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The Bank of Canada and Monetary Policy
CHAPTER 13
THE BANK OF CANADA
AND MONETARY POLICY
CHAPTER OVERVIEW
The objectives and the mechanics of monetary policy are covered in this chapter. It is organized around
seven major topics: (1) the balance sheet of the Bank of Canada; (2) the techniques of monetary policy;
(3) a graphic restatement of monetary policy; (4) the cause–effect chain of monetary policy; (5) a survey
of the advantages and disadvantages of monetary policy; (6) the dilemma of which targets should be the
goal of monetary policy–interest rates or money supply; (7) the impact of monetary policy operating in an
open world economy. Finally, there is a brief, but important, synopsis of mainstream theory and policies.
The purpose of the concluding sections is to summarize all the macro theory developed so far and fit the
pieces together as an integrated whole for students.
WHAT’S NEW
The early part of the chapter remains much the same, but the section previously titled “Effectiveness of
Monetary Policy” has been reorganized and extensively revised. Its new title is “Monetary Policy in
Action,” and it focuses on current issues and applications while still exposing students to the strengths
and weaknesses of monetary policy.
The definition of the prime interest rate is changed. Instead of referring to it as the rate for the most
creditworthy customers, it is now identified as a “benchmark” or “reference point” upon which many
rates are set.
There is a new “Consider This” box titled “Asymmetry of Monetary Policy” to help illustrate the pushing
on a string analogy.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to understand:
1.
2.
3.
4.
5.
The main functions of the Bank of Canada.
The goals and tools of monetary policy.
The mechanism by which monetary policy affects GDP and the price level.
The effectiveness of monetary policy and its shortcomings.
About the effects of the international economy on the operation of monetary policy.
COMMENTS AND TEACHING SUGGESTIONS
1.
Plan a visual demonstration of open market operations. The creation of new reserves in the banking
system seems like a magician’s trick to most students, and the further expansion of the money
supply through bank loans seems like just more smoke and mirrors. This is a good opportunity to
get students involved through role playing. Assign individual students or small groups parts in the
process: the Bank of Canada, several member banks, bank customers. Walk through several
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The Bank of Canada and Monetary Policy
transactions to show how purchases by the Bank of Canada monetize Canadian government
securities, putting dollars in the hands of bank customers. One economics teacher was well known
on campus for vaulting to the top of his desk and throwing pennies to students to demonstrate
money creation. Be sure to show the process in reverse as well.
2.
The discussion of the Bank of Canada’s consolidated balance sheet is important. Demonstrate the
changes that take place on the Bank of Canada’s balance sheet and the chartered bank’s balance
sheets as open market operations are carried out. The quantitative controls merit considerable
emphasis. Be sure to note how the text explains the relative significance of these quantitative
controls, with focus on open market operations.
STUDENT STUMBLING BLOCKS
1.
Open market operations are puzzling to students, who may not be familiar with bonds in the first
place. Begin by a brief review of the federal government’s debt, which will convince them that
there are billions of dollars’ worth of government bonds in existence. Convince students that the
Bank of Canada has significant power to affect the money supply by buying or selling these
securities. Also remind students that the Bank of Canada deals only in government bonds, not
corporate stocks or bonds.
2.
One memory tip suggested by a teacher is to tell students that when the Bank of Canada “sells”
securities, that “soaks” up money, i.e., the money supply decreases. The link between “sell” and
“soak” should be an easy one for students to remember. Likewise, the Bank of Canada’s
“purchase” can be associated with “pump.”
LECTURE NOTES
I.
Introduction to Monetary Policy
A. Reemphasize that the Bank of Canada formulates policy and implements policy.
B. The fundamental objective of monetary policy is to aid the economy in achieving
full-employment output with stable prices.
1. To do this, the Bank of Canada changes the nation’s money supply.
2. To change money supply, the Bank of Canada manipulates size of excess reserves held
by banks.
C. Monetary policy has a very powerful impact on the economy.
II.
Consolidated Balance Sheet of the Bank of Canada
A. The assets on the Bank of Canada’s balance sheet contain two major items.
1. Government of Canada securities.
2. Loans to chartered banks.
B. The liability side of the balance sheet contains three major items.
1. Chartered bank deposits held at Bank of Canada.
2. Government of Canada funds.
3. Bank of Canada Notes outstanding, our paper currency.
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III.
The Bank of Canada has Three Major “Tools” of Monetary Policy
A. Open-market operations refer to the Bank of Canada’s buying and selling of government
bonds.
B. Switching government of Canada deposits.
C. The overnight lending rate.
D. “Easy” monetary policy occurs when the Bank of Canada tries to increase money supply by
expanding excess reserves in order to stimulate the economy.
E. “Tight” monetary policy occurs when Bank of Canada tries to decrease money supply by
decreasing excess reserves in order to slow spending in the economy during an inflationary
period
F. For several reasons, open-market operations give the Bank of Canada most control of the two
“tools.”
1. Open-market operations are most important. This decision is flexible because securities
can be bought or sold quickly and in great quantities. Reserves change quickly in
response.
IV.
Monetary Policy, Real GDP, and the Price Level: How Policy Affects the Economy
A. Cause-effect chain:
1. Money market impact is shown in Key Graph 13-2.
a. Demand for money is comprised of two parts.
i. Transactions demand is directly related to GDP.
ii. Asset demand is inversely related to interest rates, so total money demands is
inversely related to interest rates.
b. Supply of money is assumed to be set by the Bank of Canada.
c. Interaction of supply and demand determines the market rate of interest, as seen in
Figure 13-2(a).
d. Interest rate determines amount of investment businesses will be willing to make.
Investment demand is inversely related to interest rates, as seen in Figure 13-2(b).
e. Effect of interest rate changes on level of investment is great because interest cost of
large, long-term investment is sizable part of investment cost.
f.
As investment rises or falls, equilibrium GDP rises or falls by a multiple amount, as
seen in Figure 13-2(c).
2. Expansionary or easy money policy: The Bank of Canada takes steps to increase excess
reserves, which lowers the interest rate and increases investment which, in turn, increases
GDP by a multiple amount. (See Column 1, Table 13-2)
3. Contractionary or tight money policy is the reverse of an easy policy: Excess reserves
fall, which raises interest rate, which decreases investment, which, in turn, decreases
GDP by a multiple amount of the change in investment. (See Column 2, Table 13-2)
4. Aggregate supply and monetary policy:
a. Easy monetary policy may be inflationary if initial equilibrium is at or near fullemployment.
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The Bank of Canada and Monetary Policy
b. If economy is below full-employment, easy monetary policy can shift aggregate
demand and GDP toward full-employment equilibrium.
c. Likewise a tight monetary policy can reduce inflation if economy is near fullemployment, but can make unemployment worse in a recession.
5. Try the Quick Quiz in Figure 13-2.
V.
Monetary Policy in Action
A. Strengths of monetary policy:
1. It is speedier and more flexible than fiscal policy since the Bank of Canada can buy and
sell securities daily.
2. It is less political. Bank of Canada Board members are isolated from political pressure.
B. Focus on the Overnight Loans Rate.
1. Currently the Bank of Canada communicates changes in monetary policy through
changes in its target for the overnight loans rate.
2. The Bank of Canada does not set either the overnight loans rate or the prime interest
rate; each is established by the interaction of lenders and borrowers, but rates generally
follow the Fed funds rate.
3. The Bank of Canada acts through open market operations, selling bonds to raise interest
rates and buying bonds to lower interest rates.
C. Shortcomings of monetary policy:
1. Control is weakening as technology makes it possible to shift from money assets to other
types; also global finance gives nations less power.
2. Cyclical asymmetry may exist: a tight monetary policy works effectively to break
inflation, but an easy monetary policy is not always as effective in stimulating the
economy from recession.
3. The velocity of money (number of times the average dollar is spent in a year) may be
unpredictable, especially in the short run and can offset the desired impact of changes in
money supply. Tight money policy may cause people to spend faster; velocity rises.
4. CONSIDER THIS … Pushing on a String
Japan’s ineffective easy money policy illustrates the potential inability of monetary
policy to bring an economy out of recession. While pulling on a string (tight money
policy) is likely to move the attached object to its desired destination, pushing on a string
is not.
5
The impact on investment may be less than traditionally thought. Japan provides a good
example. Despite interest rates of zero, investment spending remained low during the
recession.
D. Currently the Bank of Canada communicates changes in monetary policy through changes in
its target for the Bank of Canada overnight funds rate.
1. The Bank of Canada does not set either the Bank of Canada overnight funds rate or the
prime rate; each is established by the interaction of lenders and borrowers, but rates
generally follow the Bank of Canada funds rate.
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2. The Bank of Canada acts through open market operations, selling bonds to raise interest
rates and buying bonds to lower interest rates.
E. Monetary policy and the international economy:
1. Net export effect occurs when foreign financial investors respond to a change in interest
rates.
a. Tight monetary policy and higher interest rates lead to appreciation of dollar value in
foreign exchange markets; lower interest rates from an easy monetary policy will
lead to dollar depreciation in foreign exchange markets.
b. When dollar appreciates, Canadian goods become more costly to foreigners, and this
lowers demand for Canadian exports, which tends to lower GDP. This is the desired
effect of a tight money policy. Conversely, an easy money policy leads to
depreciation of dollar, greater demand for Canadian exports and higher GDP. This
policy has the desired outcome for expanding GDP.
2. Monetary policy works to correct both trade balance and GDP problems together. An
easy monetary policy leads to increased domestic spending and increased GDP, but it
also leads to depreciated dollar and higher Canadian export demand, which enhances
GDP and erases a trade deficit. The reverse is true for a tight monetary policy, which
would tend to reduce net exports and worsen a trade deficit.
3. Table 13-2 illustrates these points.
VI.
The Big Picture (see Key Graph, Figure 13-4) Shows Many Interrelationships
A. Fiscal and monetary policy are interrelated. The impact of an increase in government
spending will depend on whether it is accommodated by monetary policy. For example, if
government spending comes from money borrowed from the general public, it may be offset
by a decline in private spending, but if the government borrows from the Bank of Canada or
if the Bank of Canada increases the money supply, then the initial increase in government
spending may not be counteracted by a decline in private spending.
B. Study Key Graph 13-4 and you will see that the levels of output, employment, income, and
prices all result from the interaction of aggregate supply and aggregate demand. In particular,
note the items shown in red that constitute, or are strongly influenced by, public policy.
C. Try the Quick Quiz in Figure 13-4.
VII.
Last Word: The Taylor Rule: Could a Robot Replace the Bank of Canada?
A. Macroeconomist John Taylor of Stanford University calls for a new monetary rule that would
institutionalize appropriate Bank of Canada policy responses to changes in real output and
inflation.
B. Traditional “monetarist rule” is passive. It required the Bank of Canada to expand the money
supply at a fixed annual rate regardless of economic conditions.
C. “Discretion” is associated with the opposite: an active monetary policy where the Bank of
Canada changes the money supply and interest rates in response to changes in the economy or
to prevent undesirable results.
D. Taylor’s policy proposal would dictate active monetary actions that are precisely defined. It
combines monetarism and the more mainstream view.
E. Taylor’s rule has three parts.
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The Bank of Canada and Monetary Policy
1. If real GDP rises 1% above potential GDP, the Bank of Canada should raise the overnight
loans rate by 0.5% relative to the current inflation rate.
2. If inflation is 1% above its target of 2%, the Bank of Canada should raise the overnight
rate by 0.5% above the inflation rate.
3. If real GDP equals potential GDP and inflation is 2%, the overnight loans rate should be
about 4%, implying real interest rate of 2%.
F. Taylor would retain the Bank of Canada’s power to override the rule, so a robot really
couldn’t replace the Board. But a rule increases predictability and credibility.
G. Critics of the proposal see no reason for this rule given the success of monetary policy in the
past decade.
ANSWERS TO END-OF-CHAPTER QUESTIONS
13-1
Use chartered bank and Bank of Canada balance sheets to demonstrate the impact of the
following transactions on chartered bank reserves: (a) The Bank of Canada purchases securities
from dealers, (b) The Bank of Canada makes an advance to a chartered bank.
(a) It is assumed the Bank of Canada buys $2 billion worth of securities. This increases demand
deposits and chartered bank reserves by $2 billion. With demand deposits of $202 billion,
desired reserves are $40.4 billion, (= 20 percent of $202 billion). Therefore, excess reserves
are $1.6 billion (= $42 billion – $40.4 billion) and the banking system can increase the money
supply (by making loans) by $8 billion more (= $1.6 billion  5).
(b) It is assumed the chartered banks borrow $1 billion from the Bank of Canada. The chartered
banks may now increase the money supply (through making loans) by $5 billion (= $1 billion
 5).
Consolidated Balance Sheet:
All Chartered Banks (billions of dollars)
a
b
Assets:
Reserves
Securities
Loans
$ 40
60
102
$ 42
60
102
$ 41
60
102
Liabilities and net worth:
Demand deposits
Advances from the Bank of Canada
200
2
202
2
200
3
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Consolidated Balance Sheet:
All Chartered Banks (billions of dollars)
Assets:
Securities
Loans to chartered banks
Liabilities and net worth:
Reserves of chartered banks
Government deposits
Bank of Canada Notes
Other liabilities and net worth
13-2
a
b
$283
2
$285
2
$283
3
40
5
225
15
42
5
225
15
41
5
225
15
(Key Question) In the table below you will find simplified consolidated balance sheets for the
chartered banking system and the Bank of Canada. Use columns 1 and 2 to indicate how the
balance sheets would read after each transaction in (a) and (b) is completed. Do not accumulate
your answers; analyze each transaction separately, starting in each case from the figures provided.
All accounts are in billions of dollars.
a. A decline in the bank rate prompts chartered banks to borrow an additional $1 billion from
the Bank of Canada. Show the new balance-sheet figures in column 1 of each table.
b. The Bank of Canada sells $3 billion in securities to members of the public, who pay for the
bonds with cheques. Show the new balance-sheet figures in column 2 of each table.
c. The Bank of Canada buys $2 billion of securities from the chartered banks. Show the new
balance-sheet figures in column 3 of each table.
d. Now review each of the above three transactions, asking yourself these three questions: (1)
What change, if any, took place in the money supply as a direct and immediate result of each
transaction? (2) What increase or decrease in chartered banks’ reserves took place in each
transaction? (3) Assuming a desired reserve ratio of 20 percent, what change in the
money-creating potential of the commercial banking system occurred as a result of each
transaction?
CONSOLIDATED BALANCE SHEET: ALL CHARTERED BANKS
(1)
(2)
(3)
Assets:
Reserves
Securities
Loans
Liabilities:
Demand deposits
Advances from Bank of Canada
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$ 33
60
60
_____
_____
_____
_____
_____
_____
_____
_____
_____
150
_____
_____
_____
3
_____
_____
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The Bank of Canada and Monetary Policy
CONSOLIDATED BALANCE SHEET: BANK OF CANADA
(1)
(2)
(3)
Assets:
Securities
Advances to chartered banks
$60
3
_____
_____
_____
_____
_____
_____
Liabilities:
Reserves of chartered banks
Government of Canada deposits
Notes in circulation
$33
3
27
_____
_____
_____
_____
_____
_____
_____
_____
_____
(a) Column (1) data (top to bottom): Chartered Bank Assets: $34, 60, 60; Liabilities: $150, 4;
Bank of Canada Assets: $60, 4; Liabilities: $34, 3, 27.
(b) Column (2) data (top to bottom): Chartered Bank Assets: $30, 60, 60; Liabilities: $147, 3;
Bank of Canada Assets: $57, 3, 30, 3, 27.
(c) Column (3) data (top to bottom): $35; $58; $60; $150; $3; Bank of Canada: $62; $3; $35; $3;
$27.
(d) (d1) Money supply (demand deposits) directly changes only in (b), where it decreases by $3
billion; (d2) See balance sheets; (d3) Money-creating potential of the banking system
increases by $5 billion in (a); decreases by $12 billion in (b) (not by $15 billion—the writing
of $3 billion of cheques by the public to buy bonds reduces demand deposits by $3 billion,
thus freeing $0.6 billion of reserves. Three billion dollars minus $0.6 billion equals $2.4
billion of reduced reserves, and this multiplied by the monetary multiplier of 5 equals $12
billion); and increases by $10 billion in (c).
13-3
(Key Question) Suppose you are the governor of the Bank of Canada. The economy is
experiencing a sharp and prolonged inflationary trend. What changes in (a) open-market
operations and (b) switching government deposits would you consider? Explain in each case how
the change you advocate would affect chartered bank cash reserves and influence the money
supply.
(a) Sell government securities in the open market. This would immediately decrease the money
supply by the amount of the securities sales. If the banks had been fully loaned up, they would
now have to decrease their loans by a multiple (because of the money multiplier) of their bond
sales. This would force up interest rates (this, added to the immediate effect of the bond sales,
would tend to drive down their prices, that is, drive interest rates up), and decrease aggregate
expenditures.
(b) Switching government deposits from the chartered banks will reduce excess reserves, thus
banks could loan out fewer funds, thereby decreasing the money supply.
13-4
What is “velocity” as it applies to money? Suppose the Bank of Canada decreases the money
supply from $3 billion to $2 billion, but velocity rises from 3 to 5. By how much, if at all, will
total spending decline? What do economists mean when they say that monetary policy can
exhibit cyclical asymmetry?
The velocity of money is the number of times per year the average dollar is spent on goods and
services. The change in money supply and velocity described above would increase total
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The Bank of Canada and Monetary Policy
spending by $1 billion [3 x $3 billion = $9 billion total spending versus 5 x $2 billion = $10
billion total spending].
Cyclical asymmetry refers to the condition where a tight monetary policy is relatively potent at
contracting economic activity, while an easy money policy is relatively weak at stimulating an
economy. The weakness in easy money policy results when, even though the Bank of Canada
increases liquidity (reserves) in the system, potential borrowers are unwilling to spend (often
because of uncertainly over general weakness in the economy).
13-5
(Key Question) Distinguish between the overnight loans rate and the prime interest rate. In what
way is the overnight loans rate a measure of the tightness or looseness of monetary policy? In
2001 the Bank of Canada used open-market operations to significantly reduce overnight loans
rate. What was the logic of those actions? What was the effect on the prime interest rate?
The overnight loans rate is the interest rate banks charge one another on overnight loans needed
to meet desired reserves. The prime interest rate is the interest rate banks change on loans to
their most creditworthy customers. The tighter the monetary policy, the less the supply of excess
reserves in the banking system and the higher the overnight loans rate. The reverse is true of a
loose or easy monetary policy, which expands excess reserves, and causes the overnight loans
rate to fall.
The Bank of Canada wanted to increase excess reserves, increase money supply growth, and
lower real interest rates. In 2001 the U.S. economy was in the midst of recession, with spending
in decline and stock prices falling. The terrorist attacks of September 11, 2001, added further
uncertainty to the already weak economic outlook, and an easy money policy was seen as a way
to boost confidence. The prime interest rate fell as a result of these actions.
13-6
What is inflation targeting, and how does it differ from the current Bank of Canada policy? What
are the main benefits of inflation targeting, according to its supporters? Why do many
economists feel it is not needed or even oppose it?
An inflation targeting policy would have the Bank of Canada announce each year a target range
for the rate of inflation. Bank of Canada policy would then be geared to pursue that objective,
and failure to meet the target would require the Bank of Canada to explain what went wrong.
Supporters of inflation targeting argue that it increases the transparency and accountability of
Bank of Canada policy. It would also keep the Bank of Canada focused on what should be its
primary objective – stable prices. Some supporters would also argue that the success of past
Bank of Canada action does not ensure that it will always make the right decision, especially if it
attempts to pursue multiple objectives simultaneously.
Opponents of inflation targeting believe that the Bank of Canada needs the discretion and
flexibility to adapt policy to conditions that are changing (sometimes rapidly). They also believe
that past success in inflation targeting is partially the result of ideal economic conditions, and
opponents question its effectiveness during more economically difficult times.
13-7
(Key Question) Suppose the Bank of Canada decides to engage in a tight money policy as a way
to close an inflationary gap. Use the aggregate demand–aggregate supply model to show the
intent of this policy for a closed economy. Next, introduce the open economy and explain how
changes in the international value of the dollar might affect the location of your aggregate
demand curve.
The intent of a tight money policy would be shown as a leftward shift of the aggregate demand
curve and a decline in the price level (or, in the real world, a reduction in the rate of inflation). In
an open economy, the interest rate hike resulting from the tight money policy would entice people
abroad to buy Canadian securities. Because they would need Canadian dollars to buy these
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securities, the international demand for dollars would rise, causing the dollar to appreciate. Net
exports would fall, pushing the aggregate demand curve farther leftward than in the closed
economy.
13-8
(The Last Word) Compare and contrast the Taylor Rule for monetary policy with the simpler
inflation targets practiced by the Bank of Canada. Is the Bank of Canada’s recent monetary policy
consistent with Taylor’s rule?
The “Taylor rule” is activist and counter cyclical. It would allow a central bank to adjust the
money supply and interest rates in expansionary or contractionary fashion depending on
economic conditions
Since the early 1990s the Bank of Canada main preoccupation has, officially at least, been to
target only the rate of inflation at between 1 and 3 percent per year, which it claims indirectly
promotes full employment and economic growth. Thus, it would appear that the Bank of Canada
has pursued a kind of passive rule with only one main aim: price stability. But in reality, the Bank
of Canada has used much more discretion than it would like to admit, in line with Taylor’s rule.
For example, during the course of 2001 it pursued an aggressive policy of lowering short term
interest rates, even though the CPI during that year averaged 2.7 percent, very close to the upper
ceiling of 3 percent that would ordinarily have triggered the Bank of Canada to increase its target
overnight loans rate, not lower it. The Bank of Canada was concerned with the rapid slowdown of
the American economy during 2001, which suffered a mild recession.
Consider This
Visit the OECD website at http://www.oecd.org/. Click “Statistical Portal”, then go to the
“Quarterly Growth Rate of GDP”. Compare Japan’s growth rate with Canada, the U.S., Germany
and France. Has the years of low interest rates in Japan finally stimulated growth, or is the central
Bank of Japan, still pushing on a string?
As of early 2003, the low interest rates in Japan had not provided much stimulus. This state of
affairs may change in the future.
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