The Bank of Canada and Monetary Policy

The Bank of Canada and Monetary Policy Chapter 14 Instructor Shan A. Garib, Fall 2012

14.1 The Bank of Canada • A central bank is an institution that oversees and regulates the banking system and controls the monetary base. • The BoC is a central bank—an institution that oversees and regulates the banking system, and controls the monetary base.

14.2 The Tools of Monetary Policy • The most important job of the BoC is to control the rate of growth of the money supply • This effort focuses on the reserves held by financial institutions • The most important policy tool to do this is open-market operations

How Open-Market Operations Work • Open-Market operations are the buying and selling of CAN government securities/bonds • CAN. government securities are Treasury bills, notes, certificates, and bonds • The Fed buys and sells securities that have already been marketed by the Treasury • The total value of all outstanding CAN government securities is more than $1.0 trillion. This is our national debt • What open market operations consist of, then, is the buying and selling of chunks of the national debt

How the Fed Increases the Money Supply The CAN buys CAN Government Securities The BOC writes a check for, say, $100 million (this is money created out of nothing) Securities Firm RD + $100 DD + $100 ReqRes - 10 ExcessRes+90 The multiplier would be 10 10 X 90 million = 900 million loans to earn interest RD redeposit BoC deposit DD drawn down Assume 10% RR

How the Fed Increases the Money Supply The CAN buys CAN Government Securities The Fed writes a check for, say, $100 million (this is money created out of nothing) Securities Firm Interest Paid IR = RD + $100 DD + $100 Price of Bond RR - 10 ER + 90 If the Fed goes on a buying spree, it will quickly drive up the prices of CAN. government securities Assume 10% RR

How the Fed Increases the Money Supply The CAN buys CAN Government Securities The Fed writes a check for, say, $100 million (this is money created out of nothing) Securities Firm $80 IR = RD + $100 DD + $100 $1000 RR - 10 ER + 90 If the Fed goes on a buying spree, it will quickly drive up the prices of CAN. government securities Assume 10% RR

How the Fed Increases the Money Supply The CAN buys CAN Government Securities The Fed writes a check for, say, $100 million (this is money created out of nothing) Securities Firm $80 = 8% IR = RD + $100 DD + $100 $1000 RR - 10 ER + 90 If the Fed goes on a buying spree, it will quickly drive up the prices of CAN. government securities Assume 10% RR

How the Fed Increases the Money Supply The CAN buys CAN Government Securities The Fed writes a check for, say, $100 million (this is money created out of nothing) Securities Firm $80 = 8% IR = RD + $100 DD + $100 $1000 RR - 10 ER + 90 $80 6.67% = IR = $1200 Suppose this pushed the price of the bond up to $1200? Assume 10% RR

How the Fed Increases the Money Supply The CAN buys CAN Government Securities The Fed writes a check for, say, $100 million (this is money created out of nothing) Securities Firm $80 = 8% IR = RD + $100 DD + $100 $1000 RR - 10 ER + 90 $80 6.67% = IR = $1200 When the Fed goes into the open market to buy securities, it bids up their price and lowers their interest rate Assume 10% RR

How the Fed Decreases the Money Supply The CAN buys CAN Government Securities The Security firm writes a check for, say, $100 million to the Fed (this check is, in effect, destroyed) Securities Firm RD - $100 DD - $100 The money supply decreases When the Fed goes into the open market to sell securities, bond, and notes prices fall and interest rates climb Assume 10% RR

How the Fed Decreases the Money Supply The CAN buys CAN Government Securities The Security firm writes a check for, say, $100 million to the Fed (this check is, in effect, destroyed) Securities Firm $80 = 8% IR = RD - $100 DD - $100 $1000 $80 6.67% = IR = $1200 The money decreases When the Fed goes into the open market to sell securities, bond prices fall and interest rates climb Assume 10% RR

Borrowing Reserve Deposits • The discount rate is the interest rate paid by member banks when they borrow reserve deposits (RD) at the BOC • The federal funds rate is the interest rate banks charge each other for borrowing reserve deposits (RD) from each other • This is higher than the discount rate • Banks borrow to maintain their required reserves (RR) • Banks tend to borrow reserve deposits from each other because they may not like to call attention to the fact they are having to borrow reserve deposits

Changing Reserve Requirements • To fight inflation, before the Board would take the drastic step of raising reserve requirements • raise the discount rate • Credit will be getting tighter

Changing Reserve Requirements • If the money supply is still growing too rapidly – the Fed reaches for its biggest stick and raises reserve requirements • This weapon is so rarely used because it is simply too powerful • If the reserve requirement on demand deposits were raised by just one-half of 1%, the nation’s banks and thrift institutions would have to come up with nearly $4 billion in reserves • This would drastically reduce the nation’s money supply

Summary: The Tools of Monetary Policy • To fight recession, the BofC will • Lower the discount rate (Prime rate) • Buy securities on the open market • Lower reserve requirements • This would be done only as a last resort An Important Slide

Summary: The Tools of Monetary Policy • To fight inflation, the Fed will • Raise the discount rate • Sell securities on the open market • Raise reserve requirements • This would be done only as a last resort An Important Slide

Tools of Monetary Policy • Changing the reserve requirement • Changing the discount rate • Executing open market operations (buying and selling government securities) and thereby affecting the Federal funds rate

The Reserve Requirement and the Money Supply • The Fed can increase or decrease the money supply by changing the reserve requirement.

The Reserve Requirement and the Money Supply* • If the Fed decreases the reserve requirement, it expands the money supply. • Banks have more money to lend out. • The money multiplier increases.

The Reserve Requirement and the Money Supply* • If the Fed increases the reserve requirement, it contracts the money supply. • Banks have less money to lend out. • The money multiplier decreases.

Changing the Discount Rate • A bank can borrow reserves directly from the Fed, if it experiences a shortage of reserves. • The discount rate is the rate of interest the Fed charges for those loans it makes to banks.

Changing the Discount Rate • By changing the discount rate, the Fed can expand or contract the level of bank reserves and the money supply.

Changing the Discount Rate* • An increase in the discount rate makes it more expensive for banks to borrow from the Fed. • A decrease in the discount rate makes it less expensive for banks to borrow from the Fed.

14.3 The Demand of Money • Foregone interest is the opportunity cost (price) of money people choose to hold.

The Demand for Money • Thedemand for money is the quantities of money people are willing and able to hold at alternative interest rates, ceteris paribus. • A portfolio decision is the choice of how (where) to hold idle funds. LO1

The Demand for Money • Although holding money provides little or no interest, there are reasons for doing so: • Transactions demand. • Precautionary demand. • Speculative demand. LO1

The Demand for Money • Transactions demand for money – Money held for the purpose of making everyday market purchases. • Precautionary demand for money – Money held for unexpected market transactions or for emergencies. LO1

The Demand for Money • Speculative demand for money – Money held for speculative purposes, for later financial opportunities. LO1

Why Hold Money • John Maynard Keynes noted that people had three reasons for holding money • People hold money to make transactions • People hold money for precautionary reasons • People hold money to speculate

Why Hold money • Economists have since identified four factors that influence the three Keynesian motives for holding money • The price level • Income • The interest rate • Credit availability

The Keynesian Motives for Holding Money • The transaction motive • Individuals have day-to-day purchases for which they pay in cash or by check • Individuals take care of their rent or mortgage payment, car payment, monthly bills and major purchases by check • Businesses need substantial checking accounts to pay their bills and meet their payrolls

The Keynesian Motives for Holding Money • The precautionary motive • People will keep money on hand just in case some unforeseen emergency arises • They do not actually expect to spend this money, but they want to be ready if the need arises

The Keynesian Motives for Holding Money • The speculative motive • When interest rates are very low you don’t stand to lose much holding your assets in the form of money • Alternatively, by tying up your assets in the form of bonds, you actually stand to lose money should interest rates rise • You would be locked into very low rates • This motive is based on the belief that better opportunities for investment will come along and that, in particular, interest rates will rise

Four Influences on the Demand for Money • The price level • As the price level rises, people need to hold higher money balances to carry out day-to-day transactions • As the price level rises, the purchasing power of the dollar declines, so the longer you hold money, the less that money is worth • Even though people tend to cut down on their money balances during periods of inflation, as the price level rises people will hold larger money balances

Four Influences on the Demand for Money • Income • The more you make, the more you spend • The more you spend, the more money you need to hold as cash or in your checking account • Therefore as income rises, so does the demand for money balances

Four Influences on the Demand for Money • Interest rates • The quantity of money demanded (held) goes down as interest rates rise • The alternative to holding your assets in the form of money is to hold them in some type of interest bearing paper • As interest rates rise, these assets become more attractive than money balances

Four Influences on the Demand for Money • Credit availability • If you can get credit, you don’t need to hold so much money • The last three decades have seen a veritable explosion in consumer credit in the form of credit cards and bank loans • Over this period, increasing credit availability has been exerting a downward pressure on the demand for money

Four Influences on the Demand for Money • Four generalizations • As interest rates rise, people tend to hold less money • As the rate of inflation rises, people tend to hold more money • As the level of income rises, people tend to hold more money • As credit availability increases, people tend to hold less money

The Demand Schedule for Money The Three Demands for Money

Total Demand for Money This is the sum of the transaction demand, precautionary demand, and speculative demand for money shown in the previous slide

Total Demand for Money and the Supply of Money The interest rate of 7.2 percent is found at the intersection of the total demand for money and the supply of money (M) Since at any given time the supply of money (M) is fixed it can be represented as a vertical line As money supply increases interest rates fall and I incrases >> AD incrases

Liquidity Trap • Theliquidity trap is the portion of the money-demand curve that is horizontal. • People are willing to hold unlimited amounts of money at some (low) interest rate. LO2

14.4 The Equation of Exchange 􀂃 The formula indicating that the number of monetary units times the number of times each unit is spent on final goods and services is identical to the price level times real GDP MsV = PY LO2

The equation of exchange and the quantity theory: MSV = PY 􀂃 MS = actual money balances held by nonbanking public 􀂃 V = income velocity of money; The number of times, on average per year, each monetary unit is spent on final goods and services LO2

Income Velocity of Money 􀂃 The number of times per year the dollar is spent on final goods and services; equal to the nominal GDP divided by the money supply. LO2

Income Velocity of Money The equation of exchange and the quantity theory: MSV = PY 􀂃 P = price level or price index 􀂃 Y = real GDP per year LO2

The equation of exchange as an identity 􀂃 Total funds spent on final output MsV equals total funds received PY 􀂃 The value of goods purchased is equal to the value of goods sold 􀂃 MsV = PY = nominal GDP LO2

Quantity Theory of Money and Prices 􀂃 The hypothesis that changes in the money supply lead to equiproportional changes in the price level The quantity theory of money and prices 􀂃 Assume: V is constant Y is stable LO2

The quantity theory of money and prices 􀂃 Increases in Ms must be matched by equal increases in the price level LO2

The Bank of Canada and Monetary Policy