The Cambridge Economic History of Modern Britain

INTRODUCTION

The role of sterling was transformed, during the period from 1870 to 2010, from being the world's most widely used currency to becoming primarily a domestic currency. In many ways this process mirrored the changing role of Britain in the international economy, as described in Chapter 3, but it also happened in the context of dramatic changes in the organisation of the international economy and the development of economic ideas. This transformation of sterling's global role had important implications for the operation of monetary policy, since the international and domestic roles of sterling were closely related. The tension between internal and external policy priorities was an enduring theme throughout this period.

Monetary policy involves the manipulation of the money supply to achieve particular targets in the national economy; it is most commonly associated with the tool of interest rates, which affect the supply of and demand for money. Monetary policy thus has domestic implications since it determines the cost of borrowing and the relative returns to savings and may affect domestic economic performance. Lowering interest rates may, ceteris paribus, increase borrowing and investment and promote real economic growth. Conversely, raising the cost of borrowing and increasing the returns to saving may slow down investment, consumption and growth.

Unfortunately, the links between interest rates, money supply and economic performance are unpredictable and depend on a range of contextual factors, including the market's judgement of the credibility of the monetary targeting (Mishkin 2007). There are also variable time lags before the effects can be measured, so monetary policy is a difficult instrument to deploy with precision. In an open economy, such as that of Britain for most of the nineteenth century and the latter half of the twentieth, interest rate adjustments also have implications for the balance of payments, since higher interest rates will attract foreign capital seeking higher returns and lower interest rates may lead to a capital outflow as domestic investors seek higher returns abroad.