The efficiency of monetary control and building society developments

The efficiency of monetary control and building society

developments.

PAWLEY, Michael A.

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PAWLEY, Michael A. (1991). The efficiency of monetary control and building society

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TH E E F F I C I E N C Y OF M O N E T A R Y C O N T R O L A N D BUI L D I N G S O C I E T Y DEVELOPMENTS

by

MICHAEL A N D R E W P A W L E Y B.A. (Hons)

A thesis submitted to the C o u n c i l for N a t i o n a l A c a d e m i c Awards in partial f u l f illment of the r e q u i r e m e n t s for the deg r e e of Doctor of Philosophy.

Spo n s o r i n g Establishment: D e p a r t m e n t of A c c o u n t a n c y and F i n a n c i a l Studies. S h effield City P o l y t e c h n i c

M i c h a e l A n d r e w Pawley

Th e Eff i c i e n c y of M o netary C o n t r o l and Building Society Developments

ABS T R A C T

An analysis is made of the major factors determining

financial innovation and financial change by building

societies and banks, and the particular innovations

introduced are examined. The effects of these institutional

developments upon the growth rates of the broad monetary

aggregates relative to nominal income are analysed.

Specific attention is paid to the personal sector's motives

for holding money and particularly the willingness to hold

interest-bearing money balances at building societies and

banks. Special consideration is placed upon the abolition

of the building societies' cartel, the removal of portfolio

monetary controls on the retail banks and the entry of the

banks into the mortgage market. The effects of the

abolition of the cartel on the effectiveness of monetary

control are divided into finite stock effects and more

continuing effects. The stock effects of credit

liberalization upon the growth of the broad monetary

aggregates and the confusion caused as to the

interpretation of monetary conditions are analysed, and an

econometric evaluation of the stock effects of credit

liberalization on the personal sector's level of debt is

carried out. In terms of more continuing effects it is

hypothesized that the abolition of the cartel will have

reduced the interest elasticity of the demand for money,

but increased the interest elasticity of consumers'

Acknowledg emen t s

I w ould like to express my g r a t i t u d e to my supervisor,

Dr D J G o a cher for the expert guidance and hel p r e a dily

provided, and to R enee Hayes for coping w i t h my h a n d w r i t i n g

C O NTENTS

A b s t r a c t

A c k n o w l e d g e m e n t s

C H A P T E R O NE

INTRODUCTION

C H A P T E R TW O

MONETARY CONTROL - THEORY, PRACTICE

AND FINANCIAL CHANGE

2.0 Introduction

2.1 The Basic Postulates of Monetarism

2.2 Monetary Control in the U.K. -

Policy Prescription

2.3 Financial Innovation and Monetary

Control in the U.K.

2.4 Financial Innovation and the Conduct

of Monetary Policy

2.5 Conclusion

C H A P T E R T H R E E

BUILDING SOCIETY AND BANK DEVELOPMENTS,

1970-1979

3.0 Introduction

3.1 The Definition of Financial Innovation

and Financial Change

3.2 The Effect of the Cartel on Building

Society Operations

3.3 Monetary Control, Competition and

Innovation

3.4 Conclusion

CHAPTER FOUR

RE-REGULATION, COMPETITION AND INNOVATION

BY BUILDING SOCIETIES AND BANKS 1980-1987

4.0 Introduction

4.1 Re-regulation and Competition in the

Personal Sector Retail Financial Market

4.2 Financial Innovation by Building Societies

and Retail Banks

4.3 Regulatory Convergence, and Relative

Market Shares of Building Societies and

Banks

4.4 Conclusion

P a « e i

ii

1

9

--

11

-- 21

-

-28-

-33-

-40-

-44-

-47-

-51-

-5*9-

87 93 87

96

-

-145-C H A P T E R FIVE

FINANCIAL INNOVATION AND THE

MONETARY AGGREGATES

5.0 Introduction

5.1 Financial Innovation and the

Definition of Money

5.2 Financial Innovation and Reclassification

of the Monetary Aggregates

5.3 The Effect of Financial Innovation on the

Monetary Aggregates

5.4 Conclusion

CHAPTER SIX

COMPETITION, MORTGAGE LENDING, AND THE

MONEY-INCOME RELATIONSHIP

6.0 Introduction

6.1 House Purchase, the Mortgage 'Leak1

and the Money-Income Relationship

6.2 House Purchase, Last-time Sellers and

the Money-Income Relationship

6.3 The Buffer Stock Model and Financial

Innovartion

6.4 Credit Shocks and Endogeneity

6.5 Conclusions

CHAPTER SEVEN

FINANCIAL INNOVATION AND THE

EFFECTIVENESS OF MONETARY CONTROL

7.0 Introduction

7.1 The Abandonment of Portfolio Controls

7.2 Financial Innovation and the

Effectiveness of Monetary Control

Under the MTFS

7.3 Financial Innovation and the

Effectiveness of Monetary Base Control

7.4 Conclusion

CHAPTER EIGHT

FINANCIAL INNOVATION, THE DEMAND FOR

MONEY, THE DEMAND FOR CREDIT AND THE

CONSUMPTION FUNCTION

8.0 Introduction

8.1 Financial Innovation and the

Demand for Money Function

8.2 The Sectoral Approach

8.3 Interest Elasticity of Expenditure

8.4 Conclusion

-

156

-

-158-

-167-

-174-

-203-

-208-- 210

-306-C H A P T E R N I N E

ECONOMETRIC EVALUATION

9.0 Introduction

-320-9.1 Econometric Methodology

-322-9.2 Partial Adjustment Model

-330-9.3 ECM/ADL Models

-337-9.4 Theoretical and Empirical Considerations

of the Demand for M4

-341-9.5 Financial Innovation and the Interest

Elasticity of the Demand for

M4

-358-9.6 Conclusion

-375-C H A P T E R TE N

ECONOMETRIC EVALUATION - THE DEMAND FOR

CREDIT AND THE CONSUMERS' EXPENDITURE

FUNCTION.

10.0 Introduction

-381-10.1 The Interest Elasticity of Consumers'

-382-Expenditure

10.2 A Proxy for Credit Liberalization

-395-10.3 Specification of the Personal Sector

Demand for Credit

-403-10.4 Conclusion

-414-C H A P T E R ELEVEN

CONCLUSION

-416-A P P E N D I X -416-A

CHAPTER ONE

INTRODUCTION

This thesis presents an analysis of the e fficiency of

monetary control in relation to financial innovation by

building societies and banks. The major u n d e r l y i n g theme is

the extreme importance of the nature and de v e l o p m e n t s of the

financial system for the efficient opera t i o n of mon etary

control. A central thematic argument implicit throughout is

that the analysis and application of m o netary control cannot

be divorced from the financial system within wh i c h it

o p e r a t e s .

The central tenets of mo n e t a r i s m and mon e t a r y control

are set out in Chapter Two, and c ontrasted with the opposing

Keynesian school. The necessary and sufficient cond itions

for a monetarist policy of control of the money supply are

outlined, alongside the Keynesian viewpoint as to the

ap p r opriate manner in w hich monetary policy should be

c o n d u c t e d .

Recognition is given to the In s t i t u t i o n a l i s t school

which first warned of the lacuna that e x i sted in the

monetary economics literature as the result of an

inappropriate paradigm within which to carry out an analysis

of the monetary aspects of the economy. T h e fram e w o r k of a

static institutional system, an unchan g i n g market

environment, and the assumed passivity of financial

institutions negated, accor d i n g to the institutiona lists,

many of the central conclusions of the trad i t i o n a l m o netary

debate. A parallel is drawn between the strictures of the

-i n s t -i t u t -i o n a l -i s t school as to the eff-ic-iency of monetary

control in a changing financial system w ith recent

c o n j ectures as to the effects of financial innovati on on

monetary control.

The view p o i n t that financial innovation has in some way

affected mon e t a r y control appears widespread, and some

authors w o u l d go further in emphasizing the r e v o l u t ionary

importance of innovation upon monetary economics,

"As deposits come to bear competitive interest rates m o n e t a r y theory - models of money supply and d e m a n d and of the transmission of control measures and shocks

through financial markets to the real economy - will have to be r e w r i t t e n 11.

(Tobin 1983, pl62)

T h e r e has been a great deal of comment by the monet ary

authorities as to the effects of financial innovation and

change on their policy instruments. M uch of that co njec t u r e

has c e n tred upon the d e v e lopments in the building society

and retail bank sectors, under the broad umbrella terms of

liberalisation, innovation and financial change. C h a pter

T hree surveys the various attempts at c h a r a c t e r i s i n g the

major det e r m i n a n t s of financial innovation and for purposes

of exp o s i t i o n an analytical framework inc o r p o r a t i n g the

process of financial innovation wit h i n the m o n etary system

is adopted. It is noted that there does not exist as yet a

c o m p r e h e n s i v e study of the form and nature of the financial

innovations that h ave occurred, the reasons for their

occurrence, their effect on the efficiency of mon e t a r y

control, or of their effect on the conduct of policy.

A t t e n t i o n is paid to the twin constraints of

b u ilding societies and the banks and the man n e r in w h i c h the

market envi r o n m e n t shaped and de l i n e a t e d the operat ional

policies of these institutions. P articular note is made of

the d y n a m i c interaction between changes in the authorities*

regulatory and monetary policies and changes in financial

innovation. The possibility of regulatory induced innovation

is examined w ith reference to changes in mon e t a r y control

and the Med i u m Ter m Financial Strategy.

Sustaining the debate as to the effects of the m o ne tary

authorities' own monetary and regulatory policies upon the

degree of financial innovation and change, the evidence as

to the degree to w hich the activities of building societies

and banks have becomes less d emarcated as a result of

regulatory induced innovation is assimilated.

The manner in which specific institutional factors such

as the m u tuality of building societies and the building i

societies r ecommended rate system shaped the nature of

comp e t i t i o n between the mix of price and n on-price factors,

and hence limited the degree of financial i nnovatio n is

fully analysed, as is the effect of the cartel on the

d esired portfolio balance of the personal sector.

The operation of the building societies' cartel is

examined, and attention is drawn to the effect it had in

s moothing building society interest rates and c r eat ing an

excess demand for mortgages that varied with m o v e m e n t s in

general interest rates. An analysis is made of the e x p ected

effects of the abolition of the cartel both in terms of

finite stock adjustments and more co n t i n u i n g effects such as

s tructural changes in b u ilding societies' interest rate

-setting policies. Chapters Five and Six deal largely w ith

the Stock ad j u s t m e n t effects of the abolition of the cartel

and financial l i b e r a lization on the effectiveness of

monetary control, and C h a pter Seven examines in mor e detail

the more co n t i n u i n g effects in relation to interest rates.

One of' the major e c onomic conundrums of the 1 9 8 0 ’s has

been the fall in the income velocity of circu l a t i o n of the

broad m o n e t a r y aggregates. H a v i n g detailed the major

innovations introduced by the building societies and banks

in Chapter Four, Chapter Five examines the effect of these

innovations in stock a d justment terms upon the g r o w t h rates

of the m o netary aggregates relative to nominal incomes. The

fail in the income velocity of circulation is e x ami ned in

terms of the effects of financial innovation on the personal

sectors willingness to hold i nterest-bearing money balances.

The voluminous literature as to the meaning and

definition of money is reviewed from the angle of the

innovations introduced by building societies and banks, with

detailed comment as to the changing motives for h o l d i n g

money. The problems and difficulties of interpretin g

monetary gro w t h and cont r o l l i n g the money supply w h e n the

motives for holding money alter are synthesized with

reference to the exp e r i e n c e of monetary targeting in the

M T F S .

An investigation into the regulatory c o n v e r g e n c e of

building societies and banks and the consequences for the

d e l i neation of building society and bank a ctivities leads to

an assess m e n t of the h o m o g e n e i t y and s u b s t i t u t a b i l i t y of

for c h a nging the mon e t a r y target for purposes of monetary

control.

The analysis in C h a pter Five of the stock affects of

financial innovation upon the growth rates of the monetary

a ggregates relative to nominal income leads to the

h ypothesis that the payment of interest on extremely liquid

accounts at building societies and banks has been a major

co n t r i b u t o r y factor in the breakdown of demand for broad

money equations.

A t t e n t i o n is drawn to the dichotomy between monetar y

theory, wh i c h emphasizes money balances in the transmission

process, and reality, w h e r e the money and credit markets

interact to d e termine the transmission mechanism. Chapter

Six examines the grow t h rates of the monetary aggregates

relative to nominal incomes in terms of the demand for

credit, wit h particular attention to the personal sector's

demand for credit and stock adjustment effects that may have

caused temporary instability.

Special cons i d e r a t i o n is placed upon the effect of the i

ab olition of the b u ilding societies cartel, the entry of the

banks into the mortgage market, and the libera l i z a t i o n of

credit to the personal sector. The importance of the

freeing-up of the m o r t g a g e market is isolated, and

p a r t icularly the impact of the temporary stock adj u s t m e n t to

the personal sector's d e m a n d for money balances. Polar views

as to the exogeneity or endogeneity of money are ju dged with

reference to the b e h a v i o u r of the building societies and

banks under contrasting market conditions, and c onc lusions

drawn as to the m o n e t a r i s t assumption of exogeneity. Th e

-preliminary general hypothesis that financial i nnov ation has

in some way altered the m o n e y - i n c o m e r e l ationship is

extended to nest the h ypothesis that financial inno vation

and libera l i z a t i o n has also altered the c r e d i t - i n c o m e

relationship.

Parallels are drawn b e t ween the attempt of c o m p e t i t i o n

and credit control to promote control of the money supply in

a freely c o m p e t i t i v e system w i t h the attempt of the Medi u m

Term Financial Strategy (MTFS). It is argued that the

lessons from the GCC a p p roach w ere not taken into a ccount in

the des i g n and i m p l e m entation of the MTFS, pa r t i c u l a r l y in

the form of the likely activities of the building societies

and banks in a highly c o m p e t i t i v e market system. It is

argued that the changing financial system during the period

of the MTFS has enforced a move away from a d o gmati c

approach to monetary control towards a far more ecl ectic

ap proach that recognizes the existence of i n s tituti onal

change.

The more continuing effects of financial i nnovation

upon the effectiveness of monetary control are a s s e s s e d in

greater detail in Chapter Seven. Specifically, it is

hypoth e s i z e d that the dem a n d for money has become less

interest elastic, but that consumer's e x p e n d i t u r e has b e c o m e

more elastic with respect to interest rates as a result of

greater flexibility and importance of interest rates

following the abolition of the cartel.

The ability of the m o n etary authorities to c o n t r o l the

money supply given the innovations outlined is a n a l y s e d with

m o netary instrument, and in terms of the a p p l i c a b i l i t y of

m o netary base control (MBC).

C hapter Eight critically examines the salient

econ o m e t r i c literature on the demand for broad money

function and the dema n d for credit in the U.K. Earl ier

e c o n ometric models of the demand for money are surveyed,

w ith explicit c o n s i d e r a t i o n given to those studies that have

attempted to model financial innovation as part of the

function, and to b oth the econometric formulation and

e c o n ometric meth o d o l o g y employed.

Chapter Nine sets out a theoretical model for

evaluating ttie effects of financial innovation by building

societies and banks. Standard error - c o r r e c t i o n and

c o i n t e g r a t i n g models of the demand for money function for

the non-bank private sector (NBPS) are estimated to analyse

the earlier stated hypotheses that financial i n n o va tion has

led to instability of the demand for money, and that the

demand for money has become less elastic to interest

differentials, and less elastic to general rates of

interest. Also e v aluated is the hypothesis that w e a l t h has

become an important variable in the demand for money

function as the result of money becoming more popular for

investment purposes.

Given the analysis of Chapter Five wh i c h e m p h a s i z e s the

homogeneity of building society and bank deposit

liabilities, the M4 aggre g a t e is used in the demand for

money specification, rather than M3, wh i c h excludes b u ilding

society deposits.

-The stock effects of the l i b e r a l i z a t i o n * of credit

controls are analysed in terms of the demand for credit in

Chapter Ten. An er r o r - c o r r e c t i o n demand for credit function

w h i c h incorporates a proxy for the l i b eralization of credit

conditions is specified and the effects of a more

comp e t i t i v e system quantified. A coi n t e g r a t i o n model is also

used to c o r r o b o r a t e the results.

The h ypothesis of Chapter Seven that expe n d i t u r e has

become more sensitive to interest rates as a result of more

flexible and m a r k e t - r e l a t e d interest rates is

e c onometrically evaluated using both e r r o r - c o r r e c t i o n and

c o i n t e g r a t i o n models. The area of analysis as set out above

covers the major issues isolated by Akhtar (1983) as being

of prime importance in the e xamination of financial

i n n o v a t i o n ,

"The process of financial change may exert s i g n i fic ant influences on the empirical de f i n i t i o n of money, the money supply process, the demand for money and the role of interest rates in the transmission of monetary

influences to the rest of the economy. More generally, changes in the financial system raise questions about

the meaningfulness of monetary and financial a g g r e g a t e s and may lead to shifts or (further) instability in the relationship of those aggregates to economic activity".

(p6)

C H A PTER TWO

M O N E T A R Y C O N T R O L - THEORY, P R A C T I C E AN D F I NANCIAL CHANGE

2.0 I n t r o d u c t i o n

M o n e t a r i s t theory, long espoused by a c a d e m i c

economists, has p r o vided the major basis for m a c r o e c o n o m i c

policy in the U n i t e d K i n g d o m since the mid 1 9 7 0 * s. S e c t i o n

2 . 1 o u tlines the u n d e rlying theoretical r a t i o n a l e of

m o n e t a r i s m and the opposing theoretical basis of the

K e y n e s i a n school of thought. Th e necessary and s u f f i c i e n t

c onditions need e d for a moneta r i s t policy of c o n t r o l o ver

the m oney supply are detailed, as are the t h e o r e t i c a l

d e f i c i e n c i e s in the m o n e t a r i s t standpoint. S e c t i o n 2.2

explains the modus operandi of practical m o n e t a r i s t policy

in the U n i t e d Kingdom, how it differs from m a i n s t r e a m

theoretical m o n e t a r i s m (as det a i l e d in 2.1) and the

reasoning behind adopting such a form of policy. Th e

e xp e r i e n c e and results of m o netary control in the UK are

e x amined in s e c tion 2.3, including an a p p r a i s a l of the

con t e n t i o n that financial change and i n n o v a t i o n may be

r e s p o n s i b l e for the break d o w n of previo u s l y sta b l e

r e l a t i onships upon which theoretical m o n e t a r i s m rests, and

also r e s p o n s i b l e for the problems e n c o u n t e r e d w i t h p r a c t i c a l

m o n e t a r i s m and its s ubsequent abandonment. T h e s i m i l a r i t y is

noted b e t w e e n the warnings of the i n s t i t u t i o n a l i s t school

over two decades ago as to the effects of f i n a n c i a l c h a n g e

on m o n e t a r y policy, and subsequent o f f icial s t a t e m e n t s as to

the reasons behind the failure of p r actical m o n e t a r i s m .

S e c t i o n 2.4 analyses the views as to the effect of financial

c h a n g e on the c o n duct of m o n e t a r y co n t r o l and h o w financial

ch a n g e is exp e c t e d to mod i f y the early t h e o r e t i c a l

2.1 The Basic P o s t u l a t e s of M o n e t a r i s m

T he m o d e r n qua n t i t y theory, or "monetarism"!]!] as it

has come to be known, is firmly based on the w o r k of

F r iedman (1956). A c c o r d i n g to Friedman, the q u a n t i t y theory

is in e s s ence a theory of the dem a n d for mo n e y [2]. It is

a rgu e d that the dem a n d for money should be a n a l y s e d in the

same m a n n e r as the d e m a n d for real goods, as money yields a

flow of services or u t i lity to its holder. F r iedman

emphas i s e d the active role of m oney in income d e t e r m i n a t i o n

w i t h two statements. Firstly, he arg u e d that the d e m a n d for

money bears a stable r e l a t i o n s h i p to m oney n a t i o n a l income.

T h e velocity of c i r c u l a t i o n is assumed to be a stable

function of a small n u m b e r of variables. Secondly, F r i e d m a n

argued that the supply of money is e x o g e n o u s l y d e t e r m i n e d

either because it is fixed by policy or b e c a u s e it is

i ndependent of the v ariables w h i c h d e t e r m i n e the d e m a n d for

money (Friedman, 1970(a))[3]

It is p o ssible to use the P o s t - K e y n e s i a n IS-LM

framework along the lines of Poole (1970) to show the

relative importance of mon e t a r y policy, and the vital

importance of a stable d e m a n d for money for co n t r o l of the

money supply. In the familiar IS-LM d i a g r a m below, c o n s i d e r

the situation w h e r e b y the IS curve is s u b j e c t e d to ran d o m

shocks and may lie a n y w h e r e between IS-^ and I S2 • If, as

m onetarists claim, the money dema n d fun c t i o n is stable, and

the stock of money is fixed, income may end up at any

position along the h o r i z o n t a l axis between and Y2 • If,

on the other hand, the rate of interest is held constant,

niAfiRAM 2

r

r

0

IS -LM ANAIYSIQ

DIAGRAM 2-2

LM3/ L M

j

_

there will be fluctuations from Y3 to

Fro m this it can be seen that shifts in the IS curve

whil s t holding the quantity of m oney c o n s t a n t leads to

s m a ller fluctuations in income than does h o l d i n g the rate of

interest constant. Thus, if there is a sta b l e d e m a n d for

money, c o n t r o l of the money supply it is argued, is a more

e f f e c t i v e policy than cont r o l l i n g interest r a t e s . [4]

F u r t h e r - m o r e the a uthorities can only o b s e r v e and therefore

i n fluence a nominal rate of interest, w h e r e a s the real rate

of interest is the relevant one for the IS curve. For the

two rates of interest to be equal, e x p e c t a t i o n s of i n flation

on the part of the private sector must be zero.

Th e stability of the dema n d for m oney is c r u c i a l to

m o n e t a r i s t propositions as to the a p p r o p r i a t e c o n d u c t of

m o n etary policy . If there is a stable mo n e y d e m a n d function

the i m p l i c a t i o n is that money has a p r e d i c t a b l e i n f l u e n c e

on the economy and hence c o n t r o l of the mo n e y suppl y by the

m o n e t a r y a u t h orities is a powerful i n s t r u m e n t of e c o n o m i c

policy (Judd and Scadding, 1982). If the r e l a t i o n s h i p

b etween the monetary a ggregates and nominal i n c omes is

r eason a b l y stable and predictable, the c o n d u c t of policy

should involve a dec l a r e d emphasis on c o n t r o l of the g r o w t h

of the money stock and mon e t a r y policy sho u l d be b a s e d on

qu a n t i t a t i v e monetary targets (Desai, 1981). If there is a

stable re l a t i o n s h i p between the m o n e t a r y a g g r e g a t e and the

goal variable, it is possible to set a target g r o w t h path

for the m o netary a g g r e g a t e w h i c h will be c o n s i s t e n t w i t h the

d e s i r e d g r o w t h rate of the goal variable. Thus, if m o n e t a r y

aggreg a t e s are to be used as targets, it is a n e c e s s i t y that

there should be a stable r e l a tionship b e t w e e n the m o n e t a r y

a g g r e g a t e and the goal variable (nominal income).

Keynes and K e y n e s i a n monetary theorists, on the other

hand, d i s p u t e that the demand for money is a stable function

[5]. Keynes (1936) recognised the im p o r t a n c e of the

transactions m o t i v e for holding money in o r d e r to b r i d g e the

gap b e t w e e n p l a n n e d regular payments and r e c e i p t s of money,

and the p r e c a u t i o n a r y motive for sudden u n e x p e c t e d

expenditures. Th e m ain importance of Keynes* a n a l y s i s of the

dema n d for mo n e y is found, however, in the e m p hasis on the

‘speculative* d e m a n d for money, and the n o t i o n of

uncertainty. Keynes h i g h l i g h t e d u n c e r t a i n t y in terms of the

v a r i a b i l i t y of the rate of interest and he n c e the v ital

import a n c e of the s p e c ulative motive to the s t a b i l i t y of the

d em a n d for m o n e y . [6].

Keynes a r g u e d that at certain times, mo n e y w i l l be held

in p r e f e r e n c e to an a l t e r n a t i v e interest y i e l d i n g asset.

Such ‘speculative* holdings of money w o u l d be o v e r and ab o v e

that held for p r e cautionary motives. Money is a c a p i t a l

c e r tain asset, the nominal value of w h i c h doe s not vary. T h e

a l t e r n a t i v e to holding money is to hold an a sset (bond) the

market price of w h i c h varies a c cording to the rate of

interest [7]. W h e n choosing between the a l t e r n a t i v e of

holding money or bonds, the expected rate of i n t e r e s t is

taken into account. If the rate of interest is e x p e c t e d to

fall, c a p i t a l gains may be made; if rates a re e x p e c t e d to

money is relatively low w hen the rate of int e r e s t is

expected to fall, and gr e a t e r w h e n the rate of i n t e r e s t is

expected to rise. At any one time, w e a l t h - h o l d e r s h a v e an

opinion as to the * n o r m a l1 rat e of interest r e l a t i v e to the

c urrent rate of interest. It is assumed that d i f f e r e n t

individuals will have d i f f e r e n t expectations, s u c h that in

the a g gregate a smo o t h s p e c u l a t i v e d e m a n d for m o n e y f u n ction

is obtained w h i c h is a neg a t i v e f u n ction of the c u r r e n t

level of the rate of interest [8].

One asse r t i o n of Keynes* s p e c u l a t i v e m o t i v e is that the

normal rate of interest as p e r c e i v e d by w e a l t h h o l d e r s will

change over time, f luctuating a r o u n d the c h a n g i n g ‘normal*

rate of interest. So, rather than being c o n s t a n t as a r g u e d

by monetarists, Keynes argued that velocity i s . b o t h u n s t a b l e

and volatile. An increase in the money supply, he argued,

w ould lead to an increase in holdings of s p e c u l a t i v e

balances, such that any inc r e a s e is offset by a r e d u c t i o n in

velocity.

The implications of an u n s t a b l e dem a n d for m o n e y

function upon the opera t i o n of mon e t a r y policy ca n be seen

in the IS-LM framework. T h e d i a g r a m cxbov^shows r e l a t i v e

stability of the IS curve [9], whilst the d e m a n d for mo n e y

is u n s table and may vary from L M2 to L M3 . T h i s r e s u l t s in

variations in income from to Y3 .

A c c o r d i n g to this analysis, large f l u c t u a t i o n s in

income may occur, such that K eynesians favour c o n t r o l of the

interest rate. For example, c o n s i d e r the case w h e r e a rise

in the demand for money occurs, the LM curve s h i f t i n g f rom

LM^ to L.M'3 • T his will force up interest rates, r-^ to r3 ,

and reduce income, to Y3 • If an interest rate policy is

being fallowed (i.e. a policy of trying to keep int erest

rates constant), the money supply will be i n c r e a s e d to a l l o w

for the i n c r e a s e in the dema n d for money, s uch that income

returns to Y^. Thus, variations in the level of inc ome will

be minimised. T h e policy implications of the K e y n e s i a n m odel

of money d e m a n d are thus distin c t l y d i f f e r e n t from the

mon e t a r i s t framework. Keynes, through the i n t r o d u c t i o n of

the s p e c u l a t i v e d e m a n d for money wh i c h e x p l i c i t l y o u t l i n e s

uncertainty, was able to argue that v o l a t i l e e x p e c t a t i o n s

may cause i n s t a b i l i t y in the dem a n d for mo n e y function. T his

implies that m o n e t a r y policy via control of the m o n e y supp l y

will be ineffective.

Apart from the a s s e r t i o n that the d e m a n d for m o n e y is

in reality (i.e. not c o n s t r a i n e d to a s i m p l i f i e d t h e o r e t i c a l

construct but in real wo r l d terms), a sta b l e f u n c t i o n of a

few m e a s u r a b l e variables, a further a s s e r t i o n a p p e a r s to

di s t i n g u i s h c l e a r l y F r iedman*s approach. Money, he argues,

is a unique asset, and is therefore not a close s u b s t i t u t e

for any other asset, real or financial. C h a n g e s in the

quantity of money will thus have an impact w h i c h is s p r e a d

widely among a number of assets, causing a p e r v a s i v e c h a n g e

in all planned expenditures, both on goods and on f i n a n c i a l

assets; portf o l i o e q u i l i b r i u m is only res t o r e d a f t e r large

changes in asset yields. All forms of e x p e n d i t u r e w i l l be

T h e m o n e t a r i s t v iew therefore is that the i n terest

e l a s t i c i t y of the d e m a n d for money is low, and h enc e

mon e t a r y policy w i l l be effective. Th e u n d e r l y i n g r atio n a l e

for this pos i t i o n is that if the auth o r i t i e s ar e a b l e to

reduce the supply of money, there will only be a small

volume of idle balances wh i c h may be induced into the pool

of a c t i v e funds ( t hrough an increase in the level of

interest rates), in o rder to support the e x i s t i n g level of

expenditure. Indeed, it would require r e l a t i v e l y large

increases in the level of interest rates in o r d e r to /

u n d e r m i n e s i g n i f i c a n t l y the impact of the i n i t i a l r e d u c t i o n

in the m oney supply (through raising the v e l o c i t y of

c i r c u l a t i o n of money), and this adj u s t m e n t in i t s e l f w o u l d

tend to d e p ress the level of credit financed e x p e n d i t u r e s

w it h i n the economy. In addition, a s i g n i f i c a n t l y h i g h e r

level of i n t erest rates w ould be expected to r e d u c e the

dem a n d for bank loans and may depress the v o l u m e of b a n k

c r e a t e d deposits.

In the IS-LM d i a g r a m below, if the m o n e y s u p p l y is

reduced, nat i o n a l income will fall further (Y-^ to Y3) and

interest rates increase further (r-^ to w h e n the d e m a n d

for mo n e y is relati v e l y interest inelastic. T h e r e f o r e the

lower is the interest elasti c i t y of the d e m a n d for money,

the h i g h e r is the change in the rate of i n t e r e s t n e e d e d to

restore equilibrium, the stronger the m o n e t a r y policy.

Thus, an important element in the m o n e t a r i s t / k e y n e s i a n

d ebate lay in d i f f e r i n g opinions as to the s u b s t i t u t a b i l i t y

of m oney to real assets. Empir i c a l studies on the d e g r e e of

l m

2

L M j .

n

r2

r r

s u b s t i t u t i o n as m e asured by the interest e l a s t i c i t y of the

d e m a n d for m oney hav e not, however, p r o v i d e d results w h i c h

show w h e t h e r the moneta r i s t or k e y n e s i a n theories a r e most

valid. Th e only effect empirical wor k has had on this point

is to c o n t r a d i c t the more radical a s s e r t i o n s of b ot h

protagonists. Th e results show that there is a nega tive

r e l a t i o n s h i p between changes in i n terest rates and money

balances, but that the interest e l a s t i c i t y of the d e m a n d for

m oney seems to be quite low. T he special c ases of

zero-interest elasticity assumed by the moneta r i s t s , and the

infinite interest elasticity of the K e y n e s i a n s as

r e p r e s e n t e d by the liquidity trap are both disprove n. (See

C h a p t e r Eight for an analysis of researchers* e c o n o m e t r i c

results on interest elasticity).

M o n e t a r i s t theory asserts that a l t h o u g h a rise in the

money supply w ill increase nominal income, m o n e t a r y policy

will not have a permanent affect on the level of real

output. A rise in the money supply will aff e c t o u t p u t af t e r

a p p r o x i m a t e l y six to nine months, and a f f e c t the p r i c e level

after about twelve to eighteen months, a f t e r w h i c h output

will return to its previous level. A c c o r d i n g to the

e xpect a t i o n s - Augmented Phillips cu r v e the rise in output

is only sustained until the a c c o m p a n y i n g i n c r e a s e in

i n f l a t i o n becomes fully anticipated. At this time o utp u t

returns to its natural level, the rise in the m o n e y supply

leading only to an increase in the rate of inflation.

Thus, real income, argued Friedman, is d e t e r m i n e d by

supply - side considerations. If c h a nges in the r at e of

g r o w t h of .the money supply do not impinge on l o n g - t e r m real

income, then the price level w o u l d c h a n g e in o r d e r to

restore e q u i l i b r i u m between the supply of m o n e y and the

d e m a n d for money. So, changes in the m oney supply affect

real income only in the short-run, and prices in the long

run. This r e ceived further theoretical s u p p o r t from the

rational e x p e ctations school [10] (Muth, 1961, Lucas, 1972,

1973). Th e ada p t i v e expectations h y p o t h e s i s imp l i c i t in

F r i e d m a n ’s w o r k maintains that i n d i viduals w ill c o n t i n u o u s l y

make s y s t ematic errors as to their e s t i m a t e s of future

inflation. Rational expectations c o n t r a d i c t s this however,

and argues that expectations are b ased on all a v a i l a b l e

information, including past errors in e x p e c t a t i o n s of

inflation, and the effects of policy a c t ions w h i c h may

themselves alter expectations. Sargent and W a l l a c e (1975,

1976), show that under c onditions of r a t i o n a l expec tations,

there w ill be instantaneous a d j u s t m e n t of the e c o n o m y to an

a n t i c i p a t e d increase in tne money supply. M o n e t a r y policy

will have no effect on real output [11]. Instead, prices

will rise witn no long-term effect on real income. S a r g e n t

and W a l l a c e thus come to the same c o n c l u s i o n as Friedman,

that m o n etary policy should follow a m o n e y - s u p p l y g r o w t h

rule, rather than be used for acti v e s t a b i l i s a t i o n policy

2.2 Mon e t a r y C o n t r o l in the UK - Policy P r e s c r i p t i o n

Friedm a n ' s a s s e r t i o n of a stable d e m a n d for money

b ecame the c e n t r a l issue in d e b ates on m o n e t a r y economics.

Indeed La i d l e r (1971) has s u ggested that the s t a b i l i t y of

the demand for money over time is capable of r e f l e c t i n g the

w hole a r g ument between K eynesians and m o n e t a r i s t s as to the

role of money in the eco n o m i c system. In the U.S.A.,

F r i edman and Schwartz (1963) c l a imed to be able to show that

real m oney balances and real income were c o n n e c t e d in a

reasonably p r e d i c t a b l e way, arguing that c h a nges in the rate

of g r o w t h of the m oney stock are a n ecessary and s u f f i c i e n t

c o n d i t i o n for changes in the rate of change of m o n e y - i n c o m e

(Friedman and Schwartz, p676)[l4]. The t h e o r e t i c a l a r g u m e n t s

of Fri e d m a n and his e m p i r i c a l w ork on the d e m a n d for mo n e y

were c o r r o b o r a t e d by e m p i r i c a l research in the U n i t e d

K i n g d o m w h i c h s u g g e s t e d that the dem a n d for m o n e y f un c t i o n

was stably related to income and interest rates (Pa ish 1958,

Dow 1958, Kav a n a g h and W a l t e r s 1966, Fis h e r 1968, L a i d l e r

and Parkin 1970, L a i d l e r 1971, G o odhart and C r o c k e t t 1970).

It did seem that in the late 1960's there was a g e n e r a l

c o nsensus as to the e x i s t e n c e of a stable d e m a n d for money,

"this evidence for Britain certainly points to the ex istence of a stable demand for money f u n c t i o n in the economy. For the U n i t e d States the e v i d e n c e is

overwhelming, and for Britain it is at the very least hig h l y suggestive".

Laidler, (1971, p43)

T he i m p l i c a t i o n s of such a finding w e r e thought to be

substantial. T h r o u g h a stable dema n d for money, c o n t r o l l i n g

the m o n e t a r y a g g r e g a t e s would have a ma j o r and d e t e r m i n a t e

effect on the economy (Parkin 1978, p p 2 5 2 - 2 5 3 F r e e d m a n

1983, ppl03-104). At the time,a stable function s u g g e s t e d to

some e c o n o m i s t s that m o netary policy would be effective,

that a p a r t i c u l a r policy could be chosen and mon i t o r e d , and

that d e s i r e d levels of the monetary a g g r e g a t e s c o u l d be

a c h ieved by v a r ying the level of interest rates (Goodhart,

1984, p46). A stable demand for money thus a p p e a r e d to

pr o v i d e e m p i r i c a l support not only for the a b i l i t y of the

m o n e t a r y a u t h o r i t i e s to control the money supply, but also

for the d e s i r a b i l i t y of so doing in terms of the i n f o r m a t i o n

value of m o n e t a r y a ggregates (Courakis, 1981, p306).

Th e e c o n o m e t r i c investigations in the UK w e r e c a r r i e d

out on M3,[15] and from the moneta r i s t s t a n d p o i n t a p p e a r e d

to suggest a direct link between the rate of c h a n g e in the

money supply M3 and the rate of change in n o m i n a l incomes.

T h e line of causation, it was claimed, ran from m o n e y to

income, w i t h a lag. Thus, to bring about a r e d u c t i o n in the

rate of g r o w t h of the price level, it was d e e m e d n e c e s s a r y

to bring about a reduction in the rate of g r o w t h of the

money supply M3. T h e e c o n o metric e v i d e n c e als o s e e m e d to

suggest that as there was a link between M3 and n o m i n a l

interest rates, then c o n trol of that a g g r e g a t e c o u l d be

a c h i e v e d by m a n i p u l a t i o n of interest rates. M o r e o v e r , it was

believed at the time that control of the a g g r e g a t e c o u l d be

rates (BEQB, J u n e 1983, p202).

T h e belief in the ability of the a u t h o r i t i e s to c o n t r o l

m o n e y supply g r o w t h via interest rates was s een to be an

i mportant factor in placing g r e ater emp h a s i s on the

m a n i p u l a t i o n of interest rates in C o m p e t i t i o n and Credit

C ontrol [16]. If interest rates c o u l d be u s e d as an

ins t r u m e n t to control monetary growth, then there w o u l d be

no need for the use of direct controls o v e r banks* finan c i a l

i n t e r m e d i a t i o n activities, wh i c h had p r o v e n largely

ineffective, and w ith hindsight w ere seen to inhibit

c o m p e t i t i v e effici e n c y in the b a n king s y s t e m (BEQB, J u n e

1983) [17].

Th e r e liance on the e c o n ometric e v i d e n c e as to the

stability of the demand for money r e l a t i o n s h i p was soon seen

to be unfounded, however, (Hacche, 1974). E c o n o m e t r i c models

based on 1 9 3 0 * s d ata could not e x p lain the m o n e t a r y

movements of the early 1970*s, in p a r t i c u l a r the fast g r o w t h

of M3 af t e r the removal of direct c o n t r o l s in 1971, under

the aegis of Comp e t i t i o n and Credit Control, and the

aband o n m e n t of the retail banks interest rate agree ments.

Yet, the arg u m e n t that the previo u s l y held r e l a t i o n s h i p had

been d i s t o r t e d by structural change in the fina n c i a l syst e m

also led to the notion that once the c h a n g e s w e r e over, the

link between money and nominal income wo u l d retu r n to a

reliable, stable, relationship. D e s p i t e the fact that it

did not return to such a state, the m o n e t a r y a u t h o r i t i e s

b e l ieved after the aftermath of CCC that,

"the g r o w t h of M3 wit h i n reason a b l e limits could be d i r e c t l y influenced, o c c a s i o n a l l y to a h i g h degree, by a c o m b i n a t i o n of direct c o ntrols (now m o r e ac c e p t a b l e again) and an act i v e policy of d ebt management".

(BEQB J u n e 1983, p203)

D e s p i t e the c o n j e c t u r e as to the effects of structu ral

change in the financial system upon the g r o w t h of the money

supply, the i n s titutional backgr o u n d in w h i c h polic y actions

take place seems to have been inadeq u a t e l y c o n s i d e r e d by the

m o n e t a r y authorities. D e s pite the b r e a k d o w n of the

money-income relat i o n s h i p as shown by e c o n o m e t r i c d e m a n d for money

equations, targets were publ i s h e d for the g r o w t h of M3 in

1976, partly in response to the condit i o n s on a loan from

the Interna t i o n a l M o netary F und to m a i n t a i n d o m e s t i c credit

ex pansion with i n c e r tain limits.

A l t h o u g h it was r e c o g n i s e d that, in e c o n o m e t r i c terms,

the m o n e y - i n c o m e r e l a tionship had brok e n down, it was still

m a i n t a i n e d that monetary g r o w t h over and above the rate of

g r o w t h of nominal incomes w o u l d result in i n f l a t i o n a r y

c o n d i t i o n s ,

"I wo u l d not want to suggest that there is always a direct, simple chain of c a u s a t i o n r u n n i n g from the money supply to the price level. Indeed, it is

gene r a l l y r ecognised that i n flation can, at least for a time, follow a life of its own q uite i n d e p e n d e n t of c u r rent or past monetary developments. But tho u g h the caus a t i o n may not be simple there is an o b s e r v a b l e s tatistical relation between m o n e t a r y g r o w t h and the pace of inflation".

(BEQB, 1984(e ) , p 5 4 ) This belief that the money supply was still the

dominant impulse affecting the p rice level d e s p i t e the

b r eakdown of demand for money functions g a i n e d theo r e t i c a l

support from the emerging " b u f f e r - s t o c k " or " d i s e q u i l i b r i u m

In the 'buffer* stock model it is a r g u e d that economic

agents may be temporarily moved off their d e m a n d for money

functions by c r e d i t - s i d e shocks. This may lead to h oldings

of excess money balances, w h i c h will be slowly d i s s i p a t e d

(Artis and Lewis, 1974, 1976). The a p p l i c a b i l i t y of the

buffer st o c k model in a period of fina n c i a l i n n o v a t i o n is

e x a m i n e d in C h a pter Six.

T he theoretical standpoint of the rat i o n a l e x p e c t a t i o n s

school (see earlier) was to be e m p h a s i s e d in p r a c t i c a l

policy o p e r a t i o n through publi s h e d money supply targets:

"One purpose of a nnouncing m o n e t a r y targets is to serve n o t i c e that excessive increases in d o m e s t i c c o s t s will c ome up against resistance. If p e o p l e b e l i e v e that the m oney supply will be e x panded to a c c o m m o d a t e any

i nc r e a s e in costs and prices, h o w e v e r fast,

i n f lationary fears are likely to be increased. If, on the other hand, people are c o n v i n c e d that the rate of g r o w t h of the money supply w ill be h eld w i t h i n well-d e f i n e well-d limits, this shoulwell-d help to r e well-d u c e i n f l a t i o n a r y expectations".

(BEQB, 1 984(e)p46)

In particular, it was hoped that this wo u l d lead to wag e

claims being in some way linked to the future p u b l i c l y

a n n o u n c e d rate of gro w t h of the mo n e y supply. This, it was

thought, w ould reduce the impact of p o s s i b l e h i g h

u n e m p l o y m e n t under a tight money policy. Thi s is b e c a u s e it

was m a i n t a i n e d that if wage claims g rew faster than the rate

of g r o w t h of the money supply, it wo u l d lead to i n c r e a s e d

unemployment. By keeping ex p e c t a t i o n s of the r ate of g r o w t h

of the money supply low, it was h o p e d to r e d u c e w a g e claims

and stop u n e mployment rising. This view was taken up in the

G reen Paper on Monetary Control (1980),

"The .government believes that its m o n e t a r y policy can best be formul a t e d if it sets targets for the g r o w t h of one of the aggregates against w h i c h pol i c y can be

assessed. This gives the c l earest i n d i c a t i o n to those c o n c e r n e d in b oth financial m a r kets and d o m e s t i c

i n dustry on w h i c h to assess the d i r e c t i o n of g o v e r n m e n t p olicy and to formulate expectations**.

( P a r a . 8)

It was noted that problems had o c c u r r e d in the past

w i t h the M3 aggregate, but it was not felt that these

problems were insuperable,

**It was recogn i s e d that experi e n c e h i t h e r to in

a c h i e v i n g fairly close control of this a g g r e g a t e was not ent i r e l y reassuring. But it was felt that the a n s w e r to this might lie in c h a n g i n g the m e t h o d s of c o n t r o l rather than the target a g g r e g a t e i t s e l f ,J•

(BEBQ J u n e 1983, p204)

T h e MTFS also m a i n t a i n e d that there was a c l o s e link

between the m oney supply, the public sec t o r b o r r o w i n g

r e q u i r e m e n t (PSBR) and interest rates. It was a r g u e d that an

increase in the PSBR would lead to an i n c r e a s e in the rate

of g r o w t h of the money supply or w ould p u s h up int e r e s t

rates. This occurs because a large PSBR w h i c h re s u l t s in the

go v e r n m e n t borrowing from the banking s y s t e m n e c e s s a r i l y

increases the money supply. On the other hand, it m ay b o r r o w

from the n o n - b a n k private sector, which, it was believed,

would o ccur at steadily rising rates of i n t e r e s t (TCSC 1980

p 2 1 ) • Thus, in order to reduce the money s u p p l y w i t h o u t

resorting to h igh levels of interest rates, it was a r g u e d

that the PSBR had to be reduced. The c o m b i n e d tools of

mon e t a r y c o n t r o l were thus to be s h o r t - t e r m i n t e r e s t rates

modus ope r a n d i from a strict moneta r i s t policy p r e s c r i p t i o n

of c o n t r o l of the mon e t a r y base. Indeed, F r i e d m a n h i m s e l f

was incr e d u l o u s as to the proposed method of c o n t r o l in the

UK in his (oft quoted) e v idence to the H o u s e of C o m m o n s

T r e a s u r y and Civil S e r vice Committee,

"••••I co u l d hardly be l i e v e my eyes, w h e n I read, in the su m m a r y c h a p t e r (of the Green P a p e r on M o n e t a r y Control) * the p r incipal means of c o n t r o l l i n g the g r o w t h of the mo n e y supply must be fiscal policy - b o t h p u b l i c e x p e n d i t u r e and tax policy and interest r a t e s . 1

I n t e r p r e t e d literally this sentence is simply wrong. O nly a Rip Van Winkle, who had not read any of the

flood of lit e r a t u r e during the last d e c a d e and m o r e on the money supply process, could p o s sibly h a v e w r i t t e n that s e n t e n c e . . . 11

he continued,

"Direct c o n t r o l of the m o netary base is an a l t e r n a t i v e to fiscal policy and interest rates as a me a n s of

co n t r o l l i n g mon e t a r y growth. Of course, d i r e c t c o n t r o l of the m o n e t a r y base will affect interest r a t e s . . . b u t that is a very d i f f e r e n t thing from c o n t r o l l i n g

mo n e t a r y g r o w t h through interest rates".

(TCSC 1980 P a r a 11, p57)

T he force of F r iedman's argument is e v a l u a t e d in

Chapter S even w i t h r e ference to the effects of f i n a n c i a l

i nnovation on the e fficiency of both interest rates and

m o n etary base co n t r o l as methods of c o n t r o l l i n g the m o n e y

supply.

2.3 F i n a n c i a l Innova t i o n and Monetary C o n t r o l in the UK

T h e e x p e r i e n c e of the monetary a u t h o r i t i e s in c a r ry ing

out a policy of control of the money supply has not,

however, been a happy one,

" D e s p i t e the progress we have made towards our

objectives, it cannot be said that our e x p e r i e n c e w ith our c h o s e n framework for operating m o n e t a r y policy has been satisfactory. In common with o t h e r c ountries, that fr a m e w o r k has been one of targeting the r ate of g r o w t h of a m o n e t a r y aggregate. This i n t e r m e d i a t e o b j e c t i v e was c h o s e n in the belief that there was a r e a s o n a b l y p r e d i c t a b l e relati o n s h i p between the rate of m o n e t a r y gr o w t h and the rate of growth of nominal incomes. But in p r a c t i c e our ability to use an e s t i m a t e of that r e l a t i o n s h i p for target setting, and to m e e t those

targets, has quite frankly, been less than impressive". ( L e i g h - P e m b e r t o n 1 9 8 6 . p500.)

The B ank of England does appear to have c o n s i d e r e d the

problems of financial change at the i n t r o d u c t i o n of the

MTFS. It noted in 1980 that alt h o u g h targets w e r e set, it

was p o ssible that structural change may aff e c t the r e l a t i v e

g r o w t h rates of aggregates, but that the p r o b l e m was not

insuperable,

"No stati s t i c a l m e a s u r e of the money sup p l y can be exp e c t e d fully to e n c a psulate mon e t a r y c o n d i t i o n s , and so provide a uniquely correct basis for c o n t r o l l i n g the c o m p l e x relationships between m o netary g r o w t h and

nominal incomes. A degree of s u b s t i t u t a b i l i t y , b e t w een forms of money or liquidity just inside or o u t s i d e

their r espective measures means that it is i n s u f f i c i e n t to rely on one me a s u r e alone".

(Green Paper on M o n e t a r y C o ntrol, 1980)

In view of future events, however, it a p p e a r s that the

p r o b l e m of financial change was u n d e r estimated. In c o n t r a s t

in s i g n i f i c a n c e of changes in the financial s y s t e m for the

o p e r a t i o n of mon e t a r y control, the m o n e t a r y a u t h o r i t i e s

p r o g r e s s i v e l y e m p h a s i z e d the importance of f i nancia l

institutions during the MTFS and subseq u e n t a n a l y s e s of the

MTFS. O f f i c i a l publications have tended to c i t e the effects

of cha n g e in the financial institutional f r a m e w o r k as the

m a j o r factor for the problems expe r i e n c e d w i t h m o n e t a r y

control, yet the Bank of England*s c o n c l u s i o n that mon e t a r y

policy is a f f e c t e d by financial change is not a new

viewpoint. Indeed, the notion that the b e h a v i o u r of

financial i n s t itutions needs to be taken into a c c o u n t when

e xamining the e f ficacy of monetary con t r o l s has a long,

a l t h o u g h perhaps not popular, pedigree. Th e

* institutionalist* school (comprising, inter alia, Gur l e y

and S haw 1955, 1956, 1960, Minsky 1957, T o b i n 1963(a),

Bra i n a r d 1964, R a d c l i f f e 1959) first w a r n e d of the p o s s i b l e

dangers of ‘traditional* monetary theory, w h i c h has

p r o m u l g a t e d the view that the financial s y s t e m is

e s s e n t i a l l y a static e q u i librium system, a m e r e u n c h a n g i n g

b a c k d r o p against which policy operates, r e f l e c t e d in

**the c o m m o n tendency of class i c a l and K e y n e s i a n

economics to treat the financial s t r u c t u r e as b eing of s e condary importance, netting out the assets and

liabilities of the private sector".

( B rainard 1964 pp95-96)

O p p o s e d to this, the i n s t i t u t i o n a l i s t school takes the

actions of financial institutions as being of c e n t r a l

import a n c e in the conduct of policy. It is r e c o g n i s e d that

obs e r v e d stat i s t i c a l relationships may c h a n g e o ver time due

to changes in financial markets. Even if a pol i c y of