Chapter 14 Monetary Policy and the Bank of Canada Copyright © 2016 Pearson Canada Inc

Chapter 14

Monetary Policy and the Bank of Canada

Copyright © 2016 Pearson Canada Inc.

Main Questions

■ How is Canada’s money supply determined?

■ How should the central bank conduct monetary policy?

■ How should monetary policymaking institutions be designed?

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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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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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An All-Currency Economy (continued)

■ The liabilities of the Central Bank that are usable as money are called the monetary base or high-powered money.

■ In an all-currency economy, the money supply equals the monetary base.

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The Money Supply under Fractional Reserve Banking

■ The public wants to keep their money in bank deposits, rather than in currency for safety reasons.

■ 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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■ 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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■ A multiple expansion of loans and deposits is a process of increasing an economy’s loans and deposits by the fractional reserve banking system.

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DEP is total bank depositsBASE is the monetary baseres is the bank’s desired reserve-

deposit ratio=RES/DEPRES is total bank reserves

res

BASEDEPM

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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.

CU is currencyRESCU

DEPCU

BASE

M

RESCUBASE

DEPCUM

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The Money Supply (continued)

■ CU/DEP (cu) is the currency-deposit ratio, the decision of public

■ RES/DEP (res) is the reserve-deposit ratio, the decision of banks

(RES/DEP)(CU/DEP)

1(CU/DEP)

BASE

M

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The Money Supply (continued)

■ The money supply is the multiple of the monetary base.

■ The money multiplier decreases when either cu or res increases.

BASErescu

1cuM

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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 open-market sale. It reduces the monetary base.

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Monetary Control in Canada

■ The Bank of Canada Act suggests that the governor of the Bank of Canada should consult with and report to the government.

■ However, 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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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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■ 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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■ 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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■ 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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■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 open-market purchase from the public.

■Open-market purchases of long term bonds is known as quantitative easing.

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Tools of Monetary Policy: Open Market Operations

■Monetary policy can influence interest rate by:■Changing rates on short-term, liquid,

safe securities and expecting other rates to follow.

■Changing rates on long-term, illiquid, risky securities directly.

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Open Market Operations (continued)

■ The value of the overnight interest rate by buying/selling its securities using Special Purchase and Resale Agreements (SPRA) and Sale and Repurchase Agreements (SRA).

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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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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 of what the economy will be doing six months to two years in the future.

■ The Bank reacts to anticipated inflation not current inflation.

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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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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 policy 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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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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The Taylor Rule

■ A rule that allows for economic conditions to influence monetary policy:

)02.0(5.05.002.0 yi

Where:i=nominal overnight interest rate=inflation rate over previous four quartersy=the percentage deviation of output from

full-employment output

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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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Documents

Chapter 14 Monetary Policy and the Bank of Canada Copyright © 2016 Pearson Canada Inc