Monetary Policy

MONETARY Objectives POLICY CHAPTER 26 After studying this chapter, you will able to Describe the structure of the Bank of Canada Describe the tools used by the Bank of Canada to conduct monetary policy Explain what an open market operation is and how it works Explain how the Bank of Canada changes the quantity of money Explain how the Bank of Canada influences interest rates Explain how the Bank of Canada influences the economy

Fiddling with the Knobs The Bank of Canada

Almost every month, the financial news reports on the The Bank of Canada is Canada’s central bank. Bank of Canada’s views about interest rates. A central bank is the public authority that supervises What is the Bank of Canada? financial institutions and markets and conducts monetary Why might the Bank of Canada want to change interest policy. rates? Monetary policy is the attempt to control inflation and How does it change interest rates? moderate the business cycle by changing the quantity of money and adjusting interest rates and the exchange rate. How do interest rates influence the economy?

The Bank of Canada The Bank of Canada

The Bank of Canada was established in 1935. An independent central bank sets its own goals and The governor of the Bank is appointed by the federal makes its own decisions about how to pursue those goals government. and might listen to the views of government but is not obliged to pay any attention to those views. The current governor, who was appointed in 2001, is David Dodge. A subordinate central bank pursues goals set by the government and sometimes takes directions from the There are two possible models for the relationship government on how best to achieve those goals. between a central bank and government: The Bank of Canada pursues inflation targets laid down by Independent central bank the government but makes its own decisions on how best Subordinate central bank to achieve those goals.

1 The Bank of Canada The Bank of Canada

The Bank of Canada’s Balance Sheet The Bank of Canada’s assets are government securities Making Monetary Policy and loans to banks (plus some other small items). Monetary policy making involves three elements: The Bank of Canada’s liabilities are its notes (the $5, $10, $20, $50, and $100 notes), banks deposits, and Monetary policy objectives government deposits. Monetary policy indicators The monetary base is the sum of Bank of Canada notes Monetary policy tools outside the Bank, chartered bank deposits at the Bank of Canada, and coins held by households, firms, and banks. (Coins are issued by the government, not the Bank of Canada.) © Pearson Education Canada, 2003 © Pearson Education Canada, 2003

The Bank of Canada The Bank of Canada

Monetary Policy Objectives Monetary Policy Indicators The objectives of monetary policy, as stated in the Bank of Monetary policy indicators are the current features of Canada Act, are to the economy that the Bank looks at to determine whether it needs to apply the brake or the accelerator to influence …regulate credit and currency in the best interests of the future inflation, real GDP, and unemployment. economic life of the nation…and to mitigate by its influence fluctuations in the general level of production, The indicators change as the Bank learns more about how trade, prices and employment, so far as may be possible the economy works. within the scope of monetary action… Currently, the overnight loans rate, the interest rate on Current objective: keep the inflation rate between 1 large-scale loans that chartered banks make to each percent and 3 percent a year and smooth fluctuations as much as possible. other, is the main monetary policy indicator.

The Bank of Canada

Figure 26.1 shows the overnight loans rate since the mid 1970s. The Bank’s actions raise this interest rate to slow future inflation and lower this interest rate to boost real GDP.

2 The Bank of Canada The Bank of Canada

The Bank of Canada no longer requires chartered banks to hold a minimum level of reserves. Monetary Policy Tools The required reserve ratio in Canada is zero. The four monetary policy tools are: Bank rate is the interest rate that the Bank of Canada Required reserve ratio charges the chartered banks on the reserves it lends Bank rate and bankers’ deposit rate them. Open market operations The bankers’ deposit rate is the interest rate that the Bank of Canada pays to chartered banks on their deposits at the Government deposit shifting Bank. The Bank of Canada sets the bankers’ deposit rate at bank rate minus half a percent. © Pearson Education Canada, 2003 © Pearson Education Canada, 2003

The Bank of Canada Controlling the Quantity of Money

How an Open Market Operation Works An open market operation is the purchase or sale of When the Bank of Canada conducts an open market government of Canada securities by the Bank of Canada operation by buying a government security, it increases in the open market. banks’ reserves. Government deposit shifting is the transfer of government Banks loan the excess reserves. funds by the Bank of Canada from the government’s account at the Bank to a government account at a By making loans, they create money. chartered bank. The reverse occurs when the Bank of Canada sells a government security.

Controlling the Controlling the Quantity of Money Quantity of Money

Although the details differ, the ultimate process of how an Figure 26.2(a) illustrates open market operation changes the money supply is the an open market operation same regardless of whether the Bank of Canada conducts in which the Bank of its transactions with a commercial bank or a member of Canada buys securities the public. from a chartered bank. An open market operation that increases banks’ reserves also increases the monetary base.

3 Controlling the Quantity of Money

Figure 26.2(b) illustrates an open market operation in which the Bank of Canada buys securities from the public.

Controlling the Quantity of Money

Monetary Base and Bank Reserves The money multiplier is the amount by which a change in the monetary base is multiplied to calculate the final change in the money supply. An increase in currency held outside the banks is called a currency drain. Such a drain reduces the amount of banks’ reserves, thereby decreasing the amount that banks can loan and reducing the money multiplier.

Controlling the Quantity of Money Controlling the Quantity of Money

The Money Multiplier When the Bank of Canada increases the monetary base, a The money multiplier differs from the deposit multiplier. sequence of nine events follows. They are: 1.Banks have excess reserves The deposit multiplier shows how much a change in reserves affects deposits. 2.Banks lend excess reserves 3.Bank deposits increase The money multiplier shows how much a change in the 4.The quantity of money increases monetary base affects the money supply. 5.New money is used to make payments 6.Some of the new money remains on deposit 7.Some of the new money is a currency drain 8.Desired reserves increase because deposits have increased

4 Controlling the Quantity of Money Controlling the Quantity of Money

Figure 26.3 illustrates a round in the multiplier process Figure 26.4 keeps track of the magnitude of the multiplier following an open market operation. effect of an open market operation.

Controlling the Quantity of Money Ripple Effects of Monetary Policy

The Canadian Money Multiplier Figure 26.5 summarizes The Canadian money multiplier is the change in the the ripple effects of the quantity of money divided by the change in the monetary Bank of Canada’s base. monetary policy actions. Because there are two definitions of money, M1 and M2+, The AS-AD model helps to there are two money multipliers. see how monetary policy influences real GDP and The M1 multiplier is about 2.2. the price level. The M2+ multiplier is about 10.