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Macroeconomics, 9th Canadian Edition
Macroeconomics, 9/e
Campbell R. McConnell, University of Nebraska, Lincoln
Stanley L. Brue, Pacific Lutheran University
Thomas P. Barbiero, Ryerson University
The Bank of Canada and Monetary Policy

Chapter Highlights

CHAPTER 14
  1. The major functions of the Bank of Canada are to (a) hold deposits of the chartered banks, (b) to supply the economy with paper currency, (c) act as fiscal agent for the federal government, (d) supervise the operations of chartered banks (together with the Department of Finance), and (e) regulate the supply of money in the best interest of the economy.
  2. The Bank of Canada's two major assets are government of Canada securities and advances to chartered banks. Its three major liabilities are chartered bank reserves, government of Canada deposits, and notes in circulation.
  3. The goal of monetary policy is to assist the economy in achieving price stability, full-employment, and economic growth.
  4. As regards to monetary policy, the most important assets of the Bank of Canada are government of Canada bonds and Treasury bills.
  5. The two instruments of monetary policy are (a) open-market operations; and (b) switching of government deposits.
  6. The total demand for money is made up of the transactions and asset demands for money. The transactions demand varies directly with nominal GDP; the asset demand varies inversely with the interest rate. The money market combines the demand for money with the money supply to determine the equilibrium interest rate.
  7. Disequilibriums in the money market are corrected through changes in bond prices. As bond prices change, interest rates move in the opposite direction. At the equilibrium interest rate, bond prices tend to stabilize and the amounts of money demanded and supplied are equal.
  8. Monetary policy operates through a complex cause-effect chain: (a) policy decisions affect chartered bank reserves; (b) changes in reserves affect the supply of money; (c) changes in the money supply alter the interest rate; (d) changes in the interest rate affect investment; (e) changes in investment affect aggregate demand; (f) changes in aggregate demand affect equilibrium real GDP and the price level. Table 14-3 draws together all the basic notions relevant to the use of monetary policy.
  9. The advantages of monetary policy include its flexibility and political acceptability. In the past two decades monetary policy has been used successfully both to reduce rapid inflation and to push the economy away from recession. Today, almost all economists view monetary policy as a significant stabilization tool.
  10. Monetary policy has some limitations and potential problems: (a) Financial innovations and global considerations have made monetary policy more difficult to administer and its impact less certain. (b) Policy-instigated changes in the supply of money may be partially offset by changes in the velocity of money. (c) The impact of monetary policy will be lessened if the money demand curve is flat and the investment-demand curve is steep. The investment-demand curve may also shift, negating monetary policy. (d) Changes in interest rates resulting from monetary policy change the amount of interest income received by lenders, altering some people's spending in a way that is opposite to the intent of the monetary policy.
  11. The bank rate is the interest rate the Bank of Canada charges chartered banks when it makes loans to them. Since February 1996 the Bank of Canada has set the bank rate on the upper limit of its operating band for overnight financing.
  12. The effect of an expansionary monetary policy on domestic GDP is strengthened by the increase in net exports that results from a lower domestic interest rate. Likewise, a contractionary, or a tight, money policy is strengthened by a decline in net exports. In some situations, there may be a tradeoff between the effect of monetary policy on the international value of a nation's currency (and thus on its trade balance) and the use of monetary policy to achieve domestic stability.




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