Money Tips Network

Suppose that a country has only one bank, which finds that it needs to keep 20 per cent of its deposits in the form of cash. It receives an extra ?200 worth of cash deposits. The bank the buys ?160 of British Telecom shares, leaving ?40 cash free to meet any claims from depositors. The person from whom it bought the shares now has ?160 in cash, which is deposited with the bank. So the bank has ?360 in deposits (the original ?200 plus the new deposit of ?160), of which it needs to keep only ?72 (20 per cent) in the form of cash. The bank is therefore able to increase its total investment to ?288 (?360 – ?72) and can buy a further ?128 of BT shares. Once again the person from whom it buys the shares will receive cash, depositing this with the bank. This process will continue until the bank has deposits of ?1,000, of which ?200 is held in the form of cash. The bank’s balance sheet will then look like this:

Asset Liabilities
Cash ?200 Customer deposits ?1,000
BT shares ?800
TOTAL ?1,000 ?1,000

To find out the total amounts of deposits that can be created form the original cash base, divide 100 by the percentage which the bank needs to hold as cash (known as the cash ration). Then multiply the result by the amount of the original deposit. Thus, in this example, dividing 100 by the cash ration of 20 per cent gives 5, and multiplying that by the original deposit equals ?1,000

The cash ratio is therefore very important. If, in the example, the ratio had been only 10 per cent, the amount of deposits created from the original deposit would have been ?2,000 and not ?1,000. In practice, banks find that they need to keep around 8 per cent of their deposits in the form of cash.

This relation between the money which banks need to hold in liquid form and the amount which they can lend has been used by the Bank of England to control the level of credit in the economy.
Defining the Money Supply

As money has become increasingly sophisticated, so it has become more and more difficult to define exactly what it is. This issue assumed particular importance with the prominence of the monetarist school of economics, which believed that the level of inflation is closely related to the rate of increase of the money supply. In the late 1970s and early1980s many Western governments, including the UK’s, were strong adherents of the monetarist school and attempted to base economic policies on its theories. Accordingly, they needed to define the money supply before they could control it.

The Bank of England published several definitions of money. M1 is defined as notes and coins in circulation with the public, plus sterling current accounts held by the private sector. M2 is M1 plus private-sector sterling deposit accounts held with the deposit (commercial) banks and the discount houses. A broader definition, M3, includes virtually all the deposits held by the private and public sectors in both sterling and foreign currencies. Sterling M3, which was for many years the government’s principal monetary target, is M3 minus the foreign currency element. As something of an afterthought, the Bank devised a very narrow definition of money, M0, which consists purely of notes and coins.

By defining money solely by reference to deposits held in banks, the Bank of England realized that it was failing to take into account other deposits which might be substitutes for those in banks. For example, building society deposits are not strictly compatible with bank deposits. Traditionally it has not been possible to write a cheque on a building society account, although this too is changing. However, if building society rates are more attractive than those offered by the banks, depositors will switch their money from their bank accounts to a building society. Most society accounts will let their depositors withdraw cash instantly, and many creditors will accept a building society cheque as payment. To call bank deposits money and building society accounts non-money would be to paint an inaccurate picture of credit levels in the economy.

The Bank of England accordingly established a new set of definitions of money, the Private Sector Liquidity (PSL series). PSLI includes notes and coins, sterling bank deposits, certificates of deposits, Treasury and bank bills and similar instruments. PSL2 adds in building society deposits and shares and deposits with similar institutions like the Trustee Savings Bank (TSB). Eventually, a broad definition along these lines was named M4. However, the PSL definitions have attracted little attention from economic analysts.

In the middle of 1985 the Chancellor of the Exchequer effectively abandoned sterling M3 as a target figure for his monetary policy. It had been growing at 20 per cent a year at a time when inflation was falling. It was announced that M0 would continue to be watched (along with short-term interest rates and the exchange rate), but it seemed that the difficulty of defining money had defeated the best efforts of the monetarists.