PART III - THE MONETARY SYSTEM AND MONETARY POLICY

Summary

For many years the fundamental notion employed to understand the pre-1914 Gold Standard was the Quantity Theory of Money, one form of which is represented in figure III.1. The money supply, Ms, depended on the quantity of gold and the willingness of the financial system to create assets, such as bank deposits, on that monetary base. Excessive credit creation drove up prices. That meant profits could be made by buying gold in the UK, and selling in another gold standard country where prices had not risen so much. If gold flowed out of the country, Ms shifted down to Ms₁ and nominal income contracted.

The Bank of England was expected to maintain confidence in the monetary system so that there were no massive panic contractions in the supply of assets created by the private sector. (In a panic Ms shifts to Ms₁ and nominal income falls to PY₁. Most probably both prices and real income would decline.) Money demand, Md, increased with nominal income by a proportion k. If interest rates rose, perhaps because of an increase in the Bank's discount rate, k fell as the cost of holding money for transactions purposes increased. The same increase in interest rates also tended to reduce Ms.