 The Bank of Canada can conduct monetary policy in two different ways:  1. Open Market Operations (a signal of its intentions)  2. Target Overnight Rate Tools of Monetary Policy

 Recall: Bank of Canada sells and buys back federal gov’t bonds  By selling and buying bonds, the Bank of Canada is able to influence the money supply and interest rates  Open Market Operations: the buying and selling of bonds by the Bank of Canada in the open market. Open Market Operations

 Bank of Canada sells $1000 bond to Bondholder A  Bondholder A pays for it using a cheque from his account at Cartier Bank  Bank of Canada sends the $1000 cheque to Cartier Bank  Cartier Bank cancels cheque and reduces Bondholder A’s account by $1000  Cartier Bank pays the Bank of Canada for the cheque by having $1000 taken out of its Bank of Canada account Bond Sales Process

 The money supply now falls by $1000  Assuming a reserve ratio of 0.10, Cartier Bank’s excess reserves are cut by $900 – another reduction in the supply of money  Cartier Bank has less money available to lend  If the money multiplier is 10 (reciprocal of reserve ratio), a further decline in the money supply could be as much as $9000 (=900 x 10) Bond Sales Process

 Sales of bonds reduces the cash reserves of deposit-takers  This cuts back on lending  Decreases money supply  By selling bonds, the Bank of Canada in engaging in Contractionary Monetary Policy Bond Sales Process cont’d

 Bank of Canada buys back a $1000 bond from Bondholder B  Bondholder B receives a cheque from the Bank of Canada  She deposits cheque into her account at Cartier Bank  Cartier Bank delivers it to the Bank of Canada and receives $1000  So buying bonds back allows the Bank of Canada to practice expansionary monetary policy  Cash reserves increase, so increased lending  Money supply expands Bond Purchases

 The interest rate on overnight loans between financial institutions  If the Bank buys bonds, this reduces the need for overnight borrowing  If the Bank sells bonds, this increases the need for overnight borrowing  If the change in the target overnight rate is substantial, prime- rate may be altered  Prime Rate is the lowest interest rate charged by deposit-takers on loans  The Target Overnight Rate

 Monetary Policy is the most important stabilization tool due to two main benefits:  1. Separation from Politics  2. Speed with which it can be Applied  1. Although the Bank of Canada is under the control of parliament, it is controlled by appointed officials  2. Recall that fiscal policy suffers from recognition, decision and impact  While recognition delays may occur for monetary policy, decisions are done speedily Benefits of Monetary Policy

 1. Weakness as an Expansionary Tool  2. Broad Impact  3. Potential conflict with the goal of financial stability Drawbacks of Monetary Policy

 1. Weakness as an Expansionary Tool  During a boom, the Bank sells bonds, decreasing the money supply, increasing interest and reducing spending  During a recession/depression, the Bank buys bonds, but this won’t always increase the money supply  If deposit-takers don’t lend the money and hold onto their cash reserves, the increase in money supply won’t occur  2. Broad Impact  3. Potential conflict with the goal of financial stability Drawbacks of Monetary Policy

 1. Weakness as an Expansionary Tool  2. Broad Impact  Fiscal policy can be focused on a particular region of the country  Monetary policy affects every region  If the interest rate increases, it increases for the whole country  3. Potential conflict with the goal of financial stability Drawbacks of Monetary Policy

 1. Weakness as an Expansionary Tool  2. Broad Impact  3. Potential conflict with the goal of financial stability  Extended periods of low interest rates (e.g. the decade before 2008 financial crisis), have serious effects on financial stability  Low interest rates promote risky lending practices  This can lead to more problems Drawbacks of Monetary Policy