David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 19 Interest rates and monetary transmission
money supply at L0. The equilibrium interest rate is r0. Instead, the central bank can fix the interest rate at r0
and supply the money needed to clear the market at this interest rate. In equilibrium, the central bank supplies L0•
The central bank can fix the money supply and accept the equilibrium interest rate implied by the money
demand equation, or it can fix the interest rate and accept the equilibrium money supply implied by the
money demand equation. Central banks now do the latter.
Uncertainty about the exact size of the money multiplier or bank deposit multiplier is now unimportant.
When the interest rate starts to fall below the level r0, either because of too little demand for money or too
much supply, the Bank reduces the monetary base, through an open market operation, until the interest
rate is r0 again. Conversely, when the interest rate exceeds r0, the Bank simply increases the monetary base
until the interest rate falls to r0.
II
Quantitative easing
In Chapter 18 we saw how banks responded to the financial crisis by prioritizing the rebuilding
of their solvency. This had four aspects: (a) holding a much higher percentage of their assets in
ultra-safe bank reserves and other very liquid assets; (b) avoiding any new
lending that was thought to be risky; (c) raising profit margins throughout
the industry in order to build up capital reserves; and, where possible,
( d) issuing new shares in order to attract additional capital from
shareholders. Here we focus on the implications of (a) and (b).
Quantitative easing is
the creation of substantial
quantities of bank reserves
in order to offset a fall in the
bank deposit multiplier and
prevent large falls in bank
lending and broad money.
We show again Figure 18.4 which documents the collapse of the bank deposit
multiplier - the ratio of broad money to bank reserves - which fell from 90
in mid-2007 to 14 by late 2009. If reserves had remained constant, broad
money would have fallen to a sixth of its previous level! The complete drying up of bank lending - to each
other and to private firms - transmitted a huge shock to the real economy. House prices fell since new
mortgages became very hard to obtain, industrial production fell as firms struggled to find loans to finance
work-in-progress until it could be sold, and increasing numbers of bankruptcies were reported.
The Treasury tried to help, by making it a condition of government support for banks such as RBS that they
continued to lend to the private sector at the same level as in previous years. Unsurprisingly, the banks said
they would do so but then did not, and there was
little that the government could do.
Bank deposit multiplier, 2006-09
1 00
90
80
70
60
50
40
30
20
10
m
o +'-""' ...,.... ..., ..,.... ... ....,.. ,........,.... ...,.. ..,. ....,.... ...,
'° '° "' "' ,.... CX) CX) CX) °' °' °'
0 0 0 0 0 0 0 0 0 0 0
' ' I I I ' I I
>- 0.. c >- 0.. c >- 0.. c >- 0..
'
0 (1) 0 0 (1) 0 0 (1) 0 0 (1)
Cf)
...,
Cf)
...,
Cf)
..., Cf)
UK and US central banks have usually been run
by professional bankers, not world-class economics
professors. At the time of the crisis, the governor
of the Bank of England was Mervyn King, former
professor at the London School of Economics, and the
governor of the US Federal Reserve was Ben Bernanke,
former economics professor at Princeton University.
They understood the problem and adopted a bold
solution: quantitative easing.
The chart on the next page shows the evolution of the
reserves R of the UK banks and of the M4 measure
of broad money, in each case using an index that sets
the May 2006 level equal to 100.
The reserves of UK banks rose six-fold between May
2008 and July 2009 as the Bank of England took
450