Transcript Money and Monetary Policy

Day 2
Monetary Policy
Monetary Policy
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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:
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2.
Expansion Monetary policy.
Contractionary Monetary policy.
Expansionary Policy
Expansionary Policy is the policy of increasing the money
supply and reducing interest rates to stimulate the economy
Contractionary Policy
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
 By charging higher interest rates to lenders
than they pay to depositors, deposit-takers
make profit
 In a sense through this process, chartered
and near banks “create” deposit money
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Desired Reserves
Until 1994, chartered banks were legally
required to hold certain levels of cash
reserves, more than near banks were
required to hold
 After 1994 both banks have kept only desired
reserves
 Desired reserves are minimum cash
reserves that deposit-takers hold to satisfy
anticipated withdrawal demands
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Reserve Ratio
The more money a deposit-taker holds in
deposits, the greater the withdrawals it can
expect
 Reserve ratio are desired reserves
expressed as a percentage of deposits or as
a decimal
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Reserve Ratio = desired reserves
deposits
Excess Reserves
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Excess Reserves cash reserves that are in
excess of desired reserves
Excess reserves = cash reserves – desired reserves
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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
 Money Multiplier is the value by which the
initial change is multiplied to give the maximum
total change in money supply
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Change in money supply = change in excess reserves x money multiplier
The Multiplier Formula
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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
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Not all money is in the form of deposits; lets
consider the implications in turn
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Publicly Held Currency
 Rather
than all money going to deposit-takers, some
money does circulate and is unaffected by the money
multiplier
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Differences in Deposits
 As
deposit money expands in the succession of
transactions, not all of it will be reflected as an
increase in money supply defined as M1
Tools of Monetary Policy
Tools of Monetary Policy
This section focuses on:
 Four different tools
 Open
Market Operations
 The bank rate
 Government deposits
 Moral suasion
 Benefits/Drawbacks
of Monetary Policy
Open Market Operations
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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
 For example
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Bond Purchases
Buying bond causes the money supply
increase because it is an expansionary policy
 For example:
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The Bank Rate
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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
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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 Bank of Canada conducts
expansionary monetary policy
By contrast, Chartered Bank to Bank of Canada Bank
of Canada conducts contractionary monetary policy
Example
Moral Suasion
 Direct
influence by the Bank of Canada
on Chartered Banks’ lending policies
 It
is used only in usual circumstances
Benefits of Monetary Policy
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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
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Weakness as an Expansionary Tool
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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 and an
expansion of the money supply
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Broad impact:
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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.
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THE END of Day 2
HAVE A WONDERFUL WEDNESDAY