factor in the case, the importance of which is seldom realized—the rate of bank discount.
Under almost any sensible banking system the rate of discount is one of the regulators of the volume of credit relatively to reserve. If there is undue expansion of credit relatively to the reserve, the rate of discount is raised to curb it. If, on the other hand, there is a plethora of reserve, the rate of discount is lowered to stimulate an increase of credit. As the expansion and contraction of credit are directly related to the price level, the rate of bank discount is thus concerned very vitally with the price level.
The greatest of banks, the Bank of England, is a model in this respect. It alternately defends and releases its gold reserve, which is the basic gold reserve of England, by raising and lowering the bank rate.
The report, after the Armistice, of the Lord Cunliffe Committee on Currency, Banking and Foreign Exchange shows clearly how the bank rate keeps the English price level in tune with world price levels. Speaking of this long-established system the report says:
"When, apart from a foreign drain of gold, credit at home threatened to become unduly expanded, the old currency system tended to restrain the expansion and to prevent the consequent rise in domestic prices which ultimately causes such a drain. The expansion of credit, by forcing up prices, involves an increased demand for legal tender currency both from the banks in order to maintain their normal proportion of cash to liabilities and from the general public for the payment of wages and for retail transactions. In this case also the demand for such currency fell upon the reserve of the Bank of England, and the bank was thereupon obliged to raise its rate of discount in order to prevent the fall in the proportion of that reserve to its liabilities. The same chain of consequences as we have just described followed and speculative trade activity was similarly restrained. There was, therefore, an automatic machinery by which the volume of purchasing power in this country was continuously adjusted to world prices of commodities in general. Domestic prices were automatically regulated so as to prevent excessive import."[1]
- ↑ Federal Reserve Bulletin, December, 1918, p. 1178.
