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Appendix 1 - Reserve Requirements

Whilst the ultimate goal of the monetary policy is to keep the economy running smoothly and to ensure the individuals who form that economy are prosperous, this target must be broken down into quantifiable objectives, which in the United Kingdom and most other countries are low inflation, high employment (or low unemployment), and steady low inflationary economic growth. There are several instruments that the central bank. can use to endeavour to achieve these goals, which are the re-discount policy (often referred to as interest rates), reserve requirements, and open market operations (University of Leicester, 2006).

Perhaps one thing that the Bank of England, the United Kingdom’s central bank, uses as an instrument to implement monetary policy is to periodically change the interest rates, which are published in a quarterly inflation report, in an attempt to manipulate the economy. If the Bank of England wants to lower inflation then it will generally raise the interest rate because this will have the effect of constricting the money supply. When the money supply is constricted, people will tend to spend less, so inflation will eventually go down. The knock-on effect of lower inflation, however, is a rise in unemployment levels and a decrease in economic growth, so it is always important for the central bank to set their interest rates at a level that will achieve low inflation, high employment, and continued economic growth.

On 22nd March 2006, Gordon Brown, the current Chancellor of the Exchequer, presented the UK Budget 2006. He labeled Britain’s economy as “resilient, robust, and prudent”. Inflation had stabilised at 2% and economic growth was steady at 2.5%. Productivity was growing at 2.3%, and he commented that this was higher than at any time since the 1960’s (QCK, 2006). Although Brown failed to mention the unemployment rate, in 2005 it was 4.7% (The World Fact Book, 2006), which was lower than the natural rate of unemployment of 6%, which has been calculated by economists (University of Leicester, 2006).

To illustrate the importance that interest rates play on the economy, on 3rd August 2006 the Bank of England voted to raise the interest rates .25 percentage points to 4.75%. The reason for their decision to raise the interest rate was because economic growth had picked up from its post-Christmas dip(Bank of England, 2006). Business investment had picked up and the export industry had remained robust, which resulted in Britain’s Gross Domestic Product (GDP) raising above its average, which was 1.8% in 2005 (The World Fact Book, 2006). Inflation had raised to 2.5% in June, which was above the official target of 2% (Bank of England, 2006). Factors contributing to the rise in inflation were higher fuel prices, stealth taxes introduced by the Labour government, and the introduction of university tuition fees (Hiscott and O’Grady, 2006).

Although the August 2006 rise in interest rates was intended to bring inflation back down to its 2006 target of 2%, it is ultimately the home owner who will have to pay the price for this decision, who is already struggling to pay the many stealth taxes introduced by the Labour government (Hiscott and O’Grady, 2006). The result of the .25 percentage point increase in interest rates will ultimately result in higher mortgage rates, as lenders pass the increase on to borrowers. For example, a Halifax customer with £100,000 left to pay on a standard variable rate (SVR) mortgage will see his repayments rise from £675.21 a month to £690.91, which is an increase of £188.40 a year. The impact of the interest rate hike will be felt most strongly by borrowers who have interest-only loans. A person with a £200,000 interest-only loan would see his repayments rise by £41.67 a month, which is an annual increase of £500.04 (O’Connor, 2006). The higher repayments made by borrowers will have the effect of slowing down the housing market because consumers will lose confidence in their ability to meet their increased financial commitments that have arisen from the rise in interest rates.

A second tool that central banks use to implement monetary policy is to utilise reserve requirements. If an economy would like to increase its supply of money then it will decrease its reserve requirements, but if it would like to decrease its supply of money then it will increase its reserve requirements. It is worth remembering that an increase in the money supply generally leads to an increase in inflation, and a decrease in the money supply will lead to a decrease in inflation. As has been previously been mentioned, an increase in inflation generally leads to a rise in economic growth and employment, while a decrease in inflation will lead to lowered economic growth and employment.

In order to understand how reserve requirements affect the money supply, it is first important to understand the nature of reserve requirements. For example, the Federal Reserve, which is America’s central bank, has a reserve requirement , which is rarely altered, of 10%. If one were to take $10 and deposit it into an American bank, the bank would be required to keep 10%, or $1, of that as a reserve, and is could lend out $9. The bank receiving that deposit would be required to keep $0.90 as a reserve and would be able to lend out $8.10. This process of reserving and lending would continue until the initial deposit has increased the money supply to almost $100, or $99.54 to be precise.

The European Economic Communicty (EEC), which uses the European Central Bank as its central bank, on the other hand, has a reserve requirement of 2%, which is one-fifth that of the American reserve requirement. If one were to take an amount of E10 and deposit it into a bank within the EEC, that bank would be required to keep 2%, or E0.20, of it as a reserve and lend out 98%, or E9.80. The bank receiving that deposit would be required to keep 2%, or E0.20, as a reserve, and lend out 98%, or E9.60. This process of reserving and lending would continue until the initial deposit of E10 increased the money supply to almost E500, or E499.75 to be precise.

Therefore, a reserve requirement of 10% would increase the money supply ten-fold, but a reserve requirement of 2% would multiply it by 50! In order to see the mathematical process used to come to this conclusion, please see Appendix 1 of this paper, which provides the calculations used to prove the above argument.

A third instrument that central banks use to implement monetary policy is that of open market operations (OMO). Open market operations are defined as the sale and purchase of primarily government securities in the open market. When the central bank purchases securities, it has the effect of expanding their reserves, which will raise the money supply, and lower the short-term interest rate, and as a consequence inflation will rise. When the central bank sells securities, this has the effect of shrinking its reserves, which will contract the money supply, thus raising the short term interest rates, and as a consequence inflation will decrease (Yesin, 2005).

The advantages of open market operations are that the process is flexible and precise, quickly implemented, and easily reversible if a mistake is made. Because the central bank has control over the volume of securities it maintains through the buying and selling of those securities, the effect on the monetary base is much more certain than using reserve requirements. In recent times there has been a greater importance on the use of open market operations as a tool for monetary policy because there has been a decline in the use of reserve requirements worldwide (Yesin, 2005). For instance, the Bank of England, along with the central banks of Australia, Canada, Mexico and Sweden have abandoned use of a statutorily enforced reserve requirement ratio.

To summarise the points made in this paper, monetary policy is decided upon by governments to ensure their respective economies are running smoothly, endeavouring to ensure the individuals in their jurisdiction are able to enjoy the benefits of low inflation, high employment, and steady economic grown. The key to ensuring these goals are met is through manipulating the money supply, increasing it when a boost to the economy is needed and decreasing it when is it necessary to lower the rate of inflation. The central bank, which is an organisation that operates at arm’s length to the government, is responsible for implementing monetary policy. The tools the central bank uses to manage the money supply are manipulating interest rates, reserve requirements, and open market operations. It is worth mentioning that none of these tools are quick fixes, as it can take anywhere for 4 to 24 months to see the results of any one action.

References

Bank of England (2006). Various pages visited
URL: http://www.bankofengland.co.uk.htm
[24 July 2006]

Hiscott, G. and O’Grady, S. (10 August 2006). Madness: Loan Rates Up Again, The Daily Express, page 1-2.

O’Connor, R. (12 August 2006). Borrowers Feel Base Vibration, The Times Money, page 2.

QCK.com (2006), UK Budget 2006 – Main Points
URL: http://www.qck.com/budget-2006.html
[12 August 2006]

University of Leicester (2006). MN7022/D Foundations of Financial Analysis, 10th Edition, Learning Resources, Cheltenham.

The World Fact Book (2006), United Kingdom
URL: http://www.cia.gov/ciapublications/factbook/geos/uk/htmp#people.
[12 August 2006]

Yesin, P. (2005). Monetary Macroeconomics
URL: http://www.iew.unizh.ch/study/courses/downloads/lecture8_467.pdf
[19 August 2006]