bain_y_howells__monetary_economics__policy_and_its_theoretical_basis

THE MONEY SUPPLY PROCESS 69
ence of asymmetric information. It is argued that borrowers have a much
better idea about the risks attached to the projects for which they take out
loans than do the providers of the loans. It is very difficult for banks to
assess the creditworthiness of borrowers and their projects, this gives rise to
moral hazard and adverse selection problems. The borrower characteristics
that banks might use in the screening are discussed in Leland and Pyle
(1977) and Diamond (1984) but the important point from the FoF perspective
is that variations in the flow of lending are partly the outcome of banks’
lending decisions (Stiglitz and Weiss, 1981) and while this is the case there
is little point in focusing upon changes in the availability of reserves.
The final and by far the most powerful reason for the widespread adoption
of the FoF framework is that it is easier to apply to the way in which
the UK authorities have, in practice, tried to influence monetary conditions.
The FoF approach gives a central role to flows of new bank lending and it
is the flow of bank credit that the UK authorities have focused on, albeit in
differing ways, since 1945. Up until 1971, this control consisted of an
evolving collection of direct interventions — ‘moral suasion’ imposed on
banks to discriminate by type of borrower, then by specifying minimum
deposits and maximum payback periods for consumer loans. The first of
these was a supply-side constraint but the latter were intended to work on
the demand for loans as potential borrowers ruled themselves in or out
depending upon the severity of the conditions.
In 1971 the Competition and Credit Control arrangements swept away
all direct controls and stated the intention of relying upon variations in the
price of credit, the short term rate of interest, to regulate the demand for
credit. In the inflationary years of the 1970s, the authorities had occasional
failures of nerve when it was clear that interest rates needed to be held in
double figures, and there were occasional outbursts of direct control in the
form of supplementary special deposits (a reversion to supply-side control).
But in 1981, market methods were restored and the last twenty years have
seen a steady convergence in central bank operating procedures towards
adjustment of short-term interest rates (Borio, 1997). The short-term rate
over which central banks have direct control is the lender of last resort or
rediscount rate which we have already met as i d in 3.10. But in the B-M
approach the purpose of raising (for example) i d would be explained as an
attempt to increase the reserve ratio and reduce the size of the multiplier. In
practice, raising i d is assumed to cause banks to raise their lending and borrowing
rates and thus to reduce the demand for net new bank lending and
thus to slow the creation of new deposits. The quantity of reserves and the
resulting size of reserve ratios has nothing to do with it. In spite of the occa-