Download Copyright © 2009 Pearson Education Canada

Chapter 14
Monetary Policy and
the Bank of Canada
Copyright © 2009 Pearson Education Canada
Principles of Money Supply
Determination

The supply of money is affected by
three groups of market
participants:
the central bank;
 depository institutions;
 the public.

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14-2
An All-Currency Economy
The belief that money has value is
self justifying.
 The government helps convince the
public that paper money has value,
usually by decreeing that the
money is legal tender – creditors
are required to accept the money
in settlement of debts.

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14-3
An All-Currency Economy
(continued)
The liabilities of the Central Bank
that are usable as money are
called the monetary base or highpowered money.
 In an all-currency economy the
money supply equals the monetary
base.

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The Money Supply under
Fractional Reserve Banking
All Agricolians want to keep their
money in bank deposits, rather
than in currency.
 Liquid assets held by banks to
meet the demands for withdrawals
by depositors or to pay cheques
drawn on depositors’ accounts are
called bank reserves.

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Fractional Reserve Banking
(continued)
100% reserve banking is a banking
system where bank reserves equal
100% of deposits.
 Fraction-reserve banking is a
banking system in which banks
hold only a fraction of their
deposits in reserves.

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Fractional Reserve Banking
(continued)
In a fraction-reserve banking
system the reserve-deposit ratio –
reserves divided by deposits – is
less than one.
 Fractional-reserve banking system
is profitable for banks because a
portion of deposited funds can be
used for interest-earning loans.

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Fractional Reserve Banking
(continued)
A very simple example:
The Bank of Cheryl
Desired reserve ratio: 10%
- Peter deposit $10,000 at the bank
of Cheryl
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14-8
The Relationship Between
Reserves and Total Deposits
Maximum
Bank
.
.
.
New Deposits
(new reserves)
New Desired
Reserves
New Loans
plus Investments
(excess reserves)
1
$10,000
$1,000
$9,000
2
9,000
900
8,100
3
8,100
810
7,290
4
7,290
.
.
.
729
.
.
.
6,561
.
.
.
All other banks
Totals
65,610
6,561
59,049
$100,000
$10,000
$90,000
Fractional Reserve Banking
(continued)

A multiple expansion of loans and
deposits is a process of increase
an economy’s loans and deposits
by the fractional reserve banking
system.
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Fractional Reserve Banking
(continued)
BASE
M  DEP 
res
DEP is total bank deposits
BASE is the monetary base
res is the bank’s desired reservedeposit ratio=RES/DEP
RES is total bank reserves
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Bank Runs
If a large number of depositors
attempt to withdraw currency
simultaneously, the bank will be
unable to meet all its depositors’
demand for cash.
 A large-scale, panicky withdrawal
of deposits from a bank is called a
bank run.

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The Money Supply

The central bank may control the
monetary base but it does not
directly control the money supply.
M  CU  DEP
BASE  CU  RES
M
CU  DEP

BASE CU  RES
CU is currency
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14-13
The Money Supply
(continued)
M
(CU/DEP)  1

BASE (CU/DEP)  (RES/DEP)
CU/DEP (cu) is the currencydeposit ratio, the decision of public
 RES/DEP (res) is the reservedeposit ratio, the decision of banks

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14-14
The Money Supply
(continued)
 cu  1 
M 
 BASE
 cu  res 
The money supply is the multiple of
the monetary base.
 The money multiplier decreases
when either cu or res increases.

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Open-Market Operations
To change the level of money
supply a central bank must change
the amount of monetary base or
change the money multiplier.
 The Bank of Canada affects the
monetary base so as to influence
short-term interest rates.

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Open-Market Operations
(continued)
A purchase of assets from the
public by the central bank is called
an open-market purchase. It
increases the monetary base.
 A sale of assets to the public by the
central bank is called an openmarket sale. It reduces the
monetary base.

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14-18
Monetary Control in Canada
In fact the Bank of Canada is
independent from the government.
 It is the only institution in control
of short-term monetary policy.

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The Bank of Canada’s
Balance Sheet
The Bank’s largest asset is its
holdings of government securities.
 The Bank’s largest liability is
currency in circulation.

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14-20
The Bank of Canada’s
Balance Sheet (continued)

Deposits of chartered banks at the
Bank of Canada is a convenient
way of holding reserves and of
settling their accounts with other
banks.
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Tools of Monetary Policy:
Overnight Rates
The banks hold balances at the
Bank of Canada, called clearing or
settlement balances.
 13 large banks and credit union
associations called direct clearers
hold their reserves at the central
bank to settle their net transfers.

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Overnight Rates
(continued)

A bank with a larger balance than
it needs to meet its settlement
obligations can lend some of its
balances to another bank for one
day, charging an interest rate
called the overnight rate.
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Overnight Rates
(continued)
The Bank of Canada implements
monetary policy by influencing the
overnight rate.
 The center of a band for the
overnight rate is called the target
overnight rate.

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Overnight Rates
(continued)
The Bank is prepared to lend at the
interest rate at the top of the band
(the Bank rate).
 The bank pays interest on deposits
at the rate given by the bottom
edge of the band.

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Overnight Rates
(continued)
A lower target for the overnight
interest rate leads to increases in
asset advances to the banks, an
expansion of the monetary base
and an increase in money supply.
 The money supply and interest
rates move in opposite directions.

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Overnight Rates
(continued)
Most often banks borrow reserves
from each other.
 The Bank of Canada stands ready
to lend at the Bank rate to prevent
financial crises by serving as a
lender of last resort.

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Tools of Monetary Policy:
Open Market Operations

To increase the money supply the
Bank could conduct an openmarket purchase from the public.
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Tools of Monetary Policy:
The Exchange Fund Account
The Bank manages the federal
government’s holdings of various
currencies in the separate
exchange fund account.
 These reserves can be used to
intervene into the foreign exchange
market.

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Intermediate Targets
The Bank of Canada sets goals and
ultimate targets, e.g. price stability
and stable economic growth.
 To reach the goals the bank uses
its monetary policy tools, or
instrument – overnight rates and
open-market operations.

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Intermediate Targets
(continued)

Intermediate targets, or indicators,
are macroeconomic variables that
the Bank cannot control directly
but can influence fairly predictably
and that, in turn, are related to the
goals the Bank is trying to achieve.
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Intermediate Targets
(continued)
Intermediate targets can be the
exchange rate, monetary
aggregates and short-term nominal
interest rates.
 The Bank cannot simultaneously
target the exchange rate and the
money supply, or the money
supply and interest rates.

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Intermediate Targets
(continued)

The Bank could reduce the
instability caused by nominal
shocks by using monetary policy to
hold the interest rate constant.
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Making Monetary Policy in
Practice

The practical issues of monetary
policy are:
lags in the effects of monetary policy
on the economy;
 uncertainty about the channels
through which monetary policy works.

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Lags in the Effects of
Monetary Policy
Interest rates and the nominal
exchange rate react quickly to
changes in monetary policy.
 The full negative effects of tighter
monetary policy on real GDP is not
felt for six to eighteen months.
Prices respond even more slowly.

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Lags in the Effects of
Monetary Policy (continued)

The Bank’s policy decisions should
be based on forecasts what the
economy will be doing six months
to two years in the future.
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14-38
The Channels of Monetary
Policy Transmission

The effects of monetary policy on
the economy can work through
changes in:
real interest rates (the interest rate
channel of monetary policy).
 the real exchange rate (the exchange
rate channel of monetary policy).

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14-39
Monetary Policy
Transmission (continued)

A tightening of monetary policy
reduces both the supply and
demand for credit, mechanism
referred to as the credit channel of
monetary policy.
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The Credit Channel
The reduced bank reserves lead to
smaller quantity of customer
deposits and reduced lending by
banks.
 High interest rates add to
borrowing firm’s interest costs and
lower its profitability, making it
harder for the firm to obtain loans.

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The Conduct of Monetary
Policy: Discretion
Keynesians believe that monetary
policy can be used to smooth the
business cycle. Many, though not
all, also believe that monetary
should be used for that purpose.
 So, the Bank should use its policy
discretion to best achieve its goals.

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The Conduct of Monetary
Policy: Rules

Monetarists and classical
economists are supporters of the
rules, or automatic monetary
policy.
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The Monetarist Case for
Rules
Monetary policy has powerful
short-run effects on the real
economy.
 In the long run changes in the
money supply have their primary
effect on the price level.

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The Monetarist Case for
Rules (continued)
There is little scope for using
monetary policy actively to try to
smooth business cycle.
 The central bank cannot be relied
on to smooth business cycles
effectively.

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The Monetarist Case for
Rules (continued)

The central bank should choose a
specific monetary aggregate and
commit itself to making that
aggregate grow at a fixed
percentage rate.
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14-46
Rules and Central Bank
Credibility

The use of monetary rules can
improve the credibility of the
central bank and the credibility of
the central bank influences how
well monetary policy works.
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A Game Between Central
Bank and Firms
The central bank wants to reduce
the inflation rate to zero without
increasing in the unemployment
rate.
 It announces that it will keep M
constant and hopes households
and businesses will hold P constant
for this period.

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Rules, Commitment and
Credibility
If a central bank is credible, it can
reduce money growth and inflation
without incurring high
unemployment.
 The central bank can develop its
reputation by carrying out its
promises, but that may involve
serious costs while it is established.

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Rules, Commitment and
Credibility (continued)

Advocates of rules suggest that by
forcing the central bank to keep
promises, rules may be a
substitute for reputation in
establishing credibility.
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Rules, Commitment and
Credibility (continued)

Keynesians argue that establishing
a rule ironclad enough to create
credibility, by eliminating policy
flexibility, also create risks.
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Other Ways to Achieve
Central Bank Credibility
Appointing a “tough” central
banker.
 Changing central banker’s
incentives.
 Increasing central bank
independence.

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