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These actions are known as open-market operations. · Whenever the Bank is involved in either the purchase or sale of government securities, the reserves of the entire banking system are altered, and this affects the money supply. · When the Bank of Canada buys a treasury bill or a bond from a household or a firm, it pays for the bond with a cheque drawn on itself and payable to the seller. The seller deposits this cheque in a commercial bank, which then presents the cheque to the Bank of Canada for payment. · The bank of Canada then makes a book entry, increasing the deposit of the commercial bank at the central bank, which adds to the commercial bank’s reserves. · Typically, when the Bank buys securities on the open market, the reserves of the commercial banks are increased. These banks can then expand deposits, thereby increasing the money supply. · When the Bank sells a security to a household or firm, it receives in return the buyers cheque drawn against a deposit in a bank. The Bank presents the cheque to the commercial bank for payment. · Payment is made by a book entry that reduces the bank’s deposit at the central bank, and hence reduces its reserves. · When the central bank sells securities on the open market, the reserves of the commercial banks are decreased. These banks must in turn contract deposits, thereby decreasing the money supply. · Cash management - the shifting of government deposits between the Bank of Canada and the chartered banks – is a major tool used by the Bank of Canada in its day-to-day operations. · When the Bank transfers government deposits, it influences the reserves of the banking system relative to its target level of reserves, thereby inducing an expansion or contraction of commercial bank lending and thus an expansion or contraction of the money supply. · Open-market operations and control of government deposits give the Bank of Canada potent weapons for affecting the size of commercial bank reserves and thus for affecting the money supply. · Though the details of an open-market operation differ from the details of switching government deposits, both actions have the same basic result: they change the reserves of the banking system, and this change in reserves then gets transformed, through commercial-bank lending, into changes in the money supply. · When commercial banks borrow from the Bank of Canada, they are charged interest on their loan – the interest they are charged is called the bank rate. · The current Canadian policy of “zero reserves” is really a policy that requires the banks to have zero (or positive) reserves on average over a four-week averaging period. · Given this legal requirement, the true cost of borrowing from the Bank ends up being twice the bank rate. · AS a result, commercial banks target to hold some positive level of reserves that will make the return on the last dollar loaned out equal to the benefit of the last dollar added to the reserves. · When the Bank of Canada buys government securities in the open market, the commercial banks find themselves with excess reserves. They will expand their loans until the excess reserves drain away. · When the Bank sells government securities, the commercial banks find themselves short of reserves and hence suffer increased risk of being forced to borrow reserves from the Bank. They will cut down on their loans in an attempt to restore their reserves. · A review of the transmission mechanism in an open economy. Policy Variables and Policy Instruments · The bank conducts monetary policy to influence real national income and the price level. These ultimate objectives of the Bank’s policy are called policy variables. · The variables that it directly controls to achieve these objectives are called its policy instruments. · The Banks also has intermediate targets, which are neither the ultimate objective of policy nor are they under the direct control of the Bank. Intermediate targets nevertheless play a key role in the execution of monetary policy; their importance lies in their close relationship to policy variables. · The Bank of Canada’s twin policy variables are real national income and the price level. · Short Run: Nominal National Income. Although the Bank cares about the separate reactions of the price level and the real output, there is little that it can do in the short run to control them independently. Monetary policy is therefore not capable of pushing the price level (P) and the real national income (Y) toward independently determined targets simultaneously. For this reason, central banks often focus on nominal national income (PY) as the target for monetary policy in the short run. · Long Run: The Price Level. Because the LRAS curve is vertical, this implies that the only long run impact of monetary policy will be on the price level. · The instruments used by the Bank of Canada to conduct monetary policy are open-market operations and switching government deposits at the chartered at the chartered banks. These are the ways the Bank changes the reserves of the banking system. · Central banks have typically used intermediate targets to guide them when implementing monetary policy in the very-short run. To serve as an intermediate target, a variable must satisfy two criteria. · First, information about it must be available on a frequent basis, daily if possible. · Second, its movements must be closely correlated with those of the policy variable, so that changes in it can reasonably be expected to indicate that the policy variable is also changing (or will do so in the future). · The two most commonly used intermediate targets have been the money supply and the interest rate. · The Bank of Canada cannot expect to be able to use its control of the monetary base to influence both the interest rate and the money supply independently. · In the 1970’s, the Bank of Canada focused on the money supply as its intermediate target. Problems arose when the Bank focused exclusively on M1 as its intermediate target. · In the early 1980’s dissatisfaction with M1 as an intermediate target led the Bank of Canada to monitor several monetary aggregates rather than just one. · Changes in the demand for money imply that the stance of monetary policy cannot be judged only by looking at measures of the money supply. In such cases, interest rates provide additional information about monetary policy. · Since the early 1990’s, the Bank has used the Monetary Conditions Index as an intermediate target. The MCI contains information which reflects the open-economy nature of Canada’s monetary transmission mechanism. Lags in the Conduct of Monetary Policy · Monetarists argued that monetary policy was potentially very powerful in the sense that a given change in the money supply would lead to a substantial change in the aggregate demand, whereas Keynesians were associated with the view that monetary policy was much less powerful. · The full effects of monetary policy nevertheless occur only after quite long time lags. Execution lags, lags that occur after the decision has been made to implement the policy, can have important implications for the conduct of monetary policy. · There are four reasons why monetary policy – changes in the reserves of the banking system – does not affect the economy instantly: 2. Switching between assets takes time 4. The multiplier process takes time · Monetary policy is capable of exerting expansionary and contractionary forces on the economy, but it operates with a time lag that is long and variable. · The long execution lag of monetary policy makes monetary fine-tuning difficult; the policy may have destabilizing effects. · Monetarists in Canada typically argue that monetary policy is a potent force of expansionary and contractionary pressures; monetary policy works with long and variable lags; the Bank is given to sudden and sharp reversals of its policy stance. · Monetarists argue from this position that the stability of the economy would be much improved fi the Bank stopped trying to stabilize it. Monetarists thing the Bank ought to expand the money supply year in and year out at a constant rate that is equal to the rate of growth of real income. · 25 Years of Canadian Monetary Policy Bibliography: Word Count: 1473
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