1. A Primer on Monetary Policy
@ÉCOLE DES HAUTES ÉTUDES COMMERCIALES
January 2001

2. Inflation seen as a monetary phenomenon
Inflation is defined as a process of continual increases in the average level of prices.
In order to understand the conditions under which such a process is viable, it is useful to look back at the aggregate supply - aggregate demand model.

3. Inflation seen as a monetary phenomenon
AD0 Y0 P Y
unless aggregate demand is simultaneously stimulated….
the cost increases that go along with the inflationary process... Y1 Y2
would bring about a continual fall in real GDP

4. Inflation seen as a monetary phenomenon
AD0 P Y Y0 P0
AD1
AD2
Only a simultaneous and continual increase in aggregate demand can sustain the inflationary process and avoid a deep recession. P1 P2

5. Inflation seen as a monetary phenomenon
This continual expansion in aggregate demand is impossible without a simultaneous and continual expansion in the means of payment available in the economy (money).
If real incomes do not increase, what else could feed the expansion in aggregate demand ?
In theory, the central bank has the power to decelerate or accelerate the speed at which the domestic financial system expands the means of payments in the economy.
In last instance, this is how the central bank can exert a control over the rate of inflation.
Let’s study this in a Canadian context

6. The expansion of credit and money
In order to understand the basic mechanism behind the expansion of credit and money, it is useful to look at the simplified balance sheets of the central bank (the Bank of Canada) and the commercial banks, respectively.
Commercial banks (as well as credit unions, trusts, etc. members of the Canadian Payments Association (CPA)) have an account at the central bank where they hold reserves serving as settlement balances.
These settlement balances are at the base of the pyramid of assets which support the expansion of the means of payments in the economy.

7. The simplified balance sheet of a typical commercial bank
ASSETS
Loans
Money market instruments
Bonds
Other assets
Deposits at the central bank (settlement balances)
LIABILITIES + CAPITAL
Deposits
Other liabilities
Capital

8. The expansion of credit and money
When the banks make new loans, they credit the account of the borrowers and their liabilities increase pari pasu with the value of the loans.
These liabilities represent new means of payments which can be used by the banks’ clients.
When the clients start to spend this new money, the banks need more settlement balances to compensate the higher value of the client’s cash withdrawals and payments.
Under normal circumstances, only a fraction of the liabilities of the banks need be kept in the form of settlement balances because only the net value of the withdrawals and payments has to be settled.

9. The expansion of credit and money
This being said, a bank ’s need for settlement balances is larger the larger is the value of its liabilities.
It is possible for an individual bank to capture a larger share of the financial system’s total settlement balances by attracting new deposits at the expense of the other banks.
However, what is possible for an individual bank is impossible for the entire banking system.
The entire banking system cannot have more settlement balances than what is currently available in the system.
This is where the central bank comes in: the central bank has the power to increase or decrease the total volume of settlement balances available in the entire financial system.

10. Simplified balance sheet
of the central bank
ASSETS
Domestic money market instruments
Domestic bonds
Net advances to domestic financial institutions (members of the CPA in Canada)
Net assets in foreign currency (foreign exchange reserves)
LIABILITIES + CAPITAL
Government deposits
Domestic financial institutions deposits (members of the CPA in Canada)
Domestic notes and coins
Capital

11. The expansion of credit and money
The general principle is the following:
By increasing the size of its overall liabilities, the central bank injects new settlement balances in the financial system
When the domestic banks have more settlement balances, they can increase the value of their own liabilities by making new loans
The means of payments available in the economy expand.
With a higher level of domestic credit and more money in the system, aggregate demand can expand.
Let ’s see a typical example: the central bank buys money market instruments (say T-Bills) from domestic financial institutions.

12. Example: The central bank buys money market instruments from domestic financial institutions
ASSETS
Domestic money market instruments
Domestic bonds
Net advances to domestic financial institutions
Net assets in foreign currency (foreign exchange reserves)
LIABILITIES + CAPITAL
Government deposits
Domestic financial institutions deposits
Domestic notes and coins
Capital

13. Simplified balance sheet of the consolidated banking system (Step 1)
ASSETS
Loans
Domestic money market instruments
Domestic bonds
Other assets
Deposits at the central bank (settlement balances)
LIABILITIES + CAPITAL
Deposits
Other liabilities
Capital

14. Simplified balance sheet of the consolidated banking system (Step 2)
ASSETS
Loans (new loans are made)
Domestic money market instruments
Bonds
Other assets
Deposits at the central bank (settlement balances)
LIABILITIES + CAPITAL
Deposits (new means of payments are created)
Other liabilities
Capital

15. Step 3: Aggregate demand can increase...
AD0 P Y Y0 P0
AD1
AD2
Aggregate demand increases as the newly created money is spent.
In this particular example, AD increases only in nominal terms, not in real terms.
This would have been the case if the product L h y had stayed constant (which is not always true). P1 P2

16. The expansion of credit and money
In practice:
Temporal lags are involved between step 1(the banks obtain new settlement balances) and step 2 (the banks create new money), as well as between step 2 and step 3 (the new money is spent on goods and services).
In advanced industrialized countries, we estimate that it may take up to months before the full effects have been felt.
We have seen one particular example in which the central bank increases the size of its liabilities by purchasing money market instruments from the domestic financial institutions.
In fact, any purchase of assets by the central bank (paid in domestic currency) will lead to an increase in the volume of settlement balances in the system.
Symmetrically, any sale of assets by the central bank (paid in domestic currency) will lead to a fall in the volume of settlement balances in the system. Over time, the volume of settlement balances thus expands with the central bank ’s net purchases of assets.

17. How should central banks regulate these types of intervention ?
We are now at the heart of the subject: monetary policy.
How should a central bank regulate these types of intervention ?
One first remark: The word “regulate” implies a willingness and a capacity to refrain from expanding the means of payments beyond what is considered desirable. What happens when this willingness or capacity does not exist ? We will discuss that later.
Second remark: The word “should” implies an underlying objective. Usually, the main objective (sometimes the only objective) of the central bank is to preserve the purchasing power of the domestic currency, that is, keep inflation at some low target level. We will concentrate on this objective.

18. How should central banks regulate these types of intervention ?
If the link between the volume of settlement balances (SB) and the level of aggregate demand (AD) was stable, monetary policy would be fairly simple:
Expand SB at a rate equal to: 
where AS represents aggregate supply and d represents the desired rate of inflation

19. How should central banks regulate these types of intervention ?
If the rate of expansion of aggregate supply was relatively constant (this requires the labor force and average productivity to grow at constant rates and the rate of unemployment to be constant):
SB could even be expanded at a constant rate.
In practice, central bankers have found that:
The link between M and AD was both unstable and hard to predict in the short and medium run.
AS did not grow at a constant rate.
For these reasons, the current practice in most industrialized countries is:
Use a flexible instrument (usually a particular central bank interest rate like the discount rate) which can be changed at discretion to reach a fixed objective (a particular target for the rate of inflation).

20. The market for settlement balances in Canada
SB ( the volume of settlement balances in the system)
Inter-bank overnight rate
Discount rate (5,75 %)
Target rate (5,5 %)
Operating band
Lower limit (5,25 %)
D (financial system)
Settlement balances

21. The Bank of Canada injects settlement balances at the target rate of the operating band...
SB’ SB
Inter-bank overnight rate
Discount rate (5,75 %)
Target rate (5,5 %) D’
Lower limit (5,25 %)
D (financial system)
Settlement balances

22. as long as this is expected to deliver the right inflation rate ...
AD0 P Y Y0 P0
AD1
AD2
1%<  < 3 %

23. If the Bank of Canada fears the rate of inflation could rise above its target...
SB’
The cost of settlement balances being higher, financial institutions demand less and the Bank does not have to increase the stock of settlement balances as much as before.
SB’ D’
Inter-bank overnight rate
Settlement balances D SB
Initial discount rate
New discount rate
The Bank raises its discount rate which raises the target rate of the operating band by exactly the same amount...

24. When on the contrary, the Bank anticipates a rate of inflation below its target...
SB’
The cost of settlement balances being lower, financial institutions demand more and the Bank of Canada has to increase the stock by more. D
Overnight rate
Settlement balances SB
Initial discount rate D’
SB’
New discount rate
It lowers its discount rate, which lowers the target rate of the operating band by exactly the same amount...

25. From the overnight rate to other short-term interest rates (January 1980-October 2000)

26. The monetary transmission mechanism in a flexible exchange rate regime: An introduction

27. The steps of monetary policy
1. Predict over the coming 12 to 24 months the rate of expansion in aggregate supply (the rate at which L h y will increase)
2. Predict the rate at which unit costs will increase (what will be the rate of unemployment, the evolution of wages and other costs, the price of oil, etc.)
3. Infer the rate of growth in aggregate demand which will be compatible with the inflation target.
4. Decide whether the current level of interest rates and the exchange rate is compatible with the desired increase in AD.
5. If necessary, change the discount rate and injects settlement balances on demand at the new target rate.
6. Monitor the economy and repeat steps 1 through 6 on a continual basis.

28. A Primer on Monetary Policy
@ÉCOLE DES HAUTES ÉTUDES COMMERCIALES
January 2001