Monetary Policy in Canada

This is the last piece of the puzzle! This chapter is all about how the government of Canada uses policy instruments to change the money supply!

The central bank can set the money supply and let the market determine the interest rate

OR

The central bank can set the interest rate and the money supply will adjust to this interest rate

PROBLEMS WITH ADJUSTING THE MONEY SUPPLY DIRECTLY:
-The Bank of Canada (BoC) cannot directly control the money supply through the currency ratio and the reserve ratio (they can't control minds and make banks hold more or less assets and make people hold more or less money)
-Also, it's sometimes confusing as to which definition of the money supply should be used: H? M1? M2? Know know...

SO, the BoC sets the interest rate instead, and then accommodates for fluctuations and changes by using open market operations. (The US directly changes the money supply by printing more or less money, while Canada simply changes the bank rate)

There are 5 Different Policy Instruments The BoC Uses:
1: The Overnight Target Rate (Which is changes by changing the Bank Rate)
2: Buyback Operations (Specials and Reverses)
3: Shifting Government of Canada Accounts
4: Moral Suasion
5: The Announcement Effect

NOTE** It's important to know the difference between operational targets: usually, governments can only target one factor, so they have to choose between targeting

a) The Exchange Rate (from 1962-1970, Canada targeted the exchange rate and tried to keep its external value at 92.5)
b) The Interest Rate/Money Supply (from 1975-1982, the BoC would adjust interest rates to affect the money supply through the liquidity preference system. The problem was that interest rates became extremely volatile, and the government had no way of controlling the price level)
c) The Inflation Rate (the BoC uses interest rates and money supply as a policy instrument to affect the inflation rate, so the operational target is currently PRICES. The BoC tries to keep inflation at about 2%, because a little bit of inflation is healthy

Policy Variables: These are the ultimate targets for policy changes
Y - stable economic growth
U - low unemployment
P - Low Inflation !!! THIS IS THE PRESENT GOAL OF THE BoC

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THE 5 POLICY INSTRUMENTS

1: THE OVERNIGHT RATE

Note* the interest rates on borrowing increase as the term of the loan grows longer (as a compensation for leaving money inaccessible for a longer amount of time)

The Overnight Rate: This is the daily interest rate which chartered banks charge each other for borrowing money (or that investment dealers charge to banks for borrowing money) in cases where they have insufficient funds to clear cheques. These loans have a very short maturity (the term is extremely short) and the interest rates are MARKET DRIVEN

The BoC is the LENDER OF LAST RESORT

The Bank Rate is the rate which the BoC charges to lend to money to chartered banks. This is the upper limit of the overnight rate. Because the bank rate is so high, most chartered banks will not borrow from the bank of Canada unless all other sources refuse to loan them money

The Overnight Rate Operational Band: This is the difference between the highest overnight rate (the bank rate) and the lowest overnight rate (the rate the BoC pays to borrow for depoits)
-It is measured in basis points (each basis point is worth 0.01%, so an operational band of 50 basis points would mean a difference of 0.5% between the highest and lowest overnight rates)

Overnight Rate Target: the midpoint of the operational band for overnight rates, as set by the BoC
-THIS is the policy instrument used by the BoC to affect the interest rate
-There are fixed announcement dates: the BoC announces the overnight rate target 8 times per year

The USA uses a slightly different system...


OKAY: so basically, the bank rate is FIXED by the BoC
-Money's liquidity (the demand for money) is given
-The BoC accommodates the money supply to ensure equilibrium in the money market
-The money supply is thus endogenous, and becomes determined from the interest rates and the demand for money!

1: BoC increases the overnight rate (i goes up)
2: Banks increase their target reserves to buffer against this higher opportunity cost of borrowing from the BoC
3: The money supply decreases (because the reserve ratio is higher)
4: The market interest rate goes up!

This is a long-about way of showing how the market interest rate (which includes the prime rate, the 5-year mortgage rate, and commercial lines of credit) is related to the overnight interest rate!

NOTE* A change in the overnight rate target and other market interest rates usually happens very quickly BUT the demand for loans changes gradually (so the first step of the overall transmission mechanism is much faster than then subsequent steps)

As the demand for money changes, the BoC accommodates by using open market operations!

2: BUYBACK OPERATIONS (INCLUDING OPEN MARKET OPERATIONS)
-The BoC Uses Specials and Reverses to stabilize the overnight rate inside the operational band
-Buyback operations are used to fine-tune the overnight rate target within one basis point of the target

SPECIALS (Specials purchase and resale agreement):
-This is a transaction in which the BoC offers to purchase government of Canada securities from major financial players with an agreement to sell them back at a predetermined price the next business day
-This allows the BoC to put money into the system for one day
-This OFFSETS UPWARD PRESSURES on the overnight rate (by adding a bit to the money supply, the BoC decreases the interest rate a little bit)
-The BoC initiates SPRAs daily if overnight funds are generally trading above the target rate
-Differences between the purchase and the sale price determines the overnight rate

REVERSES (Sale and repurchase agreement)
-This is a transaction in which the BoC offers to SELL government securities to major financial parties with an agreement to buy them back at predetermined prices the next business day (this sale is called a reverse)
-Basically, this let's the BoC take cash out of the system for a day (by coaxing investors to temporarily store wealth in bonds instead of money)
-Reverses are used to offset downward pressures on the overnight rate
-The BoC initiates reverses daily if overnight funds are generally trading below the target rate

OPEN MARKET OPERATIONS (OMO): LONG RUN MONETARY ACCOMMODATION
-An OMO is the purchase/sale of government securities by the BoC in the open market for long run monetary accommodation
-Government securities are long run loans to the government
-Treasury bills are short term loans to the government
-These are auctioned off every Thursday, just like stocks, in a market

The BoC BUYS securities to increase excess reserves and attempt to increase the money supply
The BoC SELLS securities to decrease excess reserves and attempt to decrease the money supply

This analysis assumes that there are no cash drains, and that the reserve ratio remains constant in the long run (neither of which may be true)

3: SHIFTING GOVERNMENT OF CANADA DEPOSITS

Cash Management: The Bank of Canada shifts Government of Canada deposits to and from the Bank of Canada and the chartered banks. This is the major day-to-day instrument which the BoC uses to reinforce overnight rate targets within the operational band

Transferring money to a chartered bank increases their reserves, which allows the chartered bank to safely lend out more money, thus increasing the money supply
Transferring money from a chartered bank back to the BoC decreases chartered banks' reserves, which forces the chartered bank to lend out a smaller proportion of money, thus decreasing the money supply

4: MORAL SUASION

-The BoC enlists the cooperation of commercial banks
-This is possible because there is such a small number of banks in Canada
-Since there are not required reserves in Canada (required reserves are not legislated), this tool is more important
-For an example, the BoC may require an increase in settlement balances held at the BoC

5: THE ANNOUNCEMENT EFFECT

-There are fixed announcement dates where the BoC announces the bank rate (8 times per year)
-Like moral suasion, an increase in the bank rate sends a signal to the economy of the government's intentions, which can affect private investment (due to changed expectations)

CONCLUSION: The BoC fixes the overnight rate target, then uses buyback operations and shifting to reinforce it and open market operation to accommodate the demand for money in the long run

1: Policy instruments: The BoC sets the bank rate
2: The Money Market which defines reserves determines the money supply and the equilibrium interest rate
3: Transmission to real sector through the investment and net export effects

GAPBUSTING GUIDE

TO FIX A RECESSIONARY GAP (CREATE EASY MONEY)
-Decrease the target rate
-Increase the money supply
-Decrease interest rates
-Increase Investment and net exports
-Increase Aggregate Demand
-Y moves to the right, back to Y*

TO FIX AN INFLATIONARY GAP (TIGHTEN MONEY)
-Increase the target rate
-Decrease the money supply
-Increase interest
-Decrease investment and net exports
-Decrease aggregate demand
-Y moves left to Y*