Regulating the Money Supply: The Development of Monetary Policy in 19th Century Britain

Regulating the Money Supply: The Development of Monetary Policy in 19th Century Britain

Overview

The relationship between the Bank of England’s reserves and its banknote circulation was a long-standing issue that remained unresolved for decades. In the 1840s, Governor J. Horsley Palmer proposed regulating the reserve by the volume of discounting business, but this arrangement raised concerns about excessive banknote creation and inflation. The Bank Charter Act of 1844 attempted to address these issues by dividing the Bank into a banking department and an issue department, but subsequent crises revealed that this system was too rigid.

Context

In the early 19th century, Britain’s economy was experiencing rapid growth and industrialization. The gold standard, which linked the value of the pound to gold, was introduced in 1717, and the Bank of England was established as a central bank in 1694. However, the relationship between the Bank’s reserves and its banknote circulation remained unclear.

Inflation and deflation were major concerns for policymakers during this period. Inflation arose from excessive money creation, while deflation resulted from reduced economic activity. The balance of trade, which measured Britain’s imports and exports, was also a critical factor in determining the country’s monetary policy.

Timeline

• 1717: The gold standard is introduced, linking the value of the pound to gold.
• 1793: The Bank of England begins issuing banknotes.
• 1825: The British government issues the Paper Money Act, which allows for the creation of paper money to finance the war effort against Napoleon’s France.
• 1844: The Bank Charter Act divides the Bank into a banking department and an issue department, with a focus on regulating the reserve by the volume of discounting business.
• 1847: A major financial crisis occurs, forcing the temporary suspension of the Bank Charter Act.
• 1857: Another financial crisis arises, again requiring the relaxation of the Bank Charter Act’s restrictions.
• 1866: The Overend Gurney bank runs into difficulties and is eventually absorbed by the Bank of England.

Key Terms and Concepts

Bank Charter Act

The Bank Charter Act of 1844 divided the Bank of England into a banking department and an issue department. The banking department handled the Bank’s commercial business, while the issue department was responsible for issuing banknotes. This system aimed to regulate the reserve by limiting the amount of banknotes issued.

Gold Standard

The gold standard linked the value of the pound to gold, requiring that paper currency be backed by a corresponding amount of gold reserves.

Inflation/Deflation

Inflation arose from excessive money creation, while deflation resulted from reduced economic activity. Policymakers sought to balance these competing forces through monetary policy.

Balance of Trade

The balance of trade measured Britain’s imports and exports. A surplus in the balance of trade would increase the country’s gold reserves, allowing for more banknote creation.

Key Figures and Groups

J. Horsley Palmer

Governor of the Bank of England from 1833 to 1844, Palmer advocated for regulating the reserve by the volume of discounting business.

Sir Robert Peel

Prime Minister from 1841 to 1852, Peel was concerned about excessive banknote creation and inflation. He supported the division of the Bank into a banking department and an issue department.

Walter Bagehot

Editor of The Economist, Bagehot reformulated the Bank’s proper role in a crisis as the ’lender of last resort’, advocating for the Bank to lend freely during liquidity crises.

Mechanisms and Processes

The relationship between the Bank’s reserves and its banknote circulation is complex. Discounting business – the practice of lending money against securities or other assets – was used to regulate the reserve. However, this system proved too rigid in times of crisis:

1. The Bank Charter Act → Division of the Bank into a banking department and an issue department
2. Banking Department → Handles commercial business
3. Issue Department → Issues banknotes, regulated by the volume of discounting business
4. Crisis arises → Temporary suspension of the Bank Charter Act

Deep Background

The gold standard, introduced in 1717, linked the value of the pound to gold. This system required that paper currency be backed by a corresponding amount of gold reserves. The Bank of England was established as a central bank in 1694, and its role evolved over time.

Monetary policy, which regulates the money supply, has been shaped by various factors, including inflation, deflation, and the balance of trade. Policymakers have sought to balance these competing forces through monetary policy.

Explanation and Importance

The unresolved issue of regulating the Bank’s reserves and banknote circulation led to the 1844 Bank Charter Act. However, this system proved too rigid in times of crisis, requiring temporary suspensions. It was only after the last crisis that Walter Bagehot reformulated the Bank’s proper role as the ’lender of last resort'.

Comparative Insight

The British experience with monetary policy can be compared to other countries and periods. For example:

• The Federal Reserve System in the United States, established in 1913, also faced challenges regulating its money supply.
• In Germany, the Gold Standard was introduced in 1871, linking the value of the mark to gold.

Extended Analysis

The Lender of Last Resort

Walter Bagehot’s concept of the ’lender of last resort’ revolutionized monetary policy. The Bank should lend freely during liquidity crises, albeit at a penalty rate. This approach recognizes that the Bank must act as a buffer against economic shocks.

Monetary Policy and Economic Stability

The relationship between monetary policy and economic stability is complex. Policymakers seek to balance inflation, deflation, and the balance of trade through monetary policy. However, this system can be too rigid in times of crisis, requiring temporary suspensions or revisions.

Open Thinking Questions

• How has the gold standard influenced monetary policy? • What are the implications of regulating the reserve by the volume of discounting business? • In what ways does the concept of the ’lender of last resort’ contribute to our understanding of monetary policy?

Conclusion

The development of monetary policy in 19th century Britain highlights the complex relationship between the Bank’s reserves and its banknote circulation. The Bank Charter Act of 1844 divided the Bank into a banking department and an issue department, but this system proved too rigid in times of crisis. It was only after the last crisis that Walter Bagehot reformulated the Bank’s proper role as the ’lender of last resort'.