Monetary Policy Functions of the Bank of Canada 1) Sole issuer of currency Issues more currency to banks when needed and at other times, takes back any surpluses. 2) The government’s bank and manager of foreign currency reserves 3) The banke r’s bank and lender of last resort Commercial banks all have accounts with the Bank of Canada The B of C can make loans to banks experiencing liquidity problems 4) The auditor and inspector of comme rcial banks 5) The regulator of the money supply Expansionary Monetary Policy (easy money policy) a policy that aims to increase the amount of money in the economy and make credit cheaper and more easily available Contractionary Monetary Policy (tight money policy) a policy in which the amount of money in the economy is decreased and credit becomes harder to obtain and more expensive Tools of Monetary Policy 1) Open-market ope rations buying and selling government bonds in the open market Treasury bills are a type of bond or fixed-term debt. They can be bought for either three or six-month terms and they do not pay interest. Instead, the return is earned on them because they are purchased at a discount (at a price below the face value) but are then redeemed at the end of the fixed term at face value. If the B of C wishes to increase the money supply, it buys T-bills. The sellers of the T-bills would receive cheques from the B of C which they would deposit in their accounts at commercial banks. When the commercial banks cash in these cheques with the B of C, their accounts with the central bank are credited with the appropriate amounts. The resulting excess reserves can then be loaned out, thus leading to a multiple expansion of money in the economy. If the B of C wants to reduce the money supply, they would do the opposite and sell bonds (treasury bills). As such, people would have to make withdrawals from their commercial banks to make payment to the B of C. 2) A change in the bank rate The Bank Rate is the rate of interest payable by the commercial banks on loans from the Bank of Canada. The bank rate establishes the upper limit of a one-half point range for what is called the overnight loans rate. This is the rate at which major financial institutions borrow and lend one-day funds to each other. The upper limit is the rate at which the B of C will loan one- day funds to financial institutions, and the lower limit is the rate it will pay on one-day funds deposited by these same institutions. The commercial banks regard the bank rate as a penalty rate since they must pay it on all loans taken out from the B of C to cover temporary shortages of reserves. The entire interest rate structure moves in conjunction with the bank rate: - the prime rate is charged by commercial banks to their best customers (it’s just a little higher than the bank rate) - next is the mortgage rate - the highest interest rate is that charged on personal loans - the rates of interest paid on savings would be below the bank rate (highest would be on long-term deposits of large sums and smallest would be on small, short-term deposits) The supply of money and interest rates are closely linked; it is impossible to change one without at the same time changing the other. 3) Switching government deposits If the B of C wants to contract the money supply it can, with the approval of the ministry of Finance, transfer some of the government’s deposits from a commercial bank to the B of C. The affect on demand deposits and reserves is similar to that of open- market operations. 4) Moral Suasion The B of C informs the financial community, which is a small and fairly exclusive group, which direction it would like to go with its monetary policy. They usually comply. If the money supply is increased too much, the result will be demand-pull inflation. (Interest rates fall, investment spending increases, and aggregate demand increases. If AD increases beyond full employment, Real GDP would be unable to rise any further and the full impact of the increase in the money supply would be on the price level. ) If the money supply is not increased sufficiently, the result will be a recession and low economic growth. (An increase in Real GDP increases the demand for money . If the money supply does not increase, interest rates will increase. Investment spending falls and therefore AD. This may either halt or reverse economic growth in the economy. It may even lead to deflation.) The Pro-Active Approach to Monetary Policy 1) Keynesian Monetary Policy established in 1935 with a mandate to accomplish four separate goals: steady growth in Real GDP an exchange rate that ensures a viable balance of trade stable prices full employment No single policy tool can be used to simultaneously achieve 4 separate goals so the focus has been on stable prices and full employment. At the time it was believed that both problems could not exist at the same time. As such, policy would simply deal with the current problem. In the case of an inflationary gap, contractionary monetary policy is used (reducing the money supply and making credit tighter). Higher interest rates lower investment spending and also encourages foreigners to send their savings to Canada. The consequent increase in the demand for Canadian money in international money markets pushes up the exchange rate. As such, exports decrease. This compounds the effects from lower investment on AD and closes the inflationary gap. In the case of a recessionary gap, expansionary monetary policy is used (increasing the money supply and making credit more readily available). This has the opposite affect of that described above and closes the recessionary gap. Criticis ms: simultaneously curing both unemployment and inflation isn’t possible..... one tends to come at the expense of the other. the best the central bank can do is achieve a fine balance between the two. 2) Anti-Inflationary Monetary Policy the B of C now sees its role as preserving both internal and external value of the currency For the last eight years, the B of C has set a target inflation rate of 1 – 3% Uncertainty regarding future levels of inflation is the largest hindrance to investment spending To deal with inflationary pressures, the B of C would maintain a tight monetary policy. Higher interest rates discourage borrowing and capital spending and therefore dampen inflationary pressures. However, they also encourage foreigners to hold Canadian securities which increases the demand for the Canadian dollar and its value appreciates on the international market. Consequently, exports will decrease and imports will increase. This furthers the efforts of a tight monetary policy. Therefore, monetary policy is an effective anti- inflation tool under flexible exchange rates. However, it is not when exchange rates are fixed. In an attempt to maintain the pegged value of the dollar, the B of C ends up working against its own monetary policy strategy. Criticis ms: because the B of C is overly concerned about inflation, it may lose sight of other equally valid goals like economic growth and unemployment. some people argue that there is a significant lag before a change in the reserves of the banking system translates into a change in the amount of loans. finally, some people are against pro-active monetary policy of any kind and believe such decisions should not be left to the B of C. The Neutralist School Proponents of this philosophy believe that monetary policy is too powerful and that the central bank should be restricted to following certain established rules. They believe the B of C should focus on ensuring the quantity of money demanded remains equal to the quantity of money supplied. This implies a constant interest rate. Money demand (transactions demand) increases as Real GDP increases. Therefore, neutralists feel that each of these increases in money demand should be matched with equal increase in money supply so that interest rates remain at a pre-determined level. They also believe this pre- determined level should be announced to the world. Another variation of the neutralist school is that the B of C should have a pre-announced pace of monetary expansion and have the interest rate adjust to maintain a balance between money demand and money supply. Criticis ms: Some economists argue that stability in money markets might lead to instability in the economy. even if growth in money supply is fixed, uncontrollable changes in money demand will cause interest rates to change unpredictably. a fixed interest rate may be good in times of recession but the same level would not be so good in times of rapid expansion. Beyond Fiscal and Monetary Policy In 1973, OPEC put quotas on the amount of crude oil being exported from member countries. This quadrupled the price of crude oil on world markets and therefore caused an increase in the costs of production of most goods and services around the world. As a result, there was a decrease in short-run aggregate supply. LAS SAS2 SAS1 Price Level P2 P1 Y2 Y1 Real GDP As can be seen from the diagram above, the result was stagflation: the simultaneous occurrence of high inflation and unemployment. Economists were completely unprepared for this and found they could not deal with both problems at the same time using traditional monetary or fiscal policy tools. Direct Controls These are specific laws, rules and regulations designed to modify the way people behave. These controls tend to have an impact on the supply side of the market, but may also effect demand. 1) Tax Incentive Programs any tax changes that help stimulate people’s incentives to work and save, and businesses to invest more. Examples include reductions in personal and corporate income taxes, decreases in capital gains taxes, changes to allow bigger depreciation allowances and bigger write-offs for spending on research. 2) Pro-competition Policies these are aimed at loosening the power of big corporations and trade unions in order to make the marketplace more competitive and enable it to more easily and rapidly adjust to the changing pattern of demand and technology. Examples include anti-monopoly or anti-combine legislation, increased deregulation of industry, the privatization of government services and free trade between countries. 3) Employme nt Policies these include policies designed to increase the amount of employment and to reduce the natural rate of unemployment. Examples include improved job retraining and allowances to help workers relocate, a better system of making unemployed people aware of job and career prospects through better information, and legislation to promote equality of job opportunities and the outlawing of any type of discrimination in the workplace.
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