Money, Banking and The Bank of England - Essay Example

Money and Banking a. Introduction A simple and practical definition of the value of money would be amount of goods and services, which will be given for a unit of money. Obviously, the value of money is closely tied with “purchasing power” which could simply be defined as the ability of the holder of the money to obtain control over goods and services. In our modern society, money has taken a very important role in our economic activity. Some say that modern society is organized on a financial or pecuniary level. In other words, most of our economic activities and transactions, we measure our capabilities by means of our purchasing power which is also equated to money. With good justification, our present economic system has been described as a money economy. There is hardly any aspect of economic life that is not affect by money. Very few are able to satisfy their wants without the use of money. In our economic society, we rely largely on money and prices to keep production and consumption in step with each other and price changes are expected to help bring adjustments where they are necessary. While there are many factors, which affect the price level (or converse, the value of money), one of the most significant is that is the cash balance in the hand of the public (money supply in relation to the volume of goods). When money supply increases faster than the volume of goods, the price level is likely to rise, and the value of money to decline correspondingly. Conversely, when money supply declines in relation to the volume of goods, a downward trend is prices may be expected. In accordance with the quantity theory of money, the value of money is determined by the supply of money, velocity and amounts of goods and services present in a particular period of time. It is important to consider the determinants of the velocity of money after having considered the money supply and its composition. II. The Bank of England A society, which is organized strongly at the pecuniary level, is very much affected by the activities of the banking industry. In UK, the Bank of England, which is the central bank, controls monetary operations. This means that it is the primary agency, which has the authority to implement monetary policies. “The main goal of monetary policy for most central banks is to maintain the internal and external value of the domestic currency.” (Gray, Hoggarth & Place 2001). According to the Keynesiani theory, which was also adopted by the Banking School, monetary policy operates indirectly and only through its consequential effects on interest rates. “It is only through the rate of interest and the state of credit that the Bank of England can exercise direct influent…” (Tooke 1959, page 124). Can the Bank of England dictate the market economy of the country? Does it have full control on the quantity of money in circulation? To some extent, the Bank of England does have control of the quantity of money in circulation. Over the years, the banking industry of England developed a system, which could be called a “mono-reserve” systemii. In this system, ”private banks promised to redeem their own liabilities for Bank of England notes”. (Wray 2005, page 3). This means that private banks are mostly dependent on the Bank of England in terms of reservesiii. Consequently, there are many private banks, which are holding “Bank of England notes in vaults.“iv However, majority of these banks also have reserves in the form of deposits in other key banks in London. But then again, as the Bank of England happens to be at the center of the whole banking industry, these key London banks also have reserves in the Bank of Englandv. As the lender of last resort, the Bank of England has control over the whole banking system. In most cases, a panic would result if the central bank would show signs that it would not provide reserves. (Bagehot 1927).vi A close observation on the whole scenario would give us a sense that the whole system is centered in the Bank of England, giving the same “tremendous power in determining interest rates”(Wray 20005, page 3). What is the significance of this power to control interest rates? As money and banking are closely interrelated, the interest rates could greatly affect the velocity of money and it supply to public hands. As the Bank of England have the power to determine interest rates, it can easily cause”tight money” by simply calling in the advances it had extended to private banks and brokers all over the country. In so doing, there will be an artificial shortage of money for a time being as banks will now have limited resources to transact business for a period of time. This scenario would tend to encourage banks to attract money in the private hands by increasing their internal interest rates for deposits. Another way on which the power of the Bank of England to influence rates is when the Bank of England increase interest rates required in discounting of treasury bills or just simply refuse to discount. In a “tight money” situation like this, banks would usually react by calling “for overdrafts and force correspondent country banks to sell stock” (Wray 2005 page 4). This would often result to result to bonds will flood the market forcing its pricing down while causing interest rates to rise (Wray 1990, page 51). Naturally, this phenomenon would cause unease in the economy affecting the supply and velocity of money. “In any mono-reserve system, the monopoly supplier must supply reserves without limit whenever the banking system faces a panic.” (Bagehot 1927)vii This means that when panic ensues following”tight money” situation, it is now the duty of the Bank of England to stabilize the system by guaranteeing the stability of the banks. III. Conclusion In the present time of open economy where a single entity in theory could not dictate the stability of money transactions, one can always find a way of circumventing the system. As discussed earlier, money and banking are so closely related that the activities of one affects the status of another. Although the Bank of England in theory could not directly control the quantity of money in circulation, it can directly and indirectly affect the same by controlling and influencing the interest rates. How can this be done? As the central bank of UK, the Bank of England has the power to directly influence the banking system through the issuance of directives in the form of monetary policy. These monetary policies are mainly used for regulating the banking system. A good example of this is setting targets for bank reserves where banks all over the country are required to have a specific amount of reserves. On the other hand, the Bank of England had indirect control over the amount of money in circulation by initially performing activities which will affect its “own balance sheets or the pricing (interest rates) of central bank facilities” (Gray S., Hoggarth G and Place J. (2001 page 8). These activities are mainly aimed at liberalizing the financial systems. Indirect controls and influences are vital in a monetary era as it promotes “an efficient allocation of savings and credit in the economy.” (Gray S., Hoggarth G and Place J. (2001 page 8). A good example of this activity is that tends to liberalize the system but still influences and controls the quantity of money in circulation is the control exercised by the Bank of England on its prices. By simply affecting its own reserve, the central bank can easily influence the whole banking system, thereby effectively affect the quantity of money in circulation. Remember that the banking system of England is a “mono-reserve” system where the Bank of England is a t the center. Somehow, if the Bank of England would deplete its reserves or affect controlling measures on its reserves, the whole banking system would tend to be suck into a vortex with the central bank at the middle. The most crucial part of the whole control and influence scenario is of course the interest rates. Where an entity has control on interest rates, such entity would greatly affect the velocity of money in the hands of private individuals and in private banks. In this way, the Bank of England does have control over the quantity of money in circulation and dictate the market economy of the country. End Notes Read More