13.3 - Tools of Monetary Policy
 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
Open Market Operations
 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.
Bond Sales Process
 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 cont’d
 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 Purchases
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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
 Cartier Bank’s cash reserves increase by $1000
 If the bank has a reserve ratio of 0.10, then it only needs to hold
back $100
 The bank has excess reserves of $900 (= $1000 - $100)
𝟏
 Now, the money multiplier = 10 (=
), creates a further
𝟎.𝟏𝟎
increase in the money supply of up to $9000 (= $900 x 10)
The Target Overnight Rate
 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, primerate may be altered
 Prime Rate is the lowest interest rate charged by deposit-takers on
loans
 http://www.youtube.com/watch?v=KqI2HMlSTio
Benefits of Monetary Policy
 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
Drawbacks 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
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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
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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