Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 0

C H A P T E R 18 The Money Supply and Monetary Policy Learning objectives äUnderstand that money supply determination involves the interaction of the balance sheets of the Bank of Canada, the banking system, and the non-bank public. äUnderstand that the money supply is determined by the monetary base and the lending by chartered banks. äUnderstand that the Bank of Canada controls the money supply in the short run by controlling the overnight interest rate. äUnderstand that the implementation of monetary policy in an uncertain world involves the choice of ultimate and intermediate targets. äUnderstand 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 Ottawa Copyright 2005 © McGraw-Hill Ryerson Ltd.

Slide 2 How is the Money Supply Determined? oWho will issue the money? o19th Century in Canada: private banks o1866: governing authority started issuing its own currency. o1935: Creation of the BOC o1951: One common currency. oCash reserves: Currency held by chartered banks and chartered bank deposits at the bank of Canada. oSettlement balances: Deposits held by direct clearers at the BOC. Chapter 18: Money Supply and Monetary Policy

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 3 How is the Money Supply Determined? Chapter 18: Money Supply and Monetary Policy

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 4 How is the Money Supply Determined? Balance Sheet of the Chartered Banks, December 2002 (Billions) Table Total liabilities Total assets Other liabilities 2.3 Government of Canada deposits Non-personal term and notice deposits Personal savings deposits Other securities Loans 97.1 Gov. of Canada securities Loans and investments 101.2Demand deposits 4.2 Bank of Canada notes and deposits LIABILITIESASSETS

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 5 How is the Money Supply Determined? Balance Sheet of the Bank of Canada, December 2002 (Billions) Table ,084 Total liabilities 42,084 Total assets 1, Other liabilities 1,705 Government of Canada deposits Other 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

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 6 How is the Money Supply Determined? oMonetary Base: The sum of currency in circulation and the deposits of chartered banks at the Bank of Canada. oOpen Market Operations: Purchase or sale of government securities by the central bank. oExample: The Bank of Canada buys $1 million of government bonds from individuals or individuals that make up the non-bank public. Chapter 18: Money Supply and Monetary Policy

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 7 How is the Money Supply Determined? An Open Market Purchase from the Non-bank Public Table Government securities +1 Non-bank public LIABILITIESASSETS Deposits Chartered banks Cash reserves Bank of Canada Government securities +1Deposits +1 Chartered bank deposits

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 8 How is the Money Supply Determined? An Open Market Purchase with Currency Drain Table Government securities +.95 Non-bank public LIABILITIESASSETS Deposits Chartered banks Cash reserves Bank of Canada Government securities +.95Deposits +.95 Chartered bank deposits Currency +.05 Currency +.05

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 9 How is the Money Supply Determined? An Open Market Purchase from the Non-bank Public Table LIABILITIESASSETS Chartered banks Cash reserves Bank of Canada Government securities +1 Chartered bank deposits Government securities

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 10 How is the Money Supply Determined? Money Supply and Monetary Base 1)M = CU + D 2)B = CU + R 3)R + L = D 4)M = CU + D = CU + R + L = B + L Chapter 18: Money Supply and Monetary Policy

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 11 How is the Money Supply Determined? Bank Lending and Money Creation Table DepositsLoans LiabilitiesAssets Bank A DepositsLoans LiabilitiesAssets Bank A DepositsLoans LiabilitiesAssets Bank B

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 12 How is the Money Supply Determined? oMoney Multiplier: The ratio of the money supply to the monetary base. oFrom equations 1) and 2): Chapter 18: Money Supply and Monetary Policy (5)(5)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 13 How is the Money Supply Determined? Calculation of the M2 Multiplier, December 2002 Table RDCU = (cu + 1) /(cu + re) = R/D= CU/DReserves MultiplierrecuCashDepositsCurrency cu is determined primarily by payment habits. cu is determined primarily by payment habits. The cash reserve ratio reflects two distinct components of the banks’ demand for reserves. The cash reserve ratio reflects two distinct components of the banks’ demand for reserves. Minimum required cash reserve ratio Minimum required cash reserve ratio Cash reserves held by banks to meet their customers’ demands for currency and indebtedness of other banks from the clearing of cheques. Cash reserves held by banks to meet their customers’ demands for currency and indebtedness of other banks from the clearing of cheques.

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 14 Short Run Control of the Money Supply oZero Reserve Requirement System: The system under which direct clearers are not required to keep a minimum cash reserve ratio. oMonetary policy is implemented through settlement balances (Bank of Canada deposits). oDrawdowns/redeposits oDrawdowns/Redeposits: The transfer of government deposits between the direct clearers and the Bank of Canada. Chapter 18: Money Supply and Monetary Policy

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 15 Short Run Control of the Money Supply A Drawdown of Government Deposits Table LIABILITIESASSETS Direct Clearers Settlement balances Bank of Canada Government securities Government deposits Government deposits +1

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 16 Short Run Control of the Money Supply oOvernight Rate: The interest rate at which banks borrow or lend so they do not have a shortage or excess of settlement balances. oBOC believes that changes in the overnight rate will affect other interest rates. oTarget band for the overnight rate of 0.5 percentage points. oIf the overnight rate is edging up towards the top of the BOC target band, it will lend to direct clearers at a rate equal to the top of the band. oBank Rate: The upper end of the BOCs target band on the overnight rate. Chapter 18: Money Supply and Monetary Policy

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 17 Targets and Implementation Chapter 18: Money Supply and Monetary Policy Table 18-10: BOC target Growth Rates of M1,

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 18 Which Inflation Rate for Monetary Policy? BOXBOX 18-2 oLow and stable inflation = Long run rate of inflation oFor individuals, inflation = CPI oThe CPI is very volatile in the short run. oProxies for long run rate of inflation used by the BOC = Core, CPIXFET, and CPIW owww.bankofcanada.ca/en/cpi.htm

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 19 Short Run Control of the Money Supply oMonetary Conditions Index(MCI): Is a measure of the effects of changes in the interest rate and the exchange rate on aggregate demand. oMeasures as a weighted average of the 90-day commercial paper interest rate and the C-6 exchange rate. oPublished semi-annually in the Bank of Canada’s Monetary Policy Report Chapter 18: Money Supply and Monetary Policy

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 20 Policy Versus Discretion: The Taylor Rule BOXBOX 18-3 oTaylor Rule would involve central bank intervention based on two conditions: oThe percent deviation of current output from full employment output oThe current four-quarter average rate of inflation relative to some inflation target.

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 21 Long Term and Short Term Interest Rates BOXBOX 18-4 Interest rates of various maturities,

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 22 Action Policy in Action The MCI index, January May 2002

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 23 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 , monetary policy operated according to monetary gradualism. Chapter 18: Money Supply and Monetary Policy

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 24 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. Chapter 18: Money Supply and Monetary Policy

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 25 The End Chapter 18: Money Supply and Monetary Policy