The Bank of Canada and Monetary Policy

The Bank of Canada and Monetary Policy

CHAPTER 13

THE BANK OF CANADA
AND MONETARY POLICY

CHAPTER OVERVIEW

The objectives and the mechanics of monetary policy are covered in this chapter. It is organized around seven major topics: (1) the balance sheet of the Bank of Canada; (2) the techniques of monetary policy; (3) a graphic restatement of monetary policy; (4) the cause–effect chain of monetary policy; (5) a survey of the advantages and disadvantages of monetary policy; (6) the dilemma of which targets should be the goal of monetary policy–interest rates or money supply; (7) the impact of monetary policy operating in an open world economy. Finally, there is a brief, but important, synopsis of mainstream theory and policies. The purpose of the concluding sections is to summarize all the macro theory developed so far and fit the pieces together as an integrated whole for students.

WHAT’S NEW

The early part of the chapter remains much the same, but the section previously titled “Effectiveness of Monetary Policy” has been reorganized and extensively revised. Its new title is “Monetary Policy in Action,” and it focuses on current issues and applications while still exposing students to the strengths and weaknesses of monetary policy.

The definition of the prime interest rate is changed. Instead of referring to it as the rate for the most creditworthy customers, it is now identified as a “benchmark” or “reference point” upon which many rates are set.

There is a new “Consider This” box titled “Asymmetry of Monetary Policy” to help illustrate the pushing on a string analogy.

INSTRUCTIONAL OBJECTIVES

After completing this chapter, students should be able to understand:

1. The main functions of the Bank of Canada.
2. The goals and tools of monetary policy.
3. The mechanism by which monetary policy affects GDP and the price level.
4. The effectiveness of monetary policy and its shortcomings.
5. About the effects of the international economy on the operation of monetary policy.

COMMENTS AND TEACHING SUGGESTIONS

1. Plan a visual demonstration of open market operations. The creation of new reserves in the banking system seems like a magician’s trick to most students, and the further expansion of the money supply through bank loans seems like just more smoke and mirrors. This is a good opportunity to get students involved through role playing. Assign individual students or small groups parts in the process: the Bank of Canada, several member banks, bank customers. Walk through several transactions to show how purchases by the Bank of Canada monetize Canadian government securities, putting dollars in the hands of bank customers. One economics teacher was well known on campus for vaulting to the top of his desk and throwing pennies to students to demonstrate money creation. Be sure to show the process in reverse as well.

2. The discussion of the Bank of Canada’s consolidated balance sheet is important. Demonstrate the changes that take place on the Bank of Canada’s balance sheet and the chartered bank’s balance sheets as open market operations are carried out. The quantitative controls merit considerable emphasis. Be sure to note how the text explains the relative significance of these quantitative controls, with focus on open market operations.

STUDENT STUMBLING BLOCKS

1. Open market operations are puzzling to students, who may not be familiar with bonds in the first place. Begin by a brief review of the federal government’s debt, which will convince them that there are billions of dollars’ worth of government bonds in existence. Convince students that the Bank of Canada has significant power to affect the money supply by buying or selling these securities. Also remind students that the Bank of Canada deals only in government bonds, not corporate stocks or bonds.

2. One memory tip suggested by a teacher is to tell students that when the Bank of Canada “sells” securities, that “soaks” up money, i.e., the money supply decreases. The link between “sell” and “soak” should be an easy one for students to remember. Likewise, the Bank of Canada’s “purchase” can be associated with “pump.”

LECTURE NOTES

I.Introduction to Monetary Policy

A.Reemphasize that the Bank of Canada formulates policy and implements policy.

B.The fundamental objective of monetary policy is to aid the economy in achieving fullemployment output with stable prices.

1.To do this, the Bank of Canada changes the nation’s money supply.

2.To change money supply, the Bank of Canada manipulates size of excess reserves held by banks.

C.Monetary policy has a very powerful impact on the economy.

II.Consolidated Balance Sheet of the Bank of Canada

A.The assets on the Bank of Canada’s balance sheet contain two major items.

1.Government of Canada securities.

2.Loans to chartered banks.

B.The liability side of the balance sheet contains three major items.

1.Chartered bank deposits held at Bank of Canada.

2.Government of Canada funds.

3.Bank of Canada Notes outstanding, our paper currency.

III.The Bank of Canada has Three Major “Tools” of Monetary Policy

A.Openmarket operations refer to the Bank of Canada’s buying and selling of government bonds.

B.Switching government of Canada deposits.

C. The overnight lending rate.

D.“Easy” monetary policy occurs when the Bank of Canada tries to increase money supply by expanding excess reserves in order to stimulate the economy.

E.“Tight” monetary policy occurs when Bank of Canada tries to decrease money supply by decreasing excess reserves in order to slow spending in the economy during an inflationary period

1. For several reasons, openmarket operations give the Bank of Canada most control of the two “tools.”

1. Openmarket operations are most important. This decision is flexible because securities can be bought or sold quickly and in great quantities. Reserves change quickly in response.

IV.Monetary Policy, Real GDP, and the Price Level: How Policy Affects the Economy

A.Causeeffect chain:

1.Money market impact is shown in Key Graph 13-2.

a.Demand for money is comprised of two parts.

i.Transactions demand is directly related to GDP.

ii.Asset demand is inversely related to interest rates, so total money demands is inversely related to interest rates.

b.Supply of money is assumed to be set by the Bank of Canada.

c.Interaction of supply and demand determines the market rate of interest, as seen in Figure 13-2(a).

d.Interest rate determines amount of investment businesses will be willing to make. Investment demand is inversely related to interest rates, as seen in Figure 13-2(b).

e.Effect of interest rate changes on level of investment is great because interest cost of large, long-term investment is sizable part of investment cost.

f.As investment rises or falls, equilibrium GDP rises or falls by a multiple amount, as seen in Figure 13-2(c).

2.Expansionary or easy money policy: The Bank of Canada takes steps to increase excess reserves, which lowers the interest rate and increases investment which, in turn, increases GDP by a multiple amount. (See Column 1, Table 13-2)

3.Contractionary or tight money policy is the reverse of an easy policy: Excess reserves fall, which raises interest rate, which decreases investment, which, in turn, decreases GDP by a multiple amount of the change in investment. (See Column 2, Table 13-2)

4.Aggregate supply and monetary policy:

1. Easy monetary policy may be inflationary if initial equilibrium is at or near full-employment.
2. If economy is below full-employment, easy monetary policy can shift aggregate demand and GDP toward full-employment equilibrium.
3. Likewise a tight monetary policy can reduce inflation if economy is near full-employment, but can make unemployment worse in a recession.

5.Try the Quick Quiz in Figure 13-2.

V.Monetary Policy in Action

A.Strengths of monetary policy:

1.It is speedier and more flexible than fiscal policy since the Bank of Canada can buy and sell securities daily.

2.It is less political. Bank of Canada Board members are isolated from political pressure.

B.Focus on the Overnight Loans Rate.

1.Currently the Bank of Canada communicates changes in monetary policy through changes in its target for the overnight loans rate.

2.The Bank of Canada does not set either the overnight loans rate or the prime interest rate; each is established by the interaction of lenders and borrowers, but rates generally follow the Fed funds rate.

3.The Bank of Canada acts through open market operations, selling bonds to raise interest rates and buying bonds to lower interest rates.

1. Shortcomings of monetary policy:

1.Control is weakening as technology makes it possible to shift from money assets to other types; also global finance gives nations less power.

2.Cyclical asymmetry may exist: a tight monetary policy works effectively to break inflation, but an easy monetary policy is not always as effective in stimulating the economy from recession.

3.The velocity of money (number of times the average dollar is spent in a year) may be unpredictable, especially in the short run and can offset the desired impact of changes in money supply. Tight money policy may cause people to spend faster; velocity rises.

4.CONSIDER THIS … Pushing on a String

Japan’s ineffective easy money policy illustrates the potential inability of monetary policy to bring an economy out of recession. While pulling on a string (tight money policy) is likely to move the attached object to its desired destination, pushing on a string is not.

5The impact on investment may be less than traditionally thought. Japan provides a good example. Despite interest rates of zero, investment spending remained low during the recession.

D.Currently the Bank of Canada communicates changes in monetary policy through changes in its target for the Bank of Canada overnight funds rate.

1.The Bank of Canada does not set either the Bank of Canada overnight funds rate or the prime rate; each is established by the interaction of lenders and borrowers, but rates generally follow the Bank of Canada funds rate.

2.The Bank of Canada acts through open market operations, selling bonds to raise interest rates and buying bonds to lower interest rates.

E.Monetary policy and the international economy:

1.Net export effect occurs when foreign financial investors respond to a change in interest rates.

a.Tight monetary policy and higher interest rates lead to appreciation of dollar value in foreign exchange markets; lower interest rates from an easy monetary policy will lead to dollar depreciation in foreign exchange markets.

b.When dollar appreciates, Canadian goods become more costly to foreigners, and this lowers demand for Canadian exports, which tends to lower GDP. This is the desired effect of a tight money policy. Conversely, an easy money policy leads to depreciation of dollar, greater demand for Canadian exports and higher GDP. This policy has the desired outcome for expanding GDP.

2.Monetary policy works to correct both trade balance and GDP problems together. An easy monetary policy leads to increased domestic spending and increased GDP, but it also leads to depreciated dollar and higher Canadian export demand, which enhances GDP and erases a trade deficit. The reverse is true for a tight monetary policy, which would tend to reduce net exports and worsen a trade deficit.

3.Table 13-2 illustrates these points.

VI.The Big Picture (see Key Graph, Figure 13-4) Shows Many Interrelationships

A.Fiscal and monetary policy are interrelated. The impact of an increase in government spending will depend on whether it is accommodated by monetary policy. For example, if government spending comes from money borrowed from the general public, it may be offset by a decline in private spending, but if the government borrows from the Bank of Canada or if the Bank of Canada increases the money supply, then the initial increase in government spending may not be counteracted by a decline in private spending.

1. Study Key Graph 13-4 and you will see that the levels of output, employment, income, and prices all result from the interaction of aggregate supply and aggregate demand. In particular, note the items shown in red that constitute, or are strongly influenced by, public policy.
2. Try the Quick Quiz in Figure 13-4.

VII. Last Word: The Taylor Rule: Could a Robot Replace the Bank of Canada?

1. Macroeconomist John Taylor of Stanford University calls for a new monetary rule that would institutionalize appropriate Bank of Canada policy responses to changes in real output and inflation.
2. Traditional “monetarist rule” is passive. It required the Bank of Canada to expand the money supply at a fixed annual rate regardless of economic conditions.
3. “Discretion” is associated with the opposite: an active monetary policy where the Bank of Canada changes the money supply and interest rates in response to changes in the economy or to prevent undesirable results.
4. Taylor’s policy proposal would dictate active monetary actions that are precisely defined. It combines monetarism and the more mainstream view.
5. Taylor’s rule has three parts.

1. If real GDP rises 1% above potential GDP, the Bank of Canada should raise the overnight loans rate by 0.5% relative to the current inflation rate.
2. If inflation is 1% above its target of 2%, the Bank of Canada should raise the overnight rate by 0.5% above the inflation rate.
3. If real GDP equals potential GDP and inflation is 2%, the overnight loans rate should be about 4%, implying real interest rate of 2%.

1. Taylor would retain the Bank of Canada’s power to override the rule, so a robot really couldn’t replace the Board. But a rule increases predictability and credibility.
2. Critics of the proposal see no reason for this rule given the success of monetary policy in the past decade.

ANSWERS TO END-OF-CHAPTER QUESTIONS

13-1Use chartered bank and Bank of Canada balance sheets to demonstrate the impact of the following transactions on chartered bank reserves: (a) The Bank of Canada purchases securities from dealers, (b) The Bank of Canada makes an advance to a chartered bank.

(a)It is assumed the Bank of Canada buys $2 billion worth of securities. This increases demand deposits and chartered bank reserves by $2 billion. With demand deposits of $202 billion, desired reserves are $40.4 billion, (= 20 percent of $202 billion). Therefore, excess reserves are $1.6 billion (= $42 billion – $40.4 billion) and the banking system can increase the money supply (by making loans) by $8 billion more (= $1.6 billion  5).

(b)It is assumed the chartered banks borrow $1 billion from the Bank of Canada. The chartered banks may now increase the money supply (through making loans) by $5 billion (= $1 billion  5).

Consolidated Balance Sheet:

All Chartered Banks (billions of dollars)

a / b
Assets:
Reserves
Securities
Loans
Liabilities and net worth:
Demand deposits
Advances from the Bank of Canada / $ 40
60
102
200
2 / $ 42
60
102
202
2 / $ 41
60
102
200
3

Consolidated Balance Sheet:

All Chartered Banks (billions of dollars)

a / b
Assets:
Securities
Loans to chartered banks
Liabilities and net worth:
Reserves of chartered banks
Government deposits
Bank of Canada Notes
Other liabilities and net worth / $283
2
40
5
225
15 / $285
2
42
5
225
15 / $283
3
41
5
225
15

13-2(Key Question) In the table below you will find simplified consolidated balance sheets for the chartered banking system and the Bank of Canada. Use columns 1 and 2 to indicate how the balance sheets would read after each transaction in (a) and (b) is completed. Do not accumulate your answers; analyze each transaction separately, starting in each case from the figures provided. All accounts are in billions of dollars.

a.A decline in the bank rate prompts chartered banks to borrow an additional $1 billion from the Bank of Canada. Show the new balance-sheet figures in column 1 of each table.

b.The Bank of Canada sells $3 billion in securities to members of the public, who pay for the bonds with cheques. Show the new balance-sheet figures in column 2 of each table.

c.The Bank of Canada buys $2 billion of securities from the chartered banks. Show the new balancesheet figures in column 3 of each table.

d.Now review each of the above three transactions, asking yourself these three questions: (1) What change, if any, took place in the money supply as a direct and immediate result of each transaction? (2) What increase or decrease in chartered banks’ reserves took place in each transaction? (3) Assuming a desired reserve ratio of 20 percent, what change in the moneycreating potential of the commercial banking system occurred as a result of each transaction?

CONSOLIDATED BALANCE SHEET: ALL CHARTERED BANKS
(1) / (2) / (3)
Assets:
Reserves
Securities
Loans
Liabilities:
Demand deposits
Advances from Bank of Canada / $ 33
60
60
150
3 / _____
_____
_____
_____
_____ / _____
_____
_____
_____
_____ / _____
_____
_____
_____
_____
CONSOLIDATED BALANCE SHEET: BANK OF CANADA
(1) / (2) / (3)
Assets:
Securities
Advances to chartered banks
Liabilities:
Reserves of chartered banks
Government of Canada deposits
Notes in circulation / $60
3
$33
3
27 / _____
_____
_____
_____
_____ / _____
_____
_____
_____
_____ / _____
_____
_____
_____
_____

(a)Column (1) data (top to bottom): Chartered Bank Assets: $34, 60, 60; Liabilities: $150, 4; Bank of Canada Assets: $60, 4; Liabilities: $34, 3, 27.

(b)Column (2) data (top to bottom): Chartered Bank Assets: $30, 60, 60; Liabilities: $147, 3; Bank of Canada Assets: $57, 3, 30, 3, 27.

(c)Column (3) data (top to bottom): $35; $58; $60; $150; $3; Bank of Canada: $62; $3; $35; $3; $27.

(d)(d1) Money supply (demand deposits) directly changes only in (b), where it decreases by $3 billion; (d2) See balance sheets; (d3) Money-creating potential of the banking system increases by $5 billion in (a); decreases by $12 billion in (b) (not by $15 billion—the writing of $3 billion of cheques by the public to buy bonds reduces demand deposits by $3 billion, thus freeing $0.6 billion of reserves. Three billion dollars minus $0.6 billion equals $2.4 billion of reduced reserves, and this multiplied by the monetary multiplier of 5 equals $12 billion); and increases by $10 billion in (c).

13-3(Key Question) Suppose you are the governor of the Bank of Canada. The economy is experiencing a sharp and prolonged inflationary trend. What changes in (a) open-market operations and (b) switching government deposits would you consider? Explain in each case how the change you advocate would affect chartered bank cash reserves and influence the money supply.