I. A method for regulating the supply of currency and credit with a view to maintaining, so far as possible, the stability of the internal price level; and
II. A method for regulating the supply of foreign exchange so as to avoid purely temporary fluctuations, caused by seasonal or other influences and not due to a lasting disturbance in the relation between the internal and the external price level.
I believe that in Great Britain the ideal system can be most nearly and most easily reached by an adaptation of the actual system which has grown up, half haphazard, since the war. After the general idea has been exhibited by an application in detail to the case of Great Britain, it will be sufficient to deal somewhat briefly with the modifications required in the case of other countries.
I. Great Britain.
The system actually in operation to-day is broadly as follows:
(1) The internal price level is mainly determined by the amount of credit created by the banks, chiefly the Big Five; though in a depression, when the public are increasing their real balances, a greater amount of credit has to be created to support a given price level (in accordance with the theory explained above in Chapter III., [p. 84]) than is required in a boom, when real balances are being diminished.
The amount of credit, so created, is in its turn roughly measured by the volume of the banks’ deposits—since variations in this total must correspond to variations in the total of their investments, bill-holdings, and advances. Now there is no necessary reason a priori why the proportion between the banks’ deposits and their “cash in hand and at the Bank of England” should not fluctuate within fairly wide limits in accordance with circumstances. But in practice the banks usually work by rule of thumb and do not depart widely from their preconceived “proportions.”[51] In recent times their aggregate deposits have always been about nine times their “cash.” Since this is what is generally considered a “safe” proportion, it is bad for a bank’s reputation to fall below it, whilst on the other hand it is bad for its earning power to rise above it. Thus in one way or another the banks generally adjust their total creation of credit in one form or another (investments, bills, and advances) up to their capacity as measured by the above criterion; from which it follows that the volume of their “cash” in the shape of Bank and Currency Notes and Deposits at the Bank of England closely determines the volume of credit which they create.
[51] The Joint Stock banks have published monthly returns since January 1921. Excluding the half-yearly statement when a little “window-dressing” is temporarily arranged, the extreme range of fluctuation has been between 11·0 per cent and 11·9 per cent in the proportion of “cash” to deposits, and between 41·1 per cent and 50·1 per cent in the proportion of advances to deposits. These figures cover two and a half years of widely varying conditions. The “proportions” of individual banks differ amongst themselves, and the above is an average result, the steadiness of which is strengthened by the fact that each big bank is pretty steadfast in its own policy.
In order to follow, therefore, the train of causation a stage further, we must consider what determines the volume of their “cash.” Its amount can only be altered in one or other of three ways: (a) by the public requiring more or fewer notes in circulation, (b) by the Treasury borrowing more or less from the Currency Note Reserve, and (c) by the Bank of England increasing or diminishing its assets.[52]
[52] For the aggregate of its liabilities in the shape of deposits and of notes in circulation automatically depends on the volume of its assets.