1. Chapter 14 Monetary Policy and the Bank of Canada Copyright © 2009 Pearson Education Canada

2. 14-2 Principles of Money Supply Determination The supply of money is affected by three groups of market participants: the central bank; depository institutions; the public.

3. Copyright © 2009 Pearson Education Canada14-3 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.

4. Copyright © 2009 Pearson Education Canada14-4 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.

5. Copyright © 2009 Pearson Education Canada14-5 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.

6. Copyright © 2009 Pearson Education Canada14-6 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.

7. Copyright © 2009 Pearson Education Canada14-7 Fractional Reserve Banking (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.

8. Copyright © 2009 Pearson Education Canada14-8 Fractional Reserve Banking (continued) A very simple example: The Bank of Cheryl Desired reserve ratio: 10% - Peter deposit $10,000 at the bank of Cheryl

9. The Relationship Between Reserves and Total Deposits Maximum New Loans New DepositsNew Desiredplus Investments Bank(new reserves)Reserves(excess reserves) 1$10,000$1,000$9,000 29,0009008,100 38,1008107,290 47,2907296,561 Totals$100,000$10,000$90,000.... All other banks65,6106,56159,049

10. Copyright © 2009 Pearson Education Canada14-10 Fractional Reserve Banking (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.

11. Copyright © 2009 Pearson Education Canada14-11 Fractional Reserve Banking (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

12. Copyright © 2009 Pearson Education Canada14-12 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.

13. Copyright © 2009 Pearson Education Canada14-13 The Money Supply The central bank may control the monetary base but it does not directly control the money supply. CU is currency

14. Copyright © 2009 Pearson Education Canada14-14 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

15. Copyright © 2009 Pearson Education Canada14-15 The Money Supply (continued) The money supply is the multiple of the monetary base. The money multiplier decreases when either cu or res increases.

17. Copyright © 2009 Pearson Education Canada14-17 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.

18. Copyright © 2009 Pearson Education Canada14-18 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.

19. Copyright © 2009 Pearson Education Canada14-19 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.

20. Copyright © 2009 Pearson Education Canada14-20 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.

21. Copyright © 2009 Pearson Education Canada14-21 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.

23. Copyright © 2009 Pearson Education Canada14-23 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.

24. Copyright © 2009 Pearson Education Canada14-24 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.

25. Copyright © 2009 Pearson Education Canada14-25 Overnight Rates (continued) 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.

26. Copyright © 2009 Pearson Education Canada14-26 Overnight Rates (continued) 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.

27. Copyright © 2009 Pearson Education Canada14-27 Overnight Rates (continued) 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.

28. Copyright © 2009 Pearson Education Canada14-28 Overnight Rates (continued) 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.

30. Copyright © 2009 Pearson Education Canada14-30 Tools of Monetary Policy: Open Market Operations To increase the money supply the Bank could conduct an open- market purchase from the public.

31. Copyright © 2009 Pearson Education Canada14-31 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.

32. Copyright © 2009 Pearson Education Canada14-32 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.

33. Copyright © 2009 Pearson Education Canada14-33 Intermediate Targets (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.

34. Copyright © 2009 Pearson Education Canada14-34 Intermediate Targets (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.

35. Copyright © 2009 Pearson Education Canada14-35 Intermediate Targets (continued) The Bank could reduce the instability caused by nominal shocks by using monetary policy to hold the interest rate constant.

36. Copyright © 2009 Pearson Education Canada14-36 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.

37. Copyright © 2009 Pearson Education Canada14-37 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.

38. Copyright © 2009 Pearson Education Canada14-38 Lags in the Effects of Monetary Policy (continued) The Bank’s policy decisions should be based on forecasts what the economy will be doing six months to two years in the future.

39. Copyright © 2009 Pearson Education Canada14-39 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).

40. Copyright © 2009 Pearson Education Canada14-40 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.

41. Copyright © 2009 Pearson Education Canada14-41 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.

42. Copyright © 2009 Pearson Education Canada14-42 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 should be used for that purpose. So, the Bank should use its policy discretion to best achieve its goals.

43. Copyright © 2009 Pearson Education Canada14-43 The Conduct of Monetary Policy: Rules Monetarists and classical economists are supporters of the rules, or automatic monetary policy.

44. Copyright © 2009 Pearson Education Canada14-44 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.

45. Copyright © 2009 Pearson Education Canada14-45 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.

46. Copyright © 2009 Pearson Education Canada14-46 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.

47. Copyright © 2009 Pearson Education Canada14-47 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.

50. Copyright © 2009 Pearson Education Canada14-50 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.

51. Copyright © 2009 Pearson Education Canada14-51 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.

52. Copyright © 2009 Pearson Education Canada14-52 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.

53. Copyright © 2009 Pearson Education Canada14-53 Rules, Commitment and Credibility (continued) Keynesians argue that establishing a rule ironclad enough to create credibility, by eliminating policy flexibility, also create risks.

54. Copyright © 2009 Pearson Education Canada14-54 Other Ways to Achieve Central Bank Credibility Appointing a “tough” central banker. Changing central banker’s incentives. Increasing central bank independence.