Monetary Theory and Practice

During the course of the last fifteen years (1968–83) I have had the privilege of acting as a specialist adviser in monetary economics at the Bank of England. All the papers now republished in this collection were written during this period. Although some of them could, in principle, have been written by a monetary economist without close contact with the monetary authorities, the contents of all of them have been informed and influenced by my work in the Bank; and several of the papers arose directly and immediately from that work. As I shall explain at some greater length later, however, the papers represent my own views, and are my own responsibility, and should not be treated as a reflection of the views, or position, of the Bank as a whole. Nevertheless I am extremely grateful to the Bank for having allowed me to prepare them initially, and to republish them now.

The distinguishing characteristic of that set of assets which may be described as money is that they perform the function of a medium of exchange. This definition does not, however, allow for a clear-cut distinction in practice between those assets which should be regarded as money, and those which cannot be so treated. Cash and cheques drawn on banks are the means of payment for transactions which are generally acceptable in most developed economies, and this fact has led many to conclude that cash and demand deposits in banks are the only real monetary assets. There are, however, certain demand deposits, for example compensating balances held with banks in the USA, which cannot be freely used for transactions purposes. On the other hand, possession of a balance on time deposit, or access to overdraft facilities, may allow a purchaser to draw a cheque on his bank account even when he has insufficient demand deposits to meet that cheque. A more fundamental point is that the set of assets which is acceptable as payment for transactions is not immutable over time; it has changed in the past and could do so again in the future. If people should find it economically advantageous to accept, and to proffer, other financial claims in payment for transactions, then the set of assets which is to be described as money will alter.

Much of the econometric work undertaken in the Bank of England during the years 1969–74 has concentrated on the demand-for-money function. There have been three papers in the Bank of England Quarterly Bulletin specifically on this subject, by Goodhart and Crockett[14] by Price [26] and by Hacche[17].¹ Several other research papers have been on cognate topics. For example, there have been two papers on the timing (lead/lag) relationships between monetary aggregates and various expenditure series, the first by Crockett[10] and the second by Goodhart, Gowland and Williams[15]. Also there was a study on the substitutability among various capital-certain assets, examined within a portfolio adjustment model, which was started by Latter and Price, who reported on this work at the 1971 meeting of the Association of University Teachers of Economics, and carried to completion by Townend in a paper presented to the Econometric Society meeting at Budapest in 1972 and summarised in [28]. Although the econometric research work undertaken in the Bank has been by no means limited exclusively to studies on the demand-for-money function (or very closely related issues) — there have, to take an example, been a number of papers on the determinants of the shape of the yield curve by Burman[7], Burman and White[8/9] and Hamburger[19] — nevertheless it has formed a continuing focus for research work.

In 1971 the monetary authorities¹ in the UK adopted a new approach to monetary management, a change of policy announced and described in several papers on competition and credit control. The subsequent experience of trying to operate this revised system has, however, been troublesome and at times unhappy. The purpose here is to examine certain aspects of recent monetary developments in order to illustrate a number of more general analytical themes which may have relevance among several countries.

During the course of the 1970s the monetary authorities in the UK, as in other countries, moved towards the adoption of publicly announced quantitative targets for monetary growth. Such a publicly stated target was first promulgated in the UK during 1976, but for some few years before then the authorities were setting (private, internal and undisclosed) monetary objectives for themselves.

The structure of the banking system is in the midst of profound change. Some aspects of this have already been largely completed, for example the banks’ switch to liability management; some are still in progress, for example the continuing shift to variable rate lending, away from fixed rate lending — though this shift reflected worsening inflation, and could cease, or even reverse, were inflation conquered; others are still in the pipeline — their outline may already be discernible, but they have not yet fully taken effect; these last include prospective changes in the structure of retail deposit business and the form of payments technologies. In this chapter I shall consider these changes and explore their implications for monetary control, notably for the achievement of target rates of growth for certain specified monetary aggregates.

It is generally the case that macroeconomic models are constructed around a framework of accounting identities. For example, Keynesian models are based on the national income accounts. In monetary theory the identity MV=Py plays a central role. There is nothing reprehensible about constructing a model around a solid framework of identities. Indeed, the process of distinguishing key identities, whose existence or importance had not been previously recognised, has played a major role in the development of theory; for example, a relatively minor extension of the Keynesian identities led to the formulation of Kaldor’s theory of distribution[15].²

This article considers whether monetary base control should be the means by which the authorities control the monetary aggregates. We have approached this subject as economists rather than as representatives of the Bank of England, and we seek to contribute to what has hitherto in the UK been only a limited discussion. Many of the subjects raised in the discussion are candidates for detailed consideration on both a theoretical and a practical level. Moreover, the various proponents of monetary base control often have widely differing proposals in mind, a fact which significantly increases the scope of the analysis required. What follows here, therefore, is not intended to be an exhaustive treatment of the subject. In particular, it concentrates on the more theoretical, economic issues and only raises in passing some of the implications of the various proposals for the structure of existing financial markets and for the authorities’ present methods of operation.

The most notable difference between the US and the UK economies is that the latter is an open economy — indeed its history and circumstances have made the UK more open to external influences than most other countries of a similar size, whereas the USA approximates almost to a figurative closed economy. The interrelationship between domestic monetary developments and the balance of external payments has been close, important and involved in the UK. Moreover, the nature of this relationship has varied, particularly in response to changes in the exchange-rate regime in existence. The change from a regime of pegged, but adjustable, exchange rates — the Bretton Woods system — to a regime of more flexible, but still managed, exchange rates, a change which dates from June 1972 in the UK case, has caused modellers some (continuing) difficulty in adjusting their models to the new system.

Economists have generally tried to represent the complex real world by models that are implictly assumed to capture its underlying structure perfectly. In other words, no uncertainty is formally attached to the coefficients in the behavioural equations (most of which are assumed to be zero); uncertainty enters explicitly only through an additive error term. Moreover, the expectation of that error is zero, so that for forecasting and simulation purposes most models become deterministic in form. Careful economists will, of course, be aware of the unreality of the implicit claim to perfect knowledge of the structure of the system; nevertheless most forecasting takes place in the context of such deterministic models. We shall begin by discussing the measurement of monetary policy in such a context, then move on to take specific account of additive stochastic error, and end by considering the implications of uncertainty about the form (the coefficients) of the models themselves.

In recent years there has been a growing application of the concept of ‘disequilibrium’ between the demand for and supply of money, both as a means of elucidating certain monetary developments, i.e. to help explain movements in the observed monetary aggregates [5, 6, 11, 13, 31, 33, 34, 38],² and, more comprehensively, to treat such disequilibria as one of the major forces driving economic developments in economic models of certain countries, e.g., UK, Australia, USA [15, 16, 20, 31, 32, 41]. However, the basic concept of ‘disequilibrium money’ is contentious (see in particular White [57]), the empirical basis for adopting the approach is debatable, and its application in economic analysis still in a fledgeling stage. It is the aim of this note to explore these issues. The next section discusses some general theoretical and/or partly semantic questions concerning the nature of this disequilibrium. The subsequent section describes evidence from the UK which appears consistent with the existence of disequilibrium money holdings, and difficult to explain in other ways. The final main section considers briefly how adoption of this approach may influence the modelling of the structural form of relationships between monetary developments and the economy more widely.