13.3 - Tools of Monetary Policy

The Bank of Canada can conduct monetary policy in two different ways:1. Open Market Operations (a signal of its intentions)2. Target Overnight Rate13.3 - Tools of Monetary Policy

Recall: Bank of Canada sells and buys back federal govt bondsBy selling and buying bonds, the Bank of Canada is able to influence the money supply and interest ratesOpen Market Operations: the buying and selling of bonds by the Bank of Canada in the open market.Open Market Operations

Bank of Canada sells $1000 bond to Bondholder ABondholder A pays for it using a cheque from his account at Cartier BankBank of Canada sends the $1000 cheque to Cartier BankCartier Bank cancels cheque and reduces Bondholder As account by $1000Cartier Bank pays the Bank of Canada for the cheque by having $1000 taken out of its Bank of Canada accountBond Sales Process

The money supply now falls by $1000Assuming a reserve ratio of 0.10, Cartier Banks excess reserves are cut by $900 another reduction in the supply of moneyCartier Bank has less money available to lendIf the money multiplier is 10 (reciprocal of reserve ratio), a further decline in the money supply could be as much as $9000 (=900 x 10)Bond Sales Process

Sales of bonds reduces the cash reserves of deposit-takersThis cuts back on lendingDecreases money supply

By selling bonds, the Bank of Canada in engaging in Contractionary Monetary PolicyBond Sales Process contdBank of Canada buys back a $1000 bond from Bondholder BBondholder B receives a cheque from the Bank of Canada She deposits cheque into her account at Cartier BankCartier Bank delivers it to the Bank of Canada and receives $1000

So buying bonds back allows the Bank of Canada to practice expansionary monetary policyCash reserves increase, so increased lendingMoney supply expandsBond PurchasesBond PurchasesThe interest rate on overnight loans between financial institutionsIf the Bank buys bonds, this reduces the need for overnight borrowingIf the Bank sells bonds, this increases the need for overnight borrowingIf the change in the target overnight rate is substantial, prime-rate may be altered Prime Rate is the lowest interest rate charged by deposit-takers on loanshttp://www.youtube.com/watch?v=KqI2HMlSTioThe Target Overnight RateMonetary Policy is the most important stabilization tool due to two main benefits:1. Separation from Politics2. Speed with which it can be Applied1. Although the Bank of Canada is under the control of parliament, it is controlled by appointed officials2. Recall that fiscal policy suffers from recognition, decision and impactWhile recognition delays may occur for monetary policy, decisions are done speedilyBenefits of Monetary Policy1. Weakness as an Expansionary Tool2. Broad Impact3. Potential conflict with the goal of financial stabilityDrawbacks of Monetary Policy1. Weakness as an Expansionary ToolDuring a boom, the Bank sells bonds, decreasing the money supply, increasing interest and reducing spendingDuring a recession/depression, the Bank buys bonds, but this wont always increase the money supplyIf deposit-takers dont lend the money and hold onto their cash reserves, the increase in money supply wont occur2. Broad Impact3. Potential conflict with the goal of financial stabilityDrawbacks of Monetary Policy1. Weakness as an Expansionary Tool2. Broad ImpactFiscal policy can be focused on a particular region of the countryMonetary policy affects every regionIf the interest rate increases, it increases for the whole country3. Potential conflict with the goal of financial stabilityDrawbacks of Monetary Policy1. Weakness as an Expansionary Tool2. Broad Impact3. Potential conflict with the goal of financial stabilityExtended periods of low interest rates (e.g. the decade before 2008 financial crisis), have serious effects on financial stabilityLow interest rates promote risky lending practicesThis can lead to more problemsDrawbacks of Monetary Policy