Chapter 10
Central Banking & Monetary
Policy
MACROECONOMICS BY CURTIS,
IRVINE, AND BEGG
SECOND CANADIAN EDITION
MCGRAW-HILL RYERSON, © 2010
Learning Outcomes
2
This chapter explains:
 Central banking and the Bank of Canada
 Central banking operating techniques to control




money supply and interest rates
Monetary policy targets and instruments in
Canada
Monetary policy rules
The long-run neutrality of money
Monetary policy indicators
Chapter 10
©2010 McGraw-Hill Ryerson Ltd.
Central Banking and the Bank of Canada
3
A central bank conducts monetary policy
Monetary policy is:
Central bank action to:
∆AD & economic performance using its power to:
∆M or ∆i or ∆er (cannot do all changes simultaneously)
∆AD ∆Y + ∆Employment + ∆P
Central bank balance sheet illustrates operations
Chapter 10.1
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The Balance Sheet of the Bank of Canada, 2007
(year-end, millions of dollars)
4
Assets
Liabilities
Government of Canada Securities
Treasury bills
Government bonds of maturity
<= 3 years
> 3 years
Advances to members of the
Canadian Payment Association
Securities from Resale Agreements
Foreign currency deposits
Other assets
Total
Chapter 10.1
Notes in circulation
20,281
11,091
18,269
50,565
Deposits
Government of Canada
1,970
Chartered banks and other members 502
Canadian Payment Association
Foreign central banks
143
1
3,963
3
289
53,897
Foreign currency liabilities
Other liabilities
Total
717
53,897
©2010 McGraw-Hill Ryerson Ltd.
Central Banking and the Bank of Canada
5
 Central bank:
Is the source of monetary base, H
 Creates H by buying bonds & issuing central bank
liabilities (notes & central bank deposits)
 Bank of Canada:
 Govt bonds = 90+% of assets
 Notes in circulation = 90+% of liabilities
 Bank of Canada:
 Also promotes stability in financial markets
 E.g. “purchase and resale agreements” to provide liquidity
when needed.

Chapter 10.1
©2010 McGraw-Hill Ryerson Ltd.
Central Bank Operating Techniques
6
Three main techniques to control Monetary Base (H) &
Money supply
1.
Establishing reserve requirements
–
–
2.
Using open-market operations
–
–
3.
Main technique: buy or sell govt bonds
Determines monetary base (H) in money supply function
Setting the bank rate
–
–
Chapter 10.2
Legally Required Reserve Ratio (rr = rr*)
Determines money multiplier in money supply function
Sets cost of borrowing monetary base
Signals monetary policy change
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Open Market Operations
7
 Central bank purchase or sale of govt bonds in
financial market:


Open market purchase  ↑assets & ↑liabilities ↑monetary
base (H)
Open market sale ↓assets & ↓liabilities  ↓monetary base
(H)
 Open market operations: main instrument for longer
term management of monetary base (H)
Chapter 10.2
©2010 McGraw-Hill Ryerson Ltd.
An Open-Market Purchase and the Money Supply
8
Central Bank
Assets
Commercial Banks
Liabilities
Assets
Liabilities
1. Open-market purchase: $100 million govt bonds from pension fund
Govt bond +100 Cheque
+100
No change
2. Pension fund deposits proceeds of bond sale in a commercial bank
No change
Central bank
Pension fund
cheque
+100 deposit acct +100
3. Central bank cheque clears giving commercial banks $100 million cash
No change
Cheque o/s -100 Central bank
cheque
No change
-100
Cash issued +100 Cash
reserves
Chapter 10.2
+100
If rr = 0.05,
excess reserves +95
©2010 McGraw-Hill Ryerson Ltd.
An Open-Market Purchase and the Money Supply
9
Central Bank
Assets
Liabilities
Commercial Banks
Assets
Liabilities
4. Commercial banks increase lending and create new deposits
No change
Loans
+1900 Deposits
+1900
5. Final effect of central bank open market purchase
Govt bond +100 Cash (ΔH) +100
Cash reserves +100
Loans
+1900
+2000
Deposits +2000
6. Change in Money Supply
ΔM = ΔH/rr = $100/0.05 = $2,000
Chapter 10.2
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Money Supply Control vs Interest Rate Control
10

Chapter 10.2
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Money Supply Control or Interest Rate Control
11
Interest Rate i
M0/P
i1
A money supply fixed by
the central bank results in
an interest rate determined
by the money market
∆i
∆L ∆i
i0
∆L
L(Y1)
L(Y0)
M0/P
Chapter 10.2
M/P
©2010 McGraw-Hill Ryerson Ltd.
Money Supply Control or Interest Rate Control
12
Interest Rate i
An interest rate fixed
by the central bank
results in a money
supply set by the money
market.
∆L
∆L  ∆M
i0
M/P
∆M
L(Y1)
L(Y0)
M0/P
Chapter 10.2
M1/P
M/P
©2010 McGraw-Hill Ryerson Ltd.
Monetary Policy Targets and Instruments in Canada
13
A central bank monetary policy targets:
- Three possible targets:



Control the foreign exchange rate, or
Control the money supply, or
Control the inflation rate
A central bank must choose:
- It can only pursue one of these targets at a
time.
Chapter 10.3
©2010 McGraw-Hill Ryerson Ltd.
Monetary Policy Targets
14
 Exchange rate target:
Central bank buys/sells foreign exchange to fix
the exchange rate.
Foreign exchange operations  ∆H, ∆M & ∆i
 Money supply target:
Central bank sets i & H to fix M
 Inflation target:
Central bank sets i & H  π* the target inflation rate.
Chapter 10.3
©2010 McGraw-Hill Ryerson Ltd.
Monetary Policy Targets & Instruments in Canada
15
Bank of Canada’s monetary policy target:
 An
inflation rate (π*) = 1% - 3% on the CPI
Bank of Canada’s monetary policy instrument:
 The

overnight interest rate (onr)
The overnight rate is the interest rate large financial
institutions receive or pay on loans of H from one
day until the next
Chapter 10.3
©2010 McGraw-Hill Ryerson Ltd.
Monetary Policy Targets & Instruments in Canada
16
Bank of Canada Operating Techniques:
 Set the overnight rate  AD required for
inflation target π*
 Set operating band for overnight rate = onr
+/- 25 basis points. (100 basis points = 1%)
 Overnight rate set by Bank drives commercial
bank prime rates and mortgage rates
Chapter 10.3
©2010 McGraw-Hill Ryerson Ltd.
Monetary Policy Targets & Instruments in Canada
17
A change in the Bank’s overnight rate setting:
 Changes
commercial bank lending rates
 Changes
costs of financing and lines of credit for
businesses and households
 Works
through the monetary transmission
mechanism to change AD  π = π*
Chapter 10.3
©2010 McGraw-Hill Ryerson Ltd.
The Bank of Canada’s Settings for Overnight Rates
18
Chapter 10.3
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The Overnight Rate, Prime Rate and 5-Year Mortgage Rate
19
Chapter 10.3
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Commercial Banks and the ONR
20
Commercial banks:
• Zero settlement balance in Bank of Canada requirement
• Settlement balance <0 must borrow:
• From other banks @ onr, or
• From Bank of Canada @ Bank Rate = onr + 25bp
• Settlement balance >0 may:
• Lend to other banks @ onr, or
• Hold in Bank of Canada @ Deposit Rate = onr – 25bp
• Settlement balance requirement + Bank Rate-Deposit Rate
spread market for overnight funds
Chapter 10.3
©2010 McGraw-Hill Ryerson Ltd.
Monetary Policy Targets and Instruments in Canada
21
Bank of Canada interventions to maintain ONR setting:
 To offset upward pressure on the rate:
SPRA: special purchase & resale agreement
Buy securities today, sell back tomorrow
Price difference  onr
Temporarily increases monetary base, H
 To offset downward pressure on the rate
SRA: sale and repurchase agreement
Sell securities today and buy back tomorrow
Price difference  onr
Temporarily reduces monetary base, H
Chapter 10.3
©2010 McGraw-Hill Ryerson Ltd.
Setting and Maintain the Overnight Rate
22
• Set overnight rate
target onr0
Interest Rate
MB0
• Short term increase in
demand for MB
• Upward pressure on
Overnight rate
• SPRA to offset the
upward pressure
• Temporary increase in
H  MB1
• SRA would offset
downward
pressure on
overnight rate.
Chapter 10.3
MB1
Bank Rate
Overnight
rate
onr0
Deposit
rate
SPRA
D1
D0
MB0
MB1
Monetary Base (H)
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Bank of Canada Special Purchase and Resale Agreements and Sale
and Repurchase Agreements (monthly averages of daily data)
23
Chapter 10.3
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Central Bank Interest Setting
24
 Central Bank policy target(s):
Pursue Y = YP or π = π*
 With constant equilibrium price level (π = 0):
 Policy Target is Y = YP
 Policy instrument is the interest rate
 Set interest rate based on knowledge of transmission
mechanism  AD  Y = YP
 ∆i to offset ∆A  stabilize AD  Y @ YP
Chapter 10.4
©2010 McGraw-Hill Ryerson Ltd.
Policy Rules for Setting Interest Rates
25
 A ‘Taylor Rule’:
Policy target: Y = YP
 Current conditions set i = i0  AD required for Y = YP,
 React to transitory ∆A by ∆i to stabilize AD
 React to fundamental ∆A with ∆setting for i0

 Then:



i  i0  b(Y  Y p )
If Y = YP  i = i0
If Y≠ Yp  ∆i = b(Y – YP)
∆A  ∆i0
Chapter 10.4
©2010 McGraw-Hill Ryerson Ltd.
A Simple Taylor Rule in a Diagram
26
A Taylor Rule in action: i = i0 + b(Y – YP)
Interest rate setting
Yp
i
Y & AE
AE
YP
Y=AE
AE’(i0)
i = i0 + b(Y – YP)
i2
i0
AE(i0)
AE’(i1)
b(Y2-YP)
A’(i0) ∆A
A’(i1)
A(i0)
∆A(i)
∆Y
∆Y
∆Y
450
Yp
Y2
Y
YP
Y2
Y
If ∆A is persistent then reset i0i = i1 + b(Y – YP) to keep Y = YP
Chapter 10.4
©2010 McGraw-Hill Ryerson Ltd.
Monetary Policy Rules with Inflation Target and
Output Targets
27
 Bank sets i to get π = π* & Y = YP
i  i0  a(   * )  b(Y  Y p )
 With π > 0 real interest rate (r = i - *) affects AD & Y
through transmission mechanism
 a and b indicate weights Bank gives to π* and YP targets
 (Y – YP) indicator of future ∆π
Chapter 10.4
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Monetary Policy for “Exceptional” Times
(Recession of 2008-2009)
28
Monetary policy in deep financial crisis & recession:
 Lowering i is first policy response
 i as policy instrument constrained by ‘zero’
 i cannot be < 0
 Additional policy instruments may be needed
 Bank of Canada lowered the overnight rate to 0.25% --
effectively zero.
 Federal Reserve lowered federal funds rate to 0.0 0.25%.
Chapter 10.4
©2010 McGraw-Hill Ryerson Ltd.
Monetary Policy for “Exceptional” Times
(Recession of 2008-2009)
29
 Further monetary policy actions:
 Moral suasion – assure financial markets of continuing
central bank support

Quantitative easing – increase financial market
liquidity by expanding central asset holdings 
putting more cash into the financial system

Credit easing – provide central bank liquidity to specific
markets by targeted purchases of assets from those
markets eg commercial paper and mortgage markets
Chapter 10.4
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Evidence of Quantitative Easing in the US
Currency Component of U.S. Money Supply 2005-2009
30
Chapter 10.4
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Evidence of increased liquidity in Canada:
The Currency Component of Money Supply in Canada
31
Chapter 10.4
©2010 McGraw-Hill Ryerson Ltd.
The Long-Run Neutrality of Money
32
Money is neutral if:
∆M has no effect on output or other real variables.
 The ‘Quantity Theory of Money’: MV = PY
 M ≡ money supply
 V ≡ velocity of circulation of money (1/k)
 P ≡ price level
 Y ≡ real GDP
 Assume V & Y constant in long run
 ∆M  ∆P but ∆Y = 0  money is neutral
 Monetary policy can change P & π but not YP
Chapter 10.5
©2010 McGraw-Hill Ryerson Ltd.
Monetary Policy Indicators
33
 Monetary policy indicators:

Indicate AD stimulus or restraint from monetary policy.
 Some monetary policy indicators:
Nominal & real interest rates
Exchange rates
Rates of growth of money aggregates ie M1+ & M2+
Money supply growth minus GDP growth
Chapter 10.6
©2010 McGraw-Hill Ryerson Ltd.
Chapter Summary
34
 Central banks operate to affect behaviour of commercial





banks and financial markets
Central banks have responsibility for monetary policy
The Bank of Canada is Canada’s central bank. It is the
source of the monetary base and acts as banker to banks
and government.
Bank of Canada conducts monetary policy using its
control of the monetary base and interest rate to pursue
economic and financial market stability.
Central banks have three main operating techniques:
reserve requirements, open-market operations,
and bank rate setting.
The Bank of Canada sets an inflation rate target and
uses the overnight interest rate as its policy
instrument.
Chapter 10
©2010 McGraw-Hill Ryerson Ltd.
Chapter Summary
35
 The Bank of Canada uses SPRAs and SRAs to maintain its






overnight rate setting
A monetary policy rule like a Taylor Rule for setting i
provides a useful description of central bank policy actions
Changes in the policy instrument (i) change AD through the
transmission mechanism
Quantitative easing: central bank securities purchases to
increase the monetary base and financial system liquidity
Credit easing: central bank purchases of assets to provide
liquidity to specific markets
In the short run fixed or sticky prices allow the central
bank to change real interest rates, AD and Y
In the long run, flexible prices mean money is neutral.
Chapter 10
©2010 McGraw-Hill Ryerson Ltd.