ABSTRACT
We begin our discussion of deflationary monetary policy with the highly abstract model pictured in Fig. 1:8. Absurdly simple as this model may seem as a representation of the bewildering complexity of financial markets, it contains all the essential elements of the ideas that most economists have in mind when prescribing the techniques by which such a policy can be carried into effect by a central bank. Reference to the diagram (reproduced, with small modifications in Fig. 2:1) will make immediately clear that, if the central bank wishes to ‘tighten’ financial markets, it simply sells bonds from its own portfolio to the public. As these bonds are purchased, the public runs down its money balances, so that the bond stock in the hands of the non-bank public rises, and the money stock falls, to the accompaniment of a fall in bond prices (= a rise in bond yields). The bank credit multiplier theory implies that the central bank will not need to sell bonds to the full extent of the desired reduction in M, but only to the extent necessary to produce contraction of bank cash on a scale that will induce the banks themselves to reduce loans and thus deposits.
