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

CHAPTER 19 Interest rates and monetary transmission
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In this extreme example, raising the money supply has beneficial effects despite the fact that interest rates
have already fallen as low as they can go. In effect, interest rates cannot fall below zero.
How can we add to the money supply once interest rates have reached their effective floor? This implies that
money demand must be perfectly elastic at this minimum interest rate - what John Maynard Keynes called
the liquidity trap. In these circumstances, he thought that creating more money was pointless precisely
because it could not reduce interest rates any further. Great man that he was, he did not get everything right.
Nowadays, we know about the credit channel, and quantitative easing is proof that it can work.
These are benefits of holding inventories. The cost is that, by retaining unsold goods or buying goods not
yet inputs to production, a firm ties up money that could have earned interest. The cost of holding
inventories is the interest forgone, plus any storage charges for holding stocks.
Thus the investment demand schedule II for fixed capital in Figure 19.5 also applies to increases in working
capital, or inventories. Other things equal, a higher interest rate reduces desired stockbuilding, an upward
move along the investment demand schedule. This is part of the monetary transmission mechanism. But a
rise in potential speculative profits, or fall in storage costs for inventories, shifts the schedule II up and
raises inventory investment at any interest rate. Not all changes in investment demand are caused by
monetary policy.
Summary
• The Bank of England, the UK central bank, is banker to the banks. Because it can print money it can
never go bust. It acts as lender of last resort to the banks.
• The Bank conducts the government's monetary policy. It affects the monetary base through open
market operations, buying and selling government securities. It can also affect the money multiplier by
imposing reserve requirements on the banks, or by setting the discount rate for loans to banks at a
penalty level that encourages banks to hold excess reserves.
• There is no explicit market in money. Because people plan to hold the total supply of assets that they
own, any excess supply of bonds is matched by an excess demand for money. Interest rates adjust to
clear the market for bonds. In so doing, they clear the money market.
• A rise in the real money supply reduces the equilibrium interest rate. For a given real money supply, a
rise in real income raises the equilibrium interest rate.
• In practice, the Bank cannot control the money supply exactly. Imposing artificial regulations drives
banking business into unregulated channels. Monetary base control is difficult since the Bank acts as
lender of last resort, supplying cash when banks need it.
• Thus the Bank sets the interest rate not money supply. The demand for money at this interest rate
determines the quantity of money supplied. Interest rates are the instrument of monetary policy.
• Interest rates take time to affect the economy. Intermediate targets are used as leading indicators when
setting the interest rate.
• 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.
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