l–c) M. Equation (5), or an equation quite similar to it in principle, is now widely used in the literature. See Allan H. Meltzer, “Money Supply Revisited,” The Journal of Political Economy, Vol. LXXV (1967).

It should be noted that in the United Kingdom the cash ratio (including special deposits) applies to the sum of current and fixed deposits. Hence, any shift on the part of the public from current to fixed deposits will not affect the deposits. However, such a shift could induce the banks to switch out of lower earning assets into advances, since their interest payments have now increased. See N. J. Gibson, Financial Intermediaries and Monetary Policy (Hobart Paper No. 39, The Institute of Economic Affairs, 1967), p. 33.

The money supply in the United Kingdom is defined to include the resident deposits of the accepting houses, the overseas banks, and the discount market. These represent something like 8 per cent of total deposits. These institutions do not respect the 8 per cent convention. They also hold little cash with the Bank of England. If the cash ratio is defined as notes and coins plus cash with the Bank of England divided by total resident deposits, some element of fluctuation in the ratio is possible as a result of the operations of these institutions. See Gibson, Financial Intermediaries and Monetary Policy (cited in footnote 2), p. 35.

The importance of the public’s demand for currency in the late 1940’s and the 1950’s in the United Kingdom is investigated in a recent paper by Karl Brunner and Robert Crouch, “Money Supply Theory and British Monetary Experience,” Methods of Operation Research, III, ed. by Rudolf Henn (Meisenham, 1967). They find, in fact, considerable instability in the ratio of currency to deposits. For example, in 1947–48, although base money declined sharply, the money supply actually increased. The reason was that the currency ratio also declined very sharply in these two years.

R. L. Crouch, “Money Supply Theory and the United Kingdom’s Monetary Contraction, 1954–56,” Bulletin of the Oxford University Institute of Economics and Statistics, Vol. 30 (1968), pp. 143–55, deals in some detail with the behavior of the money supply in the years 1954–56. Between December 1954 and June 1956 the money supply fell by 1.36 per cent; other things being equal the increase in base money would, in that period, have raised the money supply by 6.45 per cent. In fact, the sharp increase in the nonbank currency/deposit ratio more than offset this, and largely explained the actual reduction in the money supply. One difficulty with this approach is that it assumes that the component contributors to the money supply are independent of each other.

R. L. Crouch, “The Genesis of Bank Deposits: New English Version,” Bulletin of the Oxford University Institute of Statistics, Vol. 27 (1965), pp. 185–99.

In all equations in this paper, standard errors will be shown below coefficients.

R. L. Crouch, “A Model of the United Kingdom’s Monetary Sector,” Econometrica, Vol. 35 (1967), pp. 398–418.

It now seems to be generally agreed that currency is more logically related to an income variable than to a money supply or deposit variable. See W. T. Newlyn, “Monetary Policy,” in Theory of Money (Oxford University Press, 1962), pp. 148–66.

N. J. Gibson has estimated the following first difference equation for currency in the United Kingdom for the 27 years including 1921–39 and 1956–65

where Y is income and R is the rate of consols (which is insignificant). See Gibson, Financial Intermediaries and Monetary Policy (cited in footnote 2).

All this suggests that the collinearity between currency and the money supply simply reflects the collinearity between the money supply and income. A slight variant of this approach is to treat currency as a function of consumption or retail sales.

V. Argy, “Money Supply Theory and the Money Multiplier,” Australian Economic Papers, Vol. 4 (1965), derives a money supply function on the assumption that currency is a function of income and bank reserves are a function not only of deposits but also of the rate of interest.

See, for example, Karl Brunner and Allan H. Meltzer, “An Alternative Approach to the Monetary Mechanism,” Subcommittee on Domestic Finance, Committee on Banking and Currency, House of Representatives (88th Congress, 2nd Session, August 17, 1964); Phillip Cagan, Determinants and Effects of Changes in the Stock of Money, 1875–1960 (National Bureau of Economic Research, New York, 1965); Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton University Press, 1963); Karl Brunner, “The Role of Money and Monetary Policy,” Federal Reserve Bank of St. Louis, Review, Vol. 50 (1968).

See A. James Meigs, Free Reserves and the Money Supply (University of Chicago Press, 1962).

Brunner and Meltzer, “An Alternative Approach to the Monetary Mechanism” (cited in footnote 9).

Brunner, “The Role of Money and Monetary Policy” (cited in footnote 9).

Cagan, Determinants and Effects of Changes in the Stock of Money, 1875–1960 (cited in footnote 9).

W. T. Newlyn, “The Supply of Money and Its Control,” The Economic Journal, Vol. LXXIV (1964), pp. 327–46; R. L. Crouch, “A Re-examination of Open Market Operations,” Oxford Economic Papers, New Series, Vol. 15 (1963); D. J. Coppock and N. J. Gibson, “The Volume of Deposits and the Cash and Liquid Assets Ratios,” The Manchester School of Economic and Social Studies, Vol. XXXI (1963), pp. 203–22; K. K. F. Zawadzki, “Are Open-Market Operations Effective?” Oxford Economic Papers, New Series, Vol. 17 (1965), pp. 10010; A. B. Cramp, “Financial Theory and Control of Bank Deposits,” Oxford Economic Papers, New Series, Vol. 20 (1968), pp. 98–108, and “The Control of Bank Deposits,” Lloyds Bank Review, New Series, No. 86 (1967), pp. 16–35.

There is some question as to whether a penal rate ought to be defined in this way. Crouch, in “A Re-examination of Open Market Operations” (cited in footnote 14), has suggested that a true penal rate is one that exceeds the rate on the most profitable asset held by the discount houses; only then would marginal costs really exceed marginal revenue. In this sense nearly all “borrowing” is at a non-penal rate. Crouch suggests that this could provide an explanation of the “discount houses’ continued willingness to borrow on ‘penal’ terms.”

It is possible to make other assumptions respecting the banks’ behavior. For example, the banks would be in equilibrium if their balance sheet was as follows: deposits 990, cash 79.2, call money 198.0, investments and advances 712.8. Instead of assuming that they contract their deposits to correspond to their liquid asset holdings, we can suppose that they build up their liquid assets in line with their deposits. (Indeed they could even restore that original level of deposits.) Building up liquid assets need not necessarily involve buying treasury bills from the public. The banks have been successful in expanding their liquid assets by increasing their holdings of commercial bills and lending at call or short notice to the nonbanking sector. These cases may be interesting only if “penal debt” is not liquidated or if nonpenal funds are made available by the Bank of England. Otherwise, the end result will be as shown in the text.

In some respects the U.K. system may not be markedly different from the U.S. system. In the United States a penal discount rate will provide some incentiveto return “base money” to the Federal Reserve Banks.

This model of back-door accommodation, which makes the “liquid asset ratio” the basis of deposit control, received some support from the Radcliffe Committee. See Committee on the Working of the Monetary System, Report (Cmnd. 827, London, 1959), para. 376 (p. 128) and paras. 583–90 (pp. 215–19). This Committee is referred to hereafter as the “Radcliffe Committee” and its Report as the “Radcliffe Report.” See also Coppock and Gibson, “The Volume of Deposits and the Cash and Liquid Assets Ratios” (cited in footnote 14). The Radcliffe Report did concede, though, that if the bill rate was not stabilized, the cash ratio would be the effective ratio. See John G. Gurley, “The Radcliffe Report and Evidence” (A Review Article), The American Economic Review, Vol. L (September 1960), pp. 672–700.

See A. E. Jasay, “The Technique of Quantitative Monetary Control,” in Radcliffe Committee, Principal Memoranda of Evidence (London, 1960), Vol. 3, pp. 129–31.

On “netting” of open market operations, see R. Crouch, “A Re-examination of Open Market Operations” (cited in footnote 14).

This special case of an open market sale of bills to the discount houses has along history in the U.K. literature. See W. Manning Dacey, “The Floating Debt Problem,” Lloyds Bank Review, New Series, No. 40 (1956), pp. 24–38. The Bankof England, in its testimony to the Radcliffe Committee, treated this as a distinctiveexample and indeed thought that a bill sale to the discount houses would leave thecash and deposits of the banks unchanged. See John H. Kareken, “Monetary Policy,” in Britain’s Economic Prospects, by Richard E. Caves and others (The Brookings Institution, Washington, 1968), p. 97.

See the discussion of this situation in Zawadzki, “Are Open-Market Operations Effective?” (cited in footnote 14).

See Newlyn, “The Supply of Money and Its Control” (cited in footnote 14).

See Coppock and Gibson, “The Volume of Deposits and the Cash and Liquid Assets Ratios” (cited in footnote 14); see also Zawadzki, “Are Open-Market Operations Effective?” (cited in footnote 14).

Brunner and Crouch in an interesting table compute the contributions of discounts and advances and of Bank of England securities portfolio to the annualpercentage changes in the base. Two features of this table are, first, the extremelysmall contributions made by discounts and advances (well below 1 per cent inevery instance) and, second, the fact that “annual or quarterly changes in the Bank’s portfolio of government securities were most definitely not offset by changes in discounts and advances.” See Brunner and Crouch, “Money Supply Theory and British Monetary Experience” (cited in footnote 4), p. 93.

The relevant multiplier is now DH=1-cc+r(1-c), which is about 2.9 for the United Kingdom.

Since June 1963 the Bank of England can charge a rate on loans to the discount houses that is in excess of the bank rate.

One way to interpret this result is in terms of an increase in the demand for money, since the interest rate on money is now higher.

A. A. Walters, “Bank Rate,” The Bankers’ Magazine (London), July 1965, pp. 7–11.

In terms of equation (5) and the discussion of the equation in the text, this means that n and H both increase in such a way that money is unchanged.

See N. J. Gibson, “Special Deposits as an Instrument of Monetary Policy,” The Manchester School of Economic and Social Studies, Vol. XXXII (1964), pp. 239–59.

The Radcliffe Report supported this view of funding. See W. Manning Dacey,” Problems of Funding,” in Money Under Review (London, 1960), pp. 97–113.

R. L. Crouch, “The Futility of Funding,” The Bankers’ Magazine (London), July 1965, pp. 1–6. Also R. L. Crouch, “The Inadequacy of ‘New-Orthodox’ Methods of Monetary Control,” The Economic Journal, Vol. LXXIV (1964), pp. 916–34.

If investments would have been lodged as security with the banks against advances and these investments are now bought outright by the banks, clearly the switch will have no effect on spending. See also the discussion in PART B.

The consideration, therefore, makes it unlikely that they would substitute commercial bills for advances.

See R. J. Ball and Pamela S. Drake, “The Impact of Credit Control on Consumer Durable Spending in the United Kingdom, 1957–1961,” The Review of Economic Studies, Vol. XXX (1963), pp. 181–94.

Excluded from the terms of reference here are allocation and distribution effects of monetary policy, the differential impact on the size of the firm, debt management involving either the choice between debt and tax or changes in the composition of debt, and a more general discussion of the monetary instrument in the context of multiple targets and multiple instruments.

The result would be virtually identical, for example, if potential borrowers—denied funds—simply liquidated their own holdings of government securities.

D. Meiselman, “Discussion,” in Monetary Process and Policy, ed. by George Horwich (Homewood, Illinois, 1967), pp. 324–25.

Milton Friedman and David Meiselman, “The Relative Stability of Monetary Velocity and the Investment Multiplier in the United States, 1897–1958,” in Stabilization Policies (Commission on Money and Credit, Englewood Cliffs, N.J., 1963), pp. 165–268, especially p. 220.

Friedman also argues that services will now be cheaper relative to the price of assets, so that there will be a substitution of services for stocks, e.g., car rentals instead of new car purchases, house rentals instead of new houses, television rentals for television purchases. He sometimes refers to this as an “implicit” interest rate effect. It is not clear, however, how this effect is meant to bring about a net change in the demand for goods. See, for example, Milton Friedman and Anna J. Schwartz, “Money and Business Cycles,” The Review of Economics and Statistics, Vol. XLV (Supplement, February 1963), pp. 32–64, and the Comments, pp. 64–78.

Milton Friedman, “The Demand for Money: Some Theoretical and Empirical Results,” The Journal of Political Economy, Vol. LXVII (August 1959), pp. 327–51. We have made no attempt to reconcile these approaches to a change in themoney supply. Friedman’s transmission mechanism remains somewhat ambiguous.

Instead of representing the authorities as changing the rate of interest bychanging the money supply, we might, alternatively, have represented the authorities as settling on a particular interest rate and then allowing the ratio of money to income to accommodate to the rate of interest. If the schedule is unstable, then a given rate of interest will be consistent with different levels of the money supply. The authorities, in other words, would have to be prepared to allow the money supply to fluctuate so as to maintain the desired interest rate.

The Radcliffe Report took the view that the relationship between the money supply and the rate of interest was both weak and unreliable. The Radcliffe Committee tended to argue that when the money supply was restricted the rise in the rate of interest would be slight, partly because of the highly liquid assets in the hands of spenders and partly because financial markets were well organized. The Committee also thought that the relationship between the money supply and the rate of interest was unreliable largely because the public’s demand for money tended to be unstable. This amounts in effect to accepting the view that the Cambridge ratio-interest rate schedule tends to be volatile, so that a change in the money supply is consistent with a range of interest rates. In the Report the volatility in the demand for money is due largely to changes in expectations of future interest rates. See Gurley, “The Radcliffe Report and Evidence” (cited in footnote 18).

Normally, monetary policy that involves a change in the money supply willalter all rates in the same direction, although to a different degree. When short-term and long-term rates move in opposite directions, it may be the outcome of a pure debt management operation (e.g., buying long and selling short). See M. Ross, “‘Operation Twist’ A Mistaken Policy,” The Journal of Political Economy Vol. LXXIV (1966).

This corresponds roughly to the distinction made by the Radcliffe Committee between a liquidity effect and an interest incentive effect (see the Radcliffe Report, cited in footnote 18, paras. 385–86 on pp. 130–31). While the Report tended to play down the interest incentive effect (except when a change in “gear” was in-volved), they attached some importance to the liquidity effect.

The effect on consumption of a change in the interest rate is generally thought to be weak. For “target” savers a rise in the rate of interest may even increase consumption.

G. C. Harcourt, P. H. Karmel, and R. H. Wallace, Economic Activity (Cam-bridge University Press, 1967), pp. 153–54.

See the criticism of this explanation by Lorie Tarshis, “The Elasticity of the Marginal Efficiency Function,” The American Economic Review, Vol. LI (De-cember 1961), pp. 958–85.

This view appeared in some of the submissions to the Radcliffe Committee. See, for example, Nicholas Kaldor, “Monetary Policy, Economic Stability and Growth,” in Principal Memoranda of Evidence (cited in footnote 19), pp. 146–52. See also the criticism by Tarshis, “The Elasticity of the Marginal Efficiency Function” (cited in footnote 48).

James Tobin, “An Essay on Principles of Debt Management,” in Fiscal and Debt Management Policies (Commission on Money and Credit, Englewood Cliffs, N.J., 1962), pp. 143–218.

The equity yield appears appropriate for equity finance, but the bond rate would be more appropriate for debt finance.

The extent to which they will be able to do this will depend on the flexibility of the earnings on their assets. For example, if they had large holdings of longer term government securities on which the return was fixed, then to that extent their ability to offer higher rates on their liabilities would be weakened.

This is the Gurley-Shaw view of intermediary finance. See John G. Gurley and Edward S. Shaw, Money in a Theory of Finance (The Brookings Institution, Washington, 1960). For a criticism of their view, see Assar Lindbeck, A Study in Monetary Analysis (Stockholm, 1963).

It is interesting that attempts have been made to show that the existence of financial intermediaries might actually reinforce monetary policy under certain conditions. The so-called leverage effect postulates that the public holds a constant ratio of bank deposits to intermediary claims. If bank deposits are reduced, the public will attempt to reduce its holdings of intermediary claims to restore the equilibrium ratio. This reduction in intermediary claims will reduce lending by intermediaries and so reinforce policy. The assumption of a fixed ratio is, however, most implausible. For an attempt to take account of leverage and interest rate effects in the analysis of financial intermediaries, see J. A. Galbraith, “Monetary Policy and Nonbank Financial Intermediaries,” The National Banking Review. Vol. 4 (1966), pp. 53–60.

The Radcliffe Committee attached some importance to the locking-in effect (see the Radcliffe Report, cited in footnote 18, para. 394 on p. 134). It did not favor direct controls on intermediaries partly because this indirect method of control was available. It should be noted that, while it felt that the locking-in effect was a useful instrument of policy, it opposed large rises in the long-term rate because the capital losses would weaken the foundations of these financial institutions (see para. 491 on p. 175).

N. J. Kavanagh and A. A. Walters, “Demand for Money in the UK, 18771961: Some Preliminary Findings,” Bulletin of the Oxford University Institute of Economics and Statistics, Vol. 28 (1966), pp. 93–116.

J. L. Ford and T. Stark, “Some Statistical Analysis of the Long-Term Rate of Interest in the United Kingdom, 1948–1963,” Bulletin of the Oxford University Institute of Economics and Statistics, Vol. 27 (1965), pp. 287–97.

A. A. Walters, “Money Multipliers in the U.K., 1880–1962,” Oxford Economic Papers, New Series, Vol. 18 (1966), pp. 270–83.

R. J. Ball, “Some Econometric Analysis of the Long-Term Rate of Interest in the United Kingdom, 1921–61,” The Manchester School of Economic and Social Studies, Vol. XXXIII (1965), pp. 45–96; only a very small selection from a large number of estimated equations.

L. R. Klein and others, An Econometric Model of the United Kingdom (Oxford, 1961), found both the bank rate and the Cambridge ratio significant in determining debenture yields.

Crouch has a rate of interest equation as part of his model of the monetary sector (“A Model of the United Kingdom’s Monetary Sector,” cited in footnote 7).The rate of interest is the treasury bill rate and the independent variables used are income, the bank rate, special deposits, and the outstanding stock of treasury bills.The sign for special deposits is negative, which he explains by saying that when special deposits rise, the banks increase their demand for liquid assets, including treasury bills, and so, lower the bill rate.

Allan H. Meltzer, “The Demand for Money: The Evidence from the Time Series,” The Journal of Political Economy, Vol. LXXI (June 1963), pp. 219–46.

M. Bronfenbrenner and T. Mayer, “Liquidity Functions in the American Economy,” Econometrica, Vol. 28 (1960).

Klein and others, An Econometric Model of the United Kingdom (cited in footnote 60); L. R. Klein, A. Hazlewood, and P. Vandome, “Re-estimation of the Econometric Model of the U.K. and Forecasts for 1961,” Bulletin of the Oxford University Institute of Statistics, Vol. 23 (1961), pp. 49–66. See also Marc Nerlove, “Two Models of the British Economy: A Fragment of a Critical Survey,” International Economic Review, Vol. 6 (May 1965), pp. 127–81.

See the Radcliffe Report (cited in footnote 18), para. 487, p. 174.

For detailed criticisms of the Radcliffe Committee’s conclusion on the insignificance of interest rates, see William H. White, “Bank Rate Vindicated?—Evidence before the Radcliffe Committee,” The Bankers’ Magazine (London), August 1959, pp. 98–104, and Gurley, “The Radcliffe Report and Evidence” (cited in footnote 18).

It is interesting that there may be an econometric bias against finding a significant role for the rate of interest. See T. Mayer, “Comments,” in Monetary Process and Policy (cited in footnote 39).

Until roughly the middle-to-late 1950’s there was general skepticism on the role of interest rates. The recent rash of evidence may be due to a number of considerations: more sophisticated techniques of investigation, improved business decision making, the higher level of interest rates, and possibly also the reduction of general uncertainty.

The following are just a few of the studies that have found the rate of interest to be significant in fixed investment: Dale W. Jorgenson, “Capital Theory and Investment Behavior,” The American Economic Review, Papers and Proceedings of the Seventy-fifth Annual Meeting, Vol. LIII (1963), pp. 247–59; Frank de Leeuw, “The Demand for Capital Goods by Manufacturers: A Study of Quarterly Time Series,” Econometrica, Vol. 30 (1962), pp. 407–23; Stephen M. Goldfeld, Commercial Bank Behavior and Economic Activity (Amsterdam, 1966); Ta-Chung Liu, “An Exploratory Quarterly Econometric Model of Effective Demand in the Postwar U.S. Economy,” Econometrica, Vol. 31 (1963), pp. 301–48; John Kareken and Robert M. Solow, “Lags in Fiscal and Monetary Policy: Part I, Lags in Monetary Policy,” in Stabilization Policies (cited in footnote 40), pp. 14–96.

See the Radcliffe Report (cited in footnote 18), para. 489, p. 174.

See William H. White, “Inventory Investment and the Rate of Interest,” Banca Nazionale del Lavoro, Quarterly Review (Rome), June 1961, pp. 141–83.

For a summary of some of these recent U.S. results, see Michael J. Hamburger, The Impact of Monetary Variables: A Selected Survey of the Recent Empirical Literature (Board of Governors of the Federal Reserve System, Staff Economic Studies, 1967).

Michael J. Hamburger, “Interest Rates and the Demand for Consumer Durable Goods,” The American Economic Review, Vol. LVII (December 1967), pp. 1131–53; Colin Wright, “Some Evidence on the Interest Elasticity of Consumption,” The American Economic Review, Vol. LVII (September 1967), pp. 850–55.

Goldfeld, Commercial Bank Behavior and Economic Activity (cited in footnote 69), pp. 111 and 123–24. The Federal Reserve-MIT model finds credit rationing to be significant only in housing. See Frank de Leeuw and Edward M. Gramlich, “The Channels of Monetary Policy,” Federal Reserve Bulletin, Vol. 55 (1969), pp. 472–91.

Edwin Kuh and John R. Meyer, “Investment, Liquidity, and Monetary Policy,” in Impacts of Monetary Policy (Commission on Money and Credit, Englewood Cliffs, N.J., 1963), pp. 339–474.

For a review of this evidence, see Don Patinkin, “Note M. Empirical Investigations of the Real-Balance Effect,” Money, Interest, and Prices: An Integration of Monetary and Value Theory (New York, Second Edition, 1965), pp. 651–64.

See Ball and Drake, “The Impact of Credit Control on Consumer Durable Spending in the United Kingdom, 1957–1961” (cited in footnote 36).

See de Leeuw and Gramlich, “The Channels of Monetary Policy” (cited in footnote 74).

See Daniel B. Suits, “The Determinants of Consumer Expenditure: A Review of Present Knowledge,” in Impacts of Monetary Policy (cited in footnote 75); Zellner, Huang, and Chau, “Further Analysis of the Short-run Consumption Function with Emphasis on the Role of Liquid Assets,” Econometrica, Vol. 33 (1965).

This is one of the interpretations placed on it by Zellner and others, ibid. They conclude their study by saying: “At present our data support the hypothesis that imbalances in consumer liquid asset holdings exert a statistically and economically significant influence on consumption expenditure. That this is the case is important since it constitutes evidence that monetary variables affect an important expenditure relationship directly and not just indirectly through interest rate effects.”

“Money Multipliers in the U.K., 1880–1962” (cited in footnote 58).

“A Model of the United Kingdom’s Monetary Sector” (cited in footnote 7).

The line of causation between money and income is not unambiguous. There are many ways in which causation may run from income to money: governments may control the money supply with reference to the behavior of income; if holdings of notes and coins by the public are determined by income, then, other things being equal, income movements will be negatively related to the supply of deposits; to the extent that the balance of payments responds to income, then income and money will be negatively related; again, changes in tax payments accompanying movements in income may affect the money supply; finally, changes in income will change interest rates, which in turn may influence the desired cash/deposit ratio of the banking system. Where money and income for the same period are used, the sign for the money coefficient may be positive or negative.

The author has also experimented with a number of regressions relating income to money. In one regression percentage changes in gross national product (Y¯) were regressed against percentage changes in money (excluding deposit accounts).


The results are poor, indicating that percentage changes in money are a poor predictor of incomes.

But an elasticity greater than 1 may simply reflect the rise in velocity.

Friedman and Schwartz, “Money and Business Cycles” (cited in footnote 41).

In a Keynesian-type model, the elasticity of income with respect to money would normally be less than 1. What is interesting is that the Keynesians would draw an exactly opposite deduction from the fact that the amplitude of income is greater than the amplitude of money. To Keynesians this would be evidence of the relative ineffectiveness of money.

“The Relative Stability of Monetary Velocity and the Investment Multiplier in the United States, 1897–1958” (cited in footnote 40).

Consumption is used as the dependent variable instead of income because autonomous expenditures are “part” of income.

Friedman’s rule—that money should grow at something like 4 per cent a year—follows directly from his view that money is the most important determinant of expenditure. He argues that it is variations in the rate of change in the money supply that have been responsible for fluctuations in the economy; hence, if therate of change in the money supply could be stabilized, the rate of change inactivity would also tend to be stabilized.

See, in particular, Albert Ando and Franco Modigliani, “The Relative Stability of Monetary Velocity and the Investment Multiplier,” pp. 693–728, and Michael De Prano and Thomas Mayer, “Tests of the Relative Importance of Autonomous Expenditures and Money,” pp. 729–52, The American Economic Review, Vol. LV (September 1965); R. Strotz in Monetary Process and Policy (cited in foot-note 39).

C. R. Barrett and A. A. Walters, “The Stability of Keynesian and Monetary Multipliers in the United Kingdom,” The Review of Economics and Statistics, Vol. XLVIII (1966), pp. 395–405.

Ibid., p. 405.

In periods when the economy is operating near the full employment level, the Keynesian multiplier would not be expected to work. This explains the negative coefficient that Friedman and Meiselman find for a few periods for autonomous expenditure; it also explains why autonomous expenditures were most significant and money least significant in the depression years.

L. Anderson and J. Jordan, “Monetary and Fiscal Actions: A Test of Their Relative Importance in Economic Stabilization,” Federal Reserve Bank of St. Louis, Review, Vol. 50 (1968).

Federal Reserve Bank of St. Louis, Review, Vol. 51 (1969); see the reply in the same issue.

The most important change was in the monetary indicator. One monetary indicator used in the Anderson and Jordan paper was base money. De Leeuw and Kalchbrenner experiment with indicators which in one instance exclude borrowings and in another exclude both borrowings and currency in the hands of the public.

The one that excludes borrowings and nonbank currency from base money.

M. J. Artis, “Two Aspects of the Monetary Debate,” National Institute of Economic and Social Research, National Institute Economic Review (London), August 1969, pp. 33–51.

G. Clayton, “British Financial Intermediaries in Theory and Practice,” The Economic Journal, Vol. LXXII (1962), pp. 869–86.

See, however, Gibson, Financial Intermediaries and Monetary Policy (cited in footnote 2), pp. 42–43. Gibson finds in fact that the interest rates the finance houses pay on deposits are “highly variable in relation to Bank rates.”

See V. Argy, “Money Substitutes and Interest Rate Determination: the Australian Case,” Banca Nazionale del Lavoro, Quarterly Review (Rome), March 1966, pp. 72–90.

“Some Econometric Analysis of the Long-Term Rate of Interest in the United Kingdom, 1921–61” (cited in footnote 59).

“Some Statistical Analysis of the Long-Term Rate of Interest in the United Kingdom, 1948–1963” (cited in footnote 57).

A third possibility, even less satisfactory, is to see if the interest coefficient in the demand for money equations has changed significantly in periods when financial intermediaries were supposed to be more active. It is impossible, unfortunately, to interpret the evidence in any way that will throw any light at all on this possibility.

Arthur Benavie, Intermediaries and Monetary Policy (Michigan Business Reports, Number 48, University of Michigan, 1965); Warren L. Smith, “Financial Intermediaries and Monetary Controls,” The Quarterly Journal of Economics, Vol. LXXIII (1959), pp. 533–53.

Meltzer, “The Demand for Money: The Evidence from the Time Series” (cited in footnote 62); Henry A. Latané, “Income Velocity and Interest Rates: A Pragmatic Approach,” The Review of Economics and Statistics, Vol. XLII (1960), pp. 445–49.

Radcliffe Report (cited in footnote 18), para. 980, pp. 336–37.

Douglas Fisher, “The Objectives of British Monetary Policy, 1951–1964,” The Journal of Finance, Vol. XXIII (1968), pp. 821–31.

“Money Multipliers in the U.K., 1880–1962” (cited in footnote 58).


“A Model of the United Kingdom’s Monetary Sector” (cited in footnote 7).

“Lags in Fiscal and Monetary Policy: Part I, Lags in Monetary Policy” (cited in footnote 69).

Brunner and Meltzer, “An Alternative Approach to the Monetary Mecha-nism” (cited in footnote 9).

There is tremendous difficulty in measuring this “inside” lag. First, it is necessary to decide when there was a need for a change in policy. This is difficult enough with single targets, but with multiple targets some weighting of the targets would seem to be implied. (This may be partly relevant to the United Kingdom.) Second, there is the problem of determining when the direction of policy actually changed.

P. Hendershott, “The Inside Lag in Monetary Policy—A Comment,” The Journal of Political Economy, Vol. LXXIV (1966).

M. H. Wiles, “The Inside Lags of Monetary Policy,” The Journal of Political Economy, Vol. LXXV (1967).

T. Havrilesky, “A Test of Monetary Policy Action,” The Journal of Political Economy, Vol. LXXV (1967).

However, the authors express very severe reservations about this result.

Thomas Mayer, “The Inflexibility of Monetary Policy,” The Review of Economics and Statistics, Vol. XL (1958), pp. 358–74.

But see the criticism by William H. White in The Review of Economics and Statistics, Vol. XLIII (1961), “The Flexibility of Anticyclical Monetary Policy,” pp. 142–47, and Vol. XLVI (1964), “The Flexibility of Monetary Policy: A Reply,” pp. 322–24. White finds that Mayer overstates the length of the lag.

“An Exploratory Quarterly Econometric Model of Effective Demand in the Postwar U.S. Economy” (cited in footnote 69).

Friedman and Schwartz, “Money and Business Cycles” (cited in footnote 41).

Friedman’s work appears to be marred by some weaknesses. First, he relates the rate of change in the money supply series to the level of economic activity. If, on the other hand, first differences in the money supply are compared with first differences in production, the lag virtually disappears, as Kareken and Solow have shown. Second, his measure of the lag implies that the money supply is the most important determinant of income. The lag could be explained by the effects of economic activity on the rate of change in money and/or by policy decisions at specific points in the cycle. See, on this, Richard G. Davis, “How Much Does Money Matter? A Look at Some Recent Evidence,” Federal Reserve Bank of New York, Monthly Review, Vol. 51 (1969), pp. 119–31. Friedman also finds the lag to be variable. This variability could be due to a number of considerations. It may be the result of the way in which an increase in money enters the system, e.g., open market operations or bank loans. It may be due to the operation of nonmonetary influences on income. Also, in an interesting paper, Tanner has shown that, even if the lag pattern is fixed, variations in the rates of change in money will themselves generate variations in the lead relationship between income and money. (J. Ernest Tanner, “Lags in the Effects of Monetary Policy: A Sta-tistical Investigation,” The American Economic Review, Vol. XXX (December 1969), pp. 794–805.)

T. Mayer, “The Lag in the Effect of Monetary Policy: Some Criticisms,” Western Economic Journal, Vol. 5 (1967); Hamburger, The Impact of Monetary Variables: A Selected Survey of the Recent Empirical Literature (cited in footnote 72); Frank de Leeuw and Edward Gramlich, “The Federal Reserve-MITE conometric Model,” Federal Reserve Bulletin, Vol. 54 (1968), pp. 11–40. One study finding a relatively short lag is by Shirley Almon, “Lags Between Investment Decisions and Their Causes,” The Review of Economics and Statistics, Vol. L (1968), pp. 193–206. The study by Anderson and Jordan (cited in footnote 95), also finds that monetary policy makes a much quicker impact than the Federal Reserve-MIT model. For a criticism of the lags in the Federal Reserve-MIT model, see also W. H. White, “The Timeliness of the Effects of Monetary Policy: The New Evidence from Econometric Models,” Banca Nazionale del Lavoro, Quarterly Review (Rome), September 1968, pp. 276–303. A critical review of alternative methods of estimating lags is to be found in V. Argy, “The Lags in Monetary Policy: An Asessment of Alternative Approaches,” Banca Nazionale del Lavoro, Quarterly Review (Rome), June 1965, pp. 157–67.

Monetary policy may make a fairly quick impact to the extent that existing projects carried over from an easier policy may be slowed down or postponed during a tight policy. Also, projects discouraged by a tight policy may be taken up again in the earlier stages of the recession. It may also be that, in periods of full employment, tight money policy may not reduce effective demand but simply reduce the inflationary gap. This means that the inflationary effects of a tight policy cannot be assumed to be carried over into the later stages of the downturn. See, on this, White, “The Flexibility of Anticyclical Monetary Policy” (cited in footnote 121).

See Reuben A. Kessel, The Cyclical Behavior of the Term Structure of Interest Rates (National Bureau of Economic Research, Occasional Paper No. 91, 1965).

Burton G. Malkiel, “The Term Structure of Interest Rates,” The American Economic Review, Papers and Proceedings of the Seventy-sixth Annual Meeting, Vol. LIV (1964), pp. 532–43.

Open market operations confined to one end of the market will similarly have term-structure effects, e.g., a “bills only” policy will tend to generate large fluctuations in the very short-term rate.

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