1010 Class 8B: The Bank of Canada and The Coyne Affair

1. 1010 Class 8B: The Bank of Canada and The Coyne Affair

2. Class 8B:Canada Expands • Outcomes Expected • Able to discuss the Importance of Bank of Canada • Able to discuss the framework of how the Financial System Works • Able to discuss the differences and roles of Fiscal and Monetary Policy • Difference Between Bank of Canada and US Federal Reserve • Group Assignment

3. Bank of Canada Created in 1934 as a private bank and in 1938 became a Federal Crown Corporation. The responsibilities of the Bank are: monetary policy; sole issuer of Canadian banknotes and currency, the promotion of a safe, sound financial system within Canada; and funds management and central banking services "for the federal government, the Bank and other clients.

4. Bank of Canada History The Bank of Canada Act received Royal Assent on 3 July 1934; the Bank began operations on 11 March 1935 and issued its first bank notes. Since then the Bank has issued five more series of bank notes, with the next to be launched in 2011. The Bank of Canada began as a privately-owned institution, with shares sold to the public at a par value of $50. In 1938, all shares were purchased by the Government of Canada and the Bank became a Crown corporation.

5. Bank of Canada History During World War II, the Bank of Canada's nine victory Bond campaigns raised almost $12 billion for the war effort. After the war, the program was continued with Canada Savings Bonds. During World War II, vaults deep beneath the Bank of Canada's headquarters provided a safe haven for tons of gold secretly moved from European central banks.

6. Bank of Canada History The Canadian dollar was allowed to float on currency markets (rather than being pegged to the US dollar) in September 1950. The dollar's exchange rate was fixed again from 1962 to 1970; it has floated ever since. In the mid-1950s, the Bank began to develop a market for government bills and bonds in Canada.

7. Bank of Canada History In 1961, a fundamental disagreement between the then-Governor of the Bank, James Coyne, and Finance Minister Donald Fleming led to Parlia-mentary debates and hearings and Coyne's eventual resignation. The "Coyne affair" led to an amendment to the Bank of Canada Act in 1967 enshrining the Bank's operational independence and creating a mechanism for resolving policy disagreements between the government and the Bank.

8. Bank of Canada History In February 1991, the Bank and the federal government introduced targets aimed at reducing inflation to 3 per cent by late 1992 and 2 per cent by late 1995. The 2 per cent target was achieved more quickly than expected and the inflation-targeting agreement has been renewed four times.

9. Bank of Canada History The Bank's Governing Council was created in 1994 to take collective responsibility for monetary policy decisions. Starting in December 2000, the Bank began making interest rate announcements on eight pre-specified dates per year.

10. Monetary Policy In any currency there is a supply of money, and an interest rate, the price at which money can be borrowed. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation and unemployment. In Canada, monetary policy is the responsibility of the Bank of Canada, a federal crown corporation that implements its policy decisions largely through its ability to alter the Canadian money supply.

11. Interest Rate Refers to the cost of money Higher rates discourage both investment and consumption Timing is crucial in monetary policy 4-6 quarters before monetary policy takes effect

12. Overnight Interest Rate • This is the rate that banks use to borrow and lend to each other in short term transactions. • Each day, banks have numerous business transactions. At the end of the day, depending on the day’s activity, they may end up with a surplus or a deficit. • Banks with surpluses lend to those that have deficits. • The Bank of Canada sets this target once a month, with a +/- difference of 0.25%.

13. Overnight Interest Rate • The Overnight Rate is directly tied to the liquidity of the economy; i.e. the more money available in the economy, the lower the rate is. • Liquidity is the access to cash or credit. • The Overnight Rate ends up affecting the entire spectrum of interest rates: • The lowered overnight rate increases the demand for credit. • Banks give out more credit. • The reverse is also true.

14. Increasing Credit Levels • The more credit available, the more financial transactions occur for goods and services. • The more that people are buying, the more physical money is needed. • Banks buy new bank notes off of the Bank of Canada by selling government securities. • These securities are assets for the government; bank notes in circulation are liabilities.

15. Inflation • General rise in prices • Measured by an index with constant basket of goods • Cause: • Excessive growth of the money supply • Growing faster than real economic growth • Excess money growth lowers the value of outstanding money • Overly strong demand vs supply

16. Inflation • Inflation is the rise in the cost of goods and services in the economy over a period of time. • If the cost of goods goes up faster than the rise in wages, the consumers buying power is less than it was previous. • High inflation is bad for the economy. • An excessive growth in money supply can cause inflation. If money supply occurs faster than economic growth, inflation will result.

17. Battle Against Inflation Inflation: Weakens currency Hard on people on fixed incomes Leads to market inefficiency Discourages long-term financing Removing inflation from economy is very painful Lag between decrease in inflation and decrease in interest rates Investment and consumption do not recover immediately Need to raise taxes, reduce government spending Inflation in Canada very low

18. Milton Freidman (1912-2006) • Expansion of money supply leads to inflation; governments should focus on price stability. • Felt that changes to real wages and real interest rates initially generated by monetary policy are offset by market adjustment in response to excess supply or demand. • His views on monetary policy, taxation, privatization and deregulation formed the policy of many neo-conservative governments.

19. Fiscal Policy • Fiscal Policy refers to the federal government's use of its annual budget. • The budget strategy can also influence the achievement of the government's objectives of internal and external balance and economic growth. • The two main instruments of fiscal policy are: • government spending • Taxation • Changes in the level and composition of taxation and government spending can impact • Aggregate demand and the level of economic activity • The pattern of resource allocation • The distribution of income.

20. Canada’s Financial Institutions The Canadian financial services sector is made up of banks, trust and loan companies, credit unions and caisses populaires, life and health insurance companies, property and casualty (P&C) insurance companies, securities dealers and exchanges, mutual fund companies and distributors, finance and leasing companies, as well as independent financial advisors, pension fund managers and independent insurance agents and brokers. Banks represent the largest portion of the Canadian financial services sectorthe 6 largest Canadian banks still account for more than 90 per cent of total bank assets and for about 76 per cent of the total assets of the deposit-taking sector.

21. History of Banking • Banks have been around for thousands of years. • Such activities such as providing loans, taking deposits and changing money have been done at banks since ancient Greece. • The modern system of banking can be traced to Italy in the Middle Ages. International trade could not have occurred without the banks. • Knights Orders like the Templars and the Hospitallersacted as bankers to finance the Crusades. Money could be deposited at one of their castles and a note was given to be redeemed at another, eliminating the need to carry money with you.

22. To Debase a Currency • A coin is said to be debased if the quantity of gold, silver, copper or nickel is reduced. Fiat or paper money is debased when volume of money printed is greater than demand. • This reduces the value of paper money and causes monetary based inflation. In contrast to commodity money in which each coin is changed, fiat currency only requires electronic or physical printing to decrease it's value.

23. Rome • For example, the value of the denarius in Roman currency gradually decreased over time as the Roman government altered both the size and the silver content of the coin. Originally, the silver used was nearly pure, weighing about 4.5 grams. From time to time, this was reduced.

25. Ludwig Von Mises • “All people, however fanatical they may be in their zeal to disparage and to fight capitalism, implicitly pay homage to it by passionately clamoring for the products it turns out.”

26. Hyperinflation

27. German 50 Mark Note 1920

28. German 20 Billion Mark Note 1923

29. Frederick A. Hayek • Felt that any government intervention in the marketplace was the first step towards totalitarianism. • Limits on the the free market will ultimately results in limits on individual freedom. • Defended individual liberty and the free-market in an academic environment where collectivism had been more fashionable • Wrote The Road to Serfdom in the waning years of World War II.

30. Hyperinflation

31. History of Banking • Further developed in the Netherlands when goldsmiths would take in gold coins and issue notes based on the value of the coins. • People could also issue notes to others allowing them to be paid from their reserves. This was the birth of the cheque. • Because these notes were not all redeemed at the same time (and returned to the goldsmiths to receive the coins deposited with them), they would then in turn loan out the coins they had on reserve to make interest off of loans. • Fractional Reserve Banking was born.

32. Fractional Reserve System Fractional-reserve banking is a form of banking where banks maintain reserves (of cash and coin or deposits at the central bank) that are only a fraction of the customer's deposits. Funds deposited into a bank are mostly lent out, and a bank keeps only a fraction (called the reserve ratio) of the quantity of deposits as reserves. Some of the funds lent out are subsequently deposited with another bank, increasing deposits at that second bank and allowing further lending.

33. Fractional Reserve System

34. Fractional Reserve System

35. History of Banking • Any deposit you make at a bank is in a sense a loan to that bank that is repayable on demand. • This goes back to the Bank Act of 1871 where chartered banks were allowed to issue their own bank notes • This is why you earn interest on your bank accounts. • The bank then takes the money you have deposited and loans it out to others. • Bank profits are realized on the difference in interest they pay to you for depositing your money with them and the amount of interest they charge someone to borrow money from the bank. • It also allows the economy to grow to a much larger size

36. History of Banking • The problem with Fractional Reserve Banking is that if people lose faith in the bank and try to redeem their notes all at once, the bank is unable to pay. • This is because the actual wealth the bank controls is not stored in one physical location, but is dispersed throughout the various borrowers. • If everyone tries to get their money out at once, this situation is called a bank run.

37. The Bank Run • http://www.youtube.com/watch?v=qu2uJWSZkck

38. Breaking the Bank

39. The History of Banking • In order to protect from this type of occurrence, governments began to create central banks.

40. What is a central bank? • A central bank is a government created public institution that: • Issues currency • Regulates money supply • Controls interest rates • Has supervisory powers over the banking industry • Regulates them • Imposes reserve requirements • Acts as a lender-of-last-resort to mitigate things like bank runs • Is usually separate from government to protect it from political interference

41. Issuing currency • Money has a long history as a means of exchange. The value of money was formerly tied to the value of the metal it was made out of (i.e. copper, silver or gold). • Paper notes eventually replaced coinage as the main source of money, mainly because the weight of coins made them cumbersome for usage when large amounts of money were required. • Currently, the central bank holds assets (foreign exchange, gold or other valuable assets). • Based on the value of these assets, and on the sale of bonds to the public, currency notes are issued.

42. Money Supply • Money supply is the total amount of money available in the economy. • Money supply data is recorded at the central bank. • This can be modified by purchasing financial assets or lending money to financial institutions. • Commercial banks then increase this through fractional reserve banking.

43. Fractional Reserve Banking • Banks maintain a portion (fraction) of their total customer’s deposits at the central bank in the form of a reserve. • The central bank requires that banks keep a minimum amount in reserve, to cover the normal demand for withdrawals. • The central bank oversees the activities of the commercial banks, provides deposit insurance to consumers and acts as a lender of last resort to commercial banks to bail them out in a time of crisis.

44. The Bank of Canada • Canada followed the British banking system, with a limited number of larger banks with multiple branches. • In the US independent local banks was the norm. • With our relatively small population spread out in rural centres, the British model made more sense: • Branch banks required less capital than a full independent bank.

45. The Bank of Canada • The branch banking system lead for a very stable banking system since the branches spread the risk around the country. • There was little need for a lender of last resort: • In the US, with its small banks they would often find themselves with seasonal cash flow problems, and a central bank (the United States Federal Reserve) was a necessity.

46. The US Federal Reserve System • The US Federal Reserve System (The Fed)was set up in 1913. • The Fed was set up in part due to a financial crisis in 1907 (called the Panic of 1907). • The New York Stock Exchange fell 50% in trading. • Bank runs were numerous. • Many regional banks had invested money in the larger NYC banks. When they started to struggle the smaller banks joined the bank runs. • Many regional banks and businesses declared bankruptcy. • New York financiers (led my JP Morgan) invested their own money to keep the banking system from collapsing. • A central bank was needed to prevent this from happening in the future.

47. The US Federal Reserve System • Duties of the US Federal Reserve: • maintain employment • keep prices stable • keep interest rates at a moderate level by regulating monetary policy • supervise banks • provide financial services • conduct research on the United States economy and the economies in the surrounding region

48. The US Federal Reserve System • The Board of Governors is appointed by the President. • It has both private and public components. • It is independent from government; its policy decisions do not have to be approved by the President or Congress. http://www.archive.org/details/gov.frb.pa.today

49. Canada vs US Banking System

50. US Federal Reserve and the current crisis • The Fed is accused of keeping interest rates artificially low after the 2001 recession. • This made borrowers reckless, and helped create the housing bubble as people drove up housing prices driven by easy access to credit. • That it was ineffective in its oversight of the banks and their activities which contributed to the crisis. • That they are creating too much money, which in turn is driving down the value of the US dollar.