Chapter 14
Monetary Policy and the Bank of
Canada
Economics 282
University of Alberta
Principles of Money Supply
Determination
• The supply of money is affected by three
groups of market participants:
– the central bank;
– depository institutions;
– the public.
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.
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.
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.
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.
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 interestearning loans.
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.
Fractional Reserve Banking
(continued)
BASE
M  DEP 
res
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
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.
The Money Supply
• The central bank may control the
monetary base but it does not directly
control the money supply.
M  CU  DEP
BASE  CU  RES
M
CU  DEP

BASE CU  RES
CU is currency
The Money Supply (continued)
M
(CU/DEP)  1

BASE (CU/DEP)  (RES/DEP)
• CU/DEP (cu) is the currency-deposit ratio,
the decision of public
• RES/DEP (res) is the reserve-deposit
ratio, the decision of banks
The Money Supply (continued)
 cu  1 
M 
 BASE
 cu  res 
• The money supply is the multiple of the
monetary base.
• The money multiplier decreases when
either cu or res increases.
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.
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.
Monetary Control in Canada
• In fact the Bank of Canada is independent
from the government.
• It is the only institution in control of shortterm monetary policy.
The Bank of Canada’s Balance
Sheet
• The Bank’s largest asset is its holdings of
government securities.
• The largest liability of the Bank is currency
in circulation.
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.
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.
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.
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.
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.
Overnight Rates (continued)
• A lower target for the overnight interest
rate leads to increase in asset advances to
the banks, the monetary base expansion
and an increase in money supply.
• The money supply and interest rates move
in opposite directions.
Overnight Rates (continued)
• Most often bank s 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.
Tools of Monetary Policy: Open
Market Operations
• To increase the money supply the Bank
could conduct an open-market purchase
from the public.
Open Market Operations
(continued)
• The value of the overnight interest rate by
buying/selling its securities using Special
Purchase and Resale Agreements (SPRA)
and Sale and Repurchase Agreements
(SRA).
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.
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.
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.
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.
Intermediate Targets
(continued)
• The Bank could reduce the instability
caused by nominal shocks by using
monetary policy to hold the interest rate
constant.
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.
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
until about six months. Prices respond
even more slowly.
Lags in the Effects of Monetary
Policy (continued)
• Te Bank’s policy decisions should be
based on forecasts what the economy will
be doing six months to two years in the
future.
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).
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.
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.
The Conduct of Monetary
Policy: Discretion
• Keynesians believe that monetary policy
can and should be used to smooth the
business cycle.
• So, the Bank should use its policy
discretion to best achieve its goals.
The Conduct of Monetary
Policy: Rules
• Monetarists and classical economists are
supporters of the rules, or automatic
monetary policy.
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.
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.
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.
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.
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 asks business to hold P constant for
this period.
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.
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.
Rules, Commitment and
Credibility (continued)
• Keynesians argue, establishing a rule
ironclad enough to create credibility, by
eliminating policy flexibility, also create
unacceptable risks.
Other Ways to Achieve Central
Bank Credibility
• Appointing a “tough” central banker.
• Changing central banker’s incentives.
• Increasing central bank independence.
End of Chapter