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Juan Castaneda starts the conversation suggesting that senior academics, policy makers, and central bankers do not seem to have a coherent theory of what causes inflation. John Greenwood then gives an overview of the current monetary policy of the Bank of England, which is based on an aggregate demand and supply model. The staff of the bank prepares estimates of aggregate demand, which is the spending side, and aggregate supply, which is composed of the potential outcome and the output gap. The output gap is the difference between the actual output and the calculated potential output. If the potential output is above the actual output, the bank might try to stimulate the economy. If aggregate demand exceeds aggregate supply, the bank will tighten policy by raising rates. However, quantifying all of this is challenging, especially in real-time. As John Greenwood concludes, while it is in part a Keynesian model it is certainly not monetarist.

John Greenwood then discusses the role played by the Bank of England in the creation of money during the Covid19 pandemic, mainly via Quantitative Easing (QE)  operations. These consist of the purchase by the central bank of assets such as government securities and potentially private sector bonds and securities by the central bank. In 2020 and 2021 the Bank of England purchased a large amount of guilts (i.e. government bonds), mainly from non-banks, resulting in the creation of additional reserves and new deposits in the banking system (i.e. money).

Why QE has now been inflationary and it wasn’t back in the aftermath of the Global Financial Crisis (2007-09)? This is a key question John Greenwood addresses in our conversation. In 2009 commercial banks focused on repairing their balance sheet and reducing bank lending, leading to subdued growth of money, broadly defined (including bank deposits). With QE central banks, in essence, ‘filled the hole’ left by commercial banks and managed to avoid a more profound fall in the amount of money. This low rate of growth of money broadly defined is what explains subdued inflation in those years. However, in 2020 and 2021, QE resulted in a significant increase in the amount of money, which explains the increase in nominal spending and ultimately in inflation, though with a delay.

The main proposition of the ‘quantitative theory of money’ is that there is a stable relationship between the quantity of money in the economy and nominal spending in the economy. If there is a change in the amount of money, in the longer run it will impact the price level: if too much money, that causes inflation, and vice versa. However, the Bank of England didn’t (doesn’t) use this rationale to assess the effects of the increase in the amount of money (which reached 15% on an annual basis between 2020 and 2021). There is roughly a  two-year delay between the policy change and inflationary figures. Instead the Bank of England seems to focus on the policy rate and not the change in the quantity of money when assessing inflation.

Overall, you will find in this episode a comprehensive overview of the monetary policy strategy of the Bank of England and the quantitative theory of money, and how the Bank of England has contributed to the 2021 – 2023 inflation episode in the UK.

Greenwood, J. (2023): ‘The monetary policy strategy of the Bank of England in 2020–21: An assessment’. In Economic Affairs Vol. 43,1. February. Pp. 53-72.

Further Reading

Friedman, M. and Schwartz, A. (1982). Monetary Trends in the United States and the United Kingdom: Their Relations to Income, Prices, and Interest Rates. University of Chicago Press.

Greenwood, J. and Hanke, S. (2022). On monetary growth and inflation in leading economies, 2021–2022: Relative prices and the overall price level. Journal of Applied Corporate Finance, 33 (4), pp. 39–51.

King, M. (2022). Monetary policy in a world of radical uncertainty. Economic Affairs, 42 (1), pp. 2–12.

The discussion then delves into the different types of banking crises: a capital crisis and a liquidity crisis. A capital crisis occurs when there is a sudden drop in a bank’s capital, for example when a large loan goes wrong. On the other hand, a liquidity crisis is when a bank is solvent (i.e. it has enough capital) but cannot meet all its payment obligations. In the event of a run on a bank this can precipitate a loss of confidence in other banks and thus provoke the collapse of the entire banking system.

The conversation then moves to how central banks should respond to a liquidity crisis. Professor Wood suggests that the central bank should lend freely to any affected bank to prevent a crisis, provided that the bank in crisis has enough assets to borrow money from the central bank. The central bank should lend on a higher interest rate to account for the greater risk incurred by the bank in crisis, even if the collateral provided is not ideal. Professor Wood makes it clear that the emphasis should be put on the stability of the whole financial system; thus any firm should be allowed to fail, as long as there is a legal mechanism in place to ensure that the process is orderly, which is the case in the UK and the US.

Finally, regarding the new regulations approved by both international and national regulators to prevent a financial crisis, Professor Wood argues that creating a framework on how to deal effectively with crises, rather than making institutions similar in terms of their balance sheets, is a better approach. Our conversation ends with a summary discussion on the importance of understanding the different types of financial crises and how to respond to them effectively.

Wood, G. (2023). ‘In search for stability’. In Economic Affairs. Vol. 43,1. February. Pp. 1-9.

Further Reading

Daníelsson, J. (2022). The Illusion of Control: Why Financial Crises Happen, and What We Can (and Can’t) Do About It.

Schwartz, A. (1986). Real and pseudo-financial crises. In F. Capie and G. Wood (Eds.), Financial Crises and the World Banking System (pp. 11–31). Macmillan.

Pollock, A. & Adler, H. (2022). Surprised Again! The COVID Crisis and the New Market Bubble.