Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 0

Copyright 2005 © McGraw-Hill Ryerson Ltd. Copyright 2005 © McGraw-Hill Ryerson Ltd. Slide Slide 11

C H A P T E R 18The Money Supply and Monetary PolicyLearning objectivesLearning objectives Understand that money supply determination involves the

interaction of the balance sheets of the Bank of Canada, the banking system, and the non-bank public.

Understand that the money supply is determined by the monetary base and the lending by chartered banks.

Understand that the Bank of Canada controls the money supply in the short run by controlling the overnight interest rate.

Understand that the implementation of monetary policy in an uncertain world involves the choice of ultimate and intermediate targets.

Understand that the term structure of interest rates explains how long-term interest rates are related to short-term interest rates.

PowerPoint® slides prepared by Marc Prud’Homme, University of OttawaPowerPoint® slides prepared by Marc Prud’Homme, University of OttawaCopyright 2005 © McGraw-Hill Ryerson Ltd. Copyright 2005 © McGraw-Hill Ryerson Ltd.


How is the Money Supply Determined?

o Who will issue the money?Who will issue the money?o 19th Century in Canada: private banks19th Century in Canada: private bankso 1866: governing authority started issuing its 1866: governing authority started issuing its

own currency.own currency.o 1935: Creation of the BOC1935: Creation of the BOCo 1951: One common currency. 1951: One common currency.

o Cash reserves: Cash reserves: Currency held by chartered Currency held by chartered banks and chartered bank deposits at the banks and chartered bank deposits at the bank of Canada. bank of Canada.

o Settlement balances: Settlement balances: Deposits held by Deposits held by direct clearers at the BOC.direct clearers at the BOC.

Ch

ap

ter 1

8: M

on

ey

Su

pp

ly a

nd

Mo

ne

tary

Po

licy


How is the Money Supply Determined? C

ha

pte

r 18

: Mo

ne

y S

up

ply

an

d M

on

eta

ry P

olic

y



Balance Sheet of the Chartered Banks, December Balance Sheet of the Chartered Banks, December 2002 (Billions) 2002 (Billions) Table 18-2Table 18-2

914.0914.0Total liabilitiesTotal liabilities914.0914.0Total assetsTotal assets

125.8 256.9Other liabilities

2.3Government of Canada deposits

686.9

180.1Non-personal term and notice deposits

373.5Personal savings deposits

Other securities

Loans

97.1 Gov. of Canada securities

Loans and investments

101.2Demand deposits4.2Bank of Canada notes and

deposits

LIABILITIESASSETS



Balance Sheet of the Bank of Canada, December 2002 Balance Sheet of the Bank of Canada, December 2002 (Billions) (Billions) Table 18-3Table 18-3

42,08442,084Total liabilitiesTotal liabilities42,08442,084Total assetsTotal assets

1,217 416Other liabilities

1,705Government of Canada deposits

391

387Other CPA members deposits

517Chartered banks deposits

Other assets

Net foreign currency assets

402Advances

Loans and investments

39,059Notes in circulation40,074

Government of Canada securities

LIABILITIESASSETS



o Monetary Base: Monetary Base: The sum of currency in The sum of currency in circulation and the deposits of chartered circulation and the deposits of chartered banks at the Bank of Canada. banks at the Bank of Canada.

o Open Market Operations: Open Market Operations: Purchase or sale Purchase or sale of government securities by the central of government securities by the central bank. bank.

o ExampleExample: The Bank of Canada buys $1 : The Bank of Canada buys $1 million of government bonds from million of government bonds from individuals or individuals that make up the individuals or individuals that make up the non-bank public. non-bank public.

Ch

ap

ter 1

8: M

on

ey

Su

pp

ly a

nd

Mo

ne

tary

Po

licy



An Open Market Purchase from the Non-bank Public An Open Market Purchase from the Non-bank Public Table 18-4Table 18-4

+1

-1

+1

Government securities

+1Non-bank publicNon-bank public

LIABILITIESASSETS

Deposits

Chartered banksChartered banks Cash reserves

Bank of CanadaBank of CanadaGovernment securities

+1Deposits

+1Chartered bank deposits



An Open Market Purchase with Currency Drain An Open Market Purchase with Currency Drain Table 18-5Table 18-5

+1

-1

+.95

Government securities

+.95Non-bank publicNon-bank public

LIABILITIESASSETS

Deposits



+.95Deposits

+.95Chartered bank deposits

Currency+.05

Currency+.05



An Open Market Purchase from the Non-bank Public An Open Market Purchase from the Non-bank Public Table 18-6Table 18-6

+1

+1

LIABILITIESASSETS



+1Chartered bank deposits

-1Government securities



Money Supply and Monetary BaseMoney Supply and Monetary Base 1)1)M = CU + DM = CU + D2)2)B = CU + RB = CU + R3)3)R + L = DR + L = D4)4)M = CU + D = CU + R + L = B + L M = CU + D = CU + R + L = B + L

Ch

ap

ter 1

8: M

on

ey

Su

pp

ly a

nd

Mo

ne

tary

Po

licy



Bank Lending and Money CreationBank Lending and Money CreationTable 18-7Table 18-7

+1000+1000

DepositsLoans

LiabilitiesAssets

Bank A

DepositsLoans

LiabilitiesAssets

Bank A

-1000-1000 +1000+1000

DepositsLoans

LiabilitiesAssets

Bank B



o Money Multiplier: Money Multiplier: The ratio of the money The ratio of the money supply to the monetary base. supply to the monetary base.

o From equations 1) and 2):From equations 1) and 2):

Ch

ap

ter 1

8: M

on

ey

Su

pp

ly a

nd

Mo

ne

tary

Po

licy

€

MB=

CU +DCU + R

=CU D+1

CU D+ R D

€

MB=

CU +DCU + R

=CU D+1

CU D+ R D

(5)(5)(5)(5)

€

MB=

cu+1cu+ re

€

MB=

cu+1cu+ re



Calculation of the Calculation of the M2M2 Multiplier, December 2002 Multiplier, December 2002Table 18-8Table 18-8

12.770.0110.0735.7531.138.9

RDCU

= (cu + 1)

/(cu + re)= R/D= CU/DReserves

MultiplierrecuCashDepositsCurrency

• cu cu is determined primarily by payment habits.is determined primarily by payment habits.

• The cash reserve ratio reflects two distinct components of the The cash reserve ratio reflects two distinct components of the banks’ demand for reserves.banks’ demand for reserves.

• Minimum required cash reserve ratioMinimum required cash reserve ratio

• Cash reserves held by banks to meet their customers’ Cash reserves held by banks to meet their customers’ demands for currency and indebtedness of other banks from demands for currency and indebtedness of other banks from the clearing of cheques. the clearing of cheques.


Short Run Control of the Money Supply

o Zero Reserve Requirement System: Zero Reserve Requirement System: The The system under which direct clearers are not system under which direct clearers are not required to keep a minimum cash reserve required to keep a minimum cash reserve ratio.ratio.o Monetary policy is implemented through Monetary policy is implemented through

settlement balances (Bank of Canada settlement balances (Bank of Canada deposits).deposits).

o Drawdowns/redeposits Drawdowns/redeposits

o Drawdowns/Redeposits: Drawdowns/Redeposits: The transfer of The transfer of government deposits between the direct government deposits between the direct clearers and the Bank of Canada. clearers and the Bank of Canada.

Ch

ap

ter 1

8: M

on

ey

Su

pp

ly a

nd

Mo

ne

tary

Po

licy



A Drawdown of Government Deposits A Drawdown of Government Deposits Table 18-9Table 18-9

+1

-1

LIABILITIESASSETS

Direct ClearersDirect ClearersSettlement balances


-1Government deposits

Government deposits

-1

Government deposits

+1



o Overnight Rate: Overnight Rate: The interest rate at which The interest rate at which banks borrow or lend so they do not have banks borrow or lend so they do not have a shortage or excess of settlement a shortage or excess of settlement balances.balances.o BOC believes that changes in the overnight rate will BOC believes that changes in the overnight rate will

affect other interest rates.affect other interest rates.o Target band for the overnight rate of 0.5 percentage Target band for the overnight rate of 0.5 percentage

points.points.o If the overnight rate is edging up towards the top of the If the overnight rate is edging up towards the top of the

BOC target band, it will lend to direct clearers at a rate BOC target band, it will lend to direct clearers at a rate equal to the top of the band.equal to the top of the band.

o Bank Rate: Bank Rate: The upper end of the BOCs The upper end of the BOCs target band on the overnight rate.target band on the overnight rate.

Ch

ap

ter 1

8: M

on

ey

Su

pp

ly a

nd

Mo

ne

tary

Po

licy


Targets and Implementation C

ha

pte

r 18

: Mo

ne

y S

up

ply

an

d M

on

eta

ry P

olic

y

Table 18-10: BOC target Growth Rates of Table 18-10: BOC target Growth Rates of M1M1, 1975-1981, 1975-1981


Which Inflation Rate for Monetary Policy?Which Inflation Rate for Monetary Policy? Which Inflation Rate for Monetary Policy?Which Inflation Rate for Monetary Policy?BOXBOXBOXBOX

18-218-2

o Low and stable inflation = Long run rate Low and stable inflation = Long run rate of inflationof inflation

o For individuals, inflation = CPIFor individuals, inflation = CPIo The CPI is very volatile in the short run.The CPI is very volatile in the short run.o Proxies for long run rate of inflation Proxies for long run rate of inflation

used by the BOC = Core, CPIXFET, and used by the BOC = Core, CPIXFET, and CPIWCPIW

o www.bankofcanada.ca/en/cpi.htm



o Monetary Conditions Index(MCI): Monetary Conditions Index(MCI): Is a Is a measure of the effects of changes in measure of the effects of changes in the interest rate and the exchange the interest rate and the exchange rate on aggregate demand. rate on aggregate demand. o Measures as a weighted average of the Measures as a weighted average of the

90-day commercial paper interest rate 90-day commercial paper interest rate and the C-6 exchange rate. and the C-6 exchange rate.

o Published semi-annually in the Bank of Published semi-annually in the Bank of Canada’s Canada’s Monetary Policy ReportMonetary Policy Report

Ch

ap

ter 1

8: M

on

ey

Su

pp

ly a

nd

Mo

ne

tary

Po

licy


Policy Versus Discretion: The Taylor Rule Policy Versus Discretion: The Taylor Rule Policy Versus Discretion: The Taylor Rule Policy Versus Discretion: The Taylor Rule BOXBOXBOXBOX

18-318-3

o Taylor Rule would involve central bank Taylor Rule would involve central bank intervention based on two conditions:intervention based on two conditions:o The percent deviation of current output from full The percent deviation of current output from full

employment outputemployment outputo The current four-quarter average rate of inflation The current four-quarter average rate of inflation

relative to some inflation target. relative to some inflation target.

€

i−π = 0.02+0.5y+0.5(π −0.02)

€

i−π = 0.02+0.5y+0.5(π −0.02)


Long Term and Short Term Interest RatesLong Term and Short Term Interest Rates Long Term and Short Term Interest RatesLong Term and Short Term Interest RatesBOXBOXBOXBOX

18-418-4Interest rates of various maturities, 1970 - 2002Interest rates of various maturities, 1970 - 2002


Policy in Action ActionPolicy in Action Action

The MCI index, January 2001 - May 2002The MCI index, January 2001 - May 2002


Chapter Summary

• The supply of money can be controlled by the Bank of Canada through its control of the monetary base.

• Chartered banks and other CPA members maintain deposits at the bank of Canada.

• The money supply can be expressed as the sum of the base and the amount of bank credit.

• The Bank of Canada determines interest rates and the money supply in the short run.

• During the 1975-1981, monetary policy operated according to monetary gradualism.

Ch

ap

ter 1

8: M

on

ey

Su

pp

ly a

nd

Mo

ne

tary

Po

licy


Chapter Summary (cont’d)

• The current Bank of Canada policy is to set the overnight rate.

• The Monetary Conditions Index “MCI” is a weighted average of the short term interest rate and the exchange rate.

Ch

ap

ter 1

8: M

on

ey

Su

pp

ly a

nd

Mo

ne

tary

Po

licy


The End C

ha

pte

r 18

: Mo

ne

y S

up

ply

an

d M

on

eta

ry P

olic

y

Documents

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 0