Day 2 Monetary Policy Monetary Policy n n

Day 2

Monetary Policy

Monetary Policy n n In order to stabilize the economy, the Bank of Canada must change interest rates, alter the money supply or both. There are two types of monetary policy: 1. 2. Expansion Monetary policy. Contractionary Monetary policy.

Expansionary Policy is the policy of increasing the money supply and reducing interest rates to stimulate the economy

Contractionary Policy is the policy of decreasing the money supply and increasing interest rates to dampen the economy

Money Creation

Money Creation Recall: deposit-takers receive deposits from savers and lend to borrowers, while keeping some cash reserves on hand for withdrawals by deposits n By charging higher interest rates to lenders than they pay to depositors, deposit-takers make profit n In a sense through this process, chartered and near banks “create” deposit money n

Desired Reserves Until 1994, chartered banks were legally required to hold certain levels of cash reserves, more than near banks were required to hold n After 1994 both banks have kept only desired reserves n Desired reserves are minimum cash reserves that deposit-takers hold to satisfy anticipated withdrawal demands n

Reserve Ratio The more money a deposit-taker holds in deposits, the greater the withdrawals it can expect n Reserve ratio are desired reserves expressed as a percentage of deposits or as a decimal n Reserve Ratio = desired reserves deposits

Excess Reserves n Excess Reserves cash reserves that are in excess of desired reserves Excess reserves = cash reserves – desired reserves n Idle cash reserves earn no profit, so deposit-takers will try to transform any excess reserves into income-producing assets ASAP. Therefore they lend out the full amount of excess reserves.

The Money Creation Process Opening a Deposit Accepting Deposit Funds Granting A Loan Withdrawing a Deposit

First Transaction

Second Transaction

Third Transaction

Fourth Transaction

Fifth Transaction

The Money Multiplier Money will continue to be created as long as banks find they have excess reserves to lend out n Money Multiplier is the value by which the initial change is multiplied to give the maximum total change in money supply n Change in money supply = change in excess reserves x money multiplier

The Multiplier Formula n n n Recall that the spending multiplier is the reciprocal of the marginal propensity to withdraw --- which indicates how much is taken out of the incomespending stream In the case of money creation process, deposit-takers hold back a certain portion of the funds in each lending cycle The multiplier is the reciprocal of the reserve ratio Money Multiplier = 1 reserve ratio

Adjustments to the Money Multiplier n Not all money is in the form of deposits; lets consider the implications in turn n Publicly Held Currency n Rather than all money going to deposit-takers, some money does circulate and is unaffected by the money multiplier n Differences in Deposits n As deposit money expands in the succession of transactions, not all of it will be reflected as an increase in money supply defined as M 1

Tools of Monetary Policy

Tools of Monetary Policy This section focuses on: n Four different tools n Open Market Operations n The bank rate n Government deposits n Moral suasion n Benefits/Drawbacks of Monetary Policy

Open Market Operations n n n Open Market Operations : The buying and selling of federal government bonds by the Bank of Canada Recall that the Bank of Canada sells and buys back federal government bonds In the Bond market, Bank of Canada is play an important tool that it conducts monetary policy Bank of Canada can use deposit-takers’ cash reserves as a lever to influence both the money supply and interest rates. There are two transactions take in the open bond market: Bond Sales and Bond Purchases

Bond Sales Selling bonds reduce the money supply decrease n For example n

Bond Purchases Buying bond causes the money supply increase because it is an expansionary policy n For example: n

The Bank Rate n n n It is the interest rate paid by chartered bank when they received Bank of Canada advances It is tied to the auction of federal treasury bills A rise in the bank rate signifies that the Bank of Canada will purse a tighter monetary policy, by lowering the money supply and raising interest rates Prime rate: The lowest possible interest rate changed by chartered banks on loans to their best corporate customers When the Prime rate varies, all other rates for depositors and borrowers also vary If the change in the bank rate is substantial, chartered banks may decide to alter their own interest rates in the same direction

Government Deposits n n n Held in Both the Bank of Canada and in Chartered Bank The Bank conducts monetary policy by moving some deposits from the Bank of Canada to Chartered Banks, or Vice Versa Increase Chartered Banks’ excess reserves cause increase in the money supply Move federal government deposits from Bank of Canada to Chartered Bank of Canada conducts expansionary monetary policy By contrast, Chartered Bank to Bank of Canada conducts contractionary monetary policy

Example

Moral Suasion n Direct influence by the Bank of Canada on Chartered Banks’ lending policies n It is used only in usual circumstances

Benefits of Monetary Policy n n n There are two benefits of Monetary Policy: Separation from Politics and Speed Separation from Politics Focused on economics rather than political goals Usually a well-publicized element of the political process Unlike fiscal policy, monetary policy focuses on economic rather than political goals Monetary policy is detached from political influence Speed Decisions regarding Monetary policy can be made speedily

Drawbacks of Monetary Policy n Weakness as an Expansionary Tool • During recession or depression, bank can increase bank’s cash reserves through open market purchases of bonds and shifts of government deposit to chartered banks The chartered banks holding extra cash reserve will not increase money supply No guarantee that this will translate into more bank loaned an expansion of the money supply • • n Broad impact: • Affected by every region of the country uniformly The Bank of Canada increase interest rate during a boom, then the impact in those parts of the economy with overheated economics and also in areas that have been relatively affected by upswing Thus, regions already enduring high unemployment rates will experience even more. • •

THE END of Day 2 HAVE A WONDERFUL WEDNESDAY