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Exam

zone

Chapter 14

Monetary Policy and the Bank of

Canada

Economics 282

University of Alberta

Principles of Money Supply

Determination • The supply of money is affected by three

groups of market participants:

– the central bank;

– depository institutions;

– the public.

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.

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.

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.

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.


(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.


(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.


(continued)

DEP is total bank deposits

BASE is the monetary base

res is the bank’s desired reserve-deposit

ratio=RES/DEP

RES is total bank reserves

res

BASEDEPM

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.

The Money Supply

• The central bank may control the

monetary base but it does not directly

control the money supply.

CU is currency RESCU

DEPCU

BASE

M

RESCUBASE

DEPCUM

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

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

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.

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.

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.

The Bank of Canada’s Balance

Sheet • The Bank’s largest asset is its holdings of

government securities.

• The largest liability of the Bank is currency

in circulation.

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.

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.

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.


• 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.


• 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.


• A lower target for the overnight interest

rate leads to increase in asset advances to

the banks, the monetary base expansion

and an increase in money supply.

• The money supply and interest rates move

in opposite directions.


• Most often bank s 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.

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 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).

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.

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.


(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.


(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.


(continued) • The Bank could reduce the instability

caused by nominal shocks by using

monetary policy to hold the interest rate

constant.

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.

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

until about six months. Prices respond

even more slowly.

Lags in the Effects of Monetary

Policy (continued) • Te Bank’s policy decisions should be

based on forecasts what the economy will

be doing six months to two years in the

future.

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).

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.

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.

The Conduct of Monetary

Policy: Discretion • Keynesians believe that monetary policy

can and should be used to smooth the

business cycle.

• So, the Bank should use its policy

discretion to best achieve its goals.

The Conduct of Monetary

Policy: Rules • Monetarists and classical economists are

supporters of the rules, or automatic

monetary policy.

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.


(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.


(continued) • The central bank should choose a specific

monetary aggregate and commit itself to

making that aggregate grow at a fixed

percentage rate.

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.

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 asks business to hold P constant for

this period.

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.


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.


Credibility (continued) • Keynesians argue, establishing a rule

ironclad enough to create credibility, by

eliminating policy flexibility, also create

unacceptable risks.

Other Ways to Achieve Central

Bank Credibility • Appointing a “tough” central banker.

• Changing central banker’s incentives.

• Increasing central bank independence.

End of Chapter

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