MONETARY POLICY

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MONETARY POLICY
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The Bank of Canada

• Canada's central bank
• supervises financial institutions, conducts
  monetary policy

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Monetary Policy

• Goal is to protect value of Canadian money
• involves the Bank of Canada changing interest
  rates to control inflation and stabilize the
  economy (smooth out the business cycle)

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Central Banks

• independent central bank
• determines monetary policy with no government
  interference
• subordinate central bank
• must follow government directions, but can still
  have significant power
• Bank of Canada

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The Bank of Canada

• Bank of Canada balance sheet shows
• Liabilities
• Bank of Canada notes (currency)
• deposits (reserves) of chartered banks
• government deposits
• assets
• government securities
• loans to banks

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Bank of Canadas Balance Sheet, March 1999

• Assets Liabilities
• (billions of dollars) (billions of dollars)

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Bank of Canadas Functions

• Act as Federal Governments Fiscal Agent
• Financial advisor
• Administers the govt.'s accounts
• Manages foreign exchange
• Debt managememt
• Provides advise on , and manages domestic
  borrowing

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Bank of Canadas Functions

• Bank Note Issue
• Design, production, distribution and destruction
  of bank notes

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Bank of Canadas Functions

• Central Banking Services
• Act as the bankers bank
• Holds deposits of financial institutions
• Lends money to financial institutions at the bank
  rate
• Lender of last resort
• Overnight loans

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Canadian Payments System

• Clearing
• Payment orders (cheques, debit cards, automatic
  bill payments) are transmitted between financial
  institutions
• Calculate the the days gross or net positions
  for each financial institution
• Settlement
• banks use funds on deposit with BOC to fulfill
  obligations to other banks
• Same procedure also used for securities,
  derivatives, FX items

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BOC and Overnight Loans

• BOC is ultimate source of liquid funds in
  payments system
• Lends money overnight to financial institutions
  unable to cover obligations on a given day

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Bank of Canadas Functions

• Monetary Policy
• Implements monetary policy
• Provides economic analysis to assist in
  determining policy
• Monetary Policy Objectives
• Monetary Policy Indicators
• Monetary Policy Tools

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Overnight Loans Rate

• Operating Band
• 50 basis point range (0.5) including rates the
  BOC charges on loans and deposits from and to
  financial institution
• Overnight Rate
• Rate at which major participants in money market
  borrow and lend funds to each other

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Overnight Loans Rate

• Bank Rate
• The minimum rate the Bank of Canada will lend to
  banks (for short-term)
• The upper limit of the operating band for the
  overnight rate
• Overnight Rate Target
• BOCs official rate (key policy rate)
• The middle of the operating band
• Sets trend for short-term interest rates

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Overnight Loans Rate
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Overnight Loans Rate

• Changing the Overnight Rate Target
• changing the rate at which the banks can borrow
  from the B of C will change the rate that the
  banks charge us
• changes in bank rate also signals where monetary
  policy is headed
• Bank rate is announced 8 times a year, following
  release of important economic stats (GDP)

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Overnight Loans Rate and Interest Rates
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Monetary Policy Tools

• Required Reserve Ratio
• Changing required reserve ratio changes the
  amount of lending the banks can do
• Bank Rate and Bankers Deposit Rate
• Act as ceiling (bank rate) and floor (deposit
  rate) for overnight rate

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Monetary Policy Tools

• Government Deposit Shifting
• Moving money from BOC accounts to accounts at
  chartered banks
• Affects reserves at chartered banks
• No affect on money supply (govt. deposits are not
  counted as money
• Small scale

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Monetary Policy Tools

• Open Market Operations
• Buying and selling govt. securities to change the
  monetary base
• Affects chartered banks reserves, lending,
  quantity of money and interest rates

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BOC Buys Securities in the Open Market
(a) The Bank of Canada buys securities from a
chartered bank
Reserves of Toronto Dominion Bank
The Bank of Canada buys securities from a bank...
and pays for the securities by increasing the
reserves of the bank
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BOC Buys Securities in the Open Market
(b) The Bank of Canada buys securities from the
public
The Bank of Canada Assets Liabilities
Reserves of Toronto Dominion Bank
The Bank of Canada buys securities from London
Life, a member of the public...
London Life Assets Liabilities
and pays for the securities by writing a cheque
that is deposited to London Lifes account at the
Toronto Dominion Bank and that increases the
reserves of the bank
Deposits at the Toronto Dominion Bank
The Toronto Dominion Bank Assets Liabilities
London Lifes Deposit
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Money Multiplier

• The money multiplier is the amount by which a
  change in the monetary base is multiplied to
  determine the resulting change in the quantity of
  money.

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The Money Multiplier

• The events that follow from an open market
  purchase of securities by the Bank of Canada are
• 1. Banks have excess reserves.
• 2. Banks lend excess reserves.
• 3. Bank deposits increase.
• 4. The quantity of money increases.
• (cont.)

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The Money Multiplier
5. New money is used to make payments. 6. Some
of the new money remains on deposit. 7. Some of
the new money is a currency drain. 8. Desired
reserves increase because deposits have
increased. 9. Excess reserves decrease, but
remain positive.
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The Multiplier Effect of an Open Market Operation
The Running Tally
The Sequence
Reserves Deposits Currency Money
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Effects of Monetary Policy
Expansionary Policy
Contractionary Policy
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Interest Rate Changes
r
MS0
5
MD
1
0
500
Real money
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Effects of Monetary Policy
Expansionary Policy
Contractionary Policy
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Effects of Monetary Policy
Expansionary Policy
Contractionary Policy
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Expansionary Monetary Policy to Lower Unemployment
LAS
140
130
Price level (GDP deflator, 1997100)
SAS
120
110
105
100
90
AD0
950
750
700
800
850
900
Real GDP (billions of 1997 dollars)
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Contractionary Monetary Policy to Lower Inflation
LAS
140
130
Price level (GDP deflator, 1997100)
125
SAS0
120
115
110
100
AD0
90
950
750
700
800
850
900
Real GDP (billions of 1997 dollars)
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Overnight Loans Rates
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Benefits of Monetary Policy

• separation from day-to-day politics

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Drawbacks of Monetary Policy

• Weakness as expansionary tool
• Lack of regional impact
• Time lag

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Monetary Base and the Interest Rate
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Money Target Versus Interest Rate Target
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MS
7
Fluctuations in the demand for money bring
fluctuations in the interest rate
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5
Interest rate (percent per year)
4
3
2
MDA
1
0
600
Real money (billions of 1997 dollars)
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Money Target Versus Interest Rate Target
MSA
8
7
Fluctuations in the demand for money bring
fluctuations in the supply of money
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Interest rate (percent per year)
Target Rate
5
4
3
MDA
0
590
600
610
Real money (billions of 1997 dollars)
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The Interest Rate and the Dollar
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Interest Rates and Real GDP Growth