The Bank of Canada, which is a crown corporation, is responsible for all monetary policies. Most policies are implemented based on decisions related to altering the Canadian money supply, which is defined as the portion of Canadian household income considered liquid. This includes all forms of cash, money on hand and on deposit at any one of the banks, credit unions, or trust companies that can be readily accessed.
The money supply is not under the direct control of the Bank of Canada because the private banking industry makes decisions relating to the deposited portion of money. Banks take deposits from Canadian businesses and individuals, then turn around and lend those funds to other businesses and individuals. Banks are fundamentally creating money because new funds are re-deposited, let us explain further.
Customer’s A, B, and C each deposit $50,000 into the bank for a total of $150,000. The bank in turn lends $100,000 to Customer D and $50,000 to Customer E. Customer D then re-deposits the $100,000 back into the bank and Customer E re-deposits the $50,000 into the bank – the process has in essence created money, yet really, there is still only the original $150,000 at play. Moreover, the bank has two factors that affect their ability to create money, interest and the economy.
Let’s look at these two factors in detail. Let’s start with interest. When the interest rate paid on financial assets increases, Canadians generally choose to keep a smaller share of their wealth in the form of cash currency, and a larger portion of their wealth as money on deposit with the financial institutions. When it comes to expanding their loan programs, the bank is limited by the requirement that they must retain reserves. Reserves are basically cash kept in vaults from deposits made by the different banks to the Bank of Canada; where it is kept on reserve to cover the portion of investments they are required to cover by law. The Bank of Canada is able to alter interest rates as well as the level of banking reserves by manipulating the money supply indirectly with amazing precision especially over the short term of 6 months or less.
One method that the Bank of Canada uses to manipulate the supply of money is called open market operation that involves Canadian Government Securities trading in the treasury bills markets and secondary bond market. When the Bank of Canada purchases Government Bonds it immediately creates an increase in the amount of money held by the general public, which in turn raises the banking system reserves, having an indirect effect on the total money supply. The additional demand puts downward pressure on bond yields and thus on the overall level of interest rates. To create the opposite effect the Bank of Canada simply sells the bonds they are holding, which then decreases the money supply and causes interest rates to raise. This ability is an incredibly powerful tool that the Bank of Canada has at their disposal. It is through this indirect control of the money that the Bank of Canada is able to influence the overall behavior of the Canadian economy. How you ask? Let’s look at an example.
When the Bank of Canada stimulates the monetary policy, in other words allows for an expansion of money supply, this will put downward pressure on interest rates because there is more money around to borrow and spend. When interest rates are lower, investment in business is strengthened and flourishes, as does the demand for housing, this essentially creates a trickle down effect that will eventually benefit the individual investor. As a result there is a rise in the overall demand for goods and services, which means the economy strengthens and achieves economic growth. In theory, with strong demand there should be increased jobs because an increase in output generally requires an increase in labor. On the contrary, when growth starts to slow or falter the result is a cyclical downturn that can result in high unemployment, and a lethargic economy in general. When there is a reduction in money growth, it acts like a tightening fist on the economy, which puts pressure on interest rates. This pressure results in the rates climbing, which can reduce investments because debt is now expensive, and the total demand for money is less.
During a time of high inflation the Bank of Canada will try to reduce interest rates in an effort to keep prices down and wages increasing. Now all that might seem pretty straight forward, but it’s not quite so easy because there is another component, the relationship between the Canadian and American financial markets. These strong links mean that the monetary policies made by the Bank of Canada also affect the exchange rate between the Canadian and US dollar. If the Bank of Canada has a monetary policy that compared to the US policy is significantly more expansionary, you will see the value of the Canadian dollar depreciate, or drop in relation to the American dollar. Alternatively if the Canadian monetary policy instead contracts, then you will see the Canadian dollar appreciate against the American dollar. The Canadian monetary policy works with a combination of interest rates and exchange rates. The Bank of Canada measures the combined impact of these two using what is called a monetary condition index, which translates to a 1% decline in short term interest rates that equals a 3% decline in the value of the Canadian dollar.
Although the Bank of Canada’s monetary policy is effective it is not without its own limitations. For example, it is unable to stimulate economic demand to reduce unemployment and at the same time restrain demand to combat inflation. It also cannot increase monetary growth rates in order to reduce the interest rates below those of the US while simultaneously stabilizing the Canadian-US exchange rate. Translated what this really means is that monetary policy decision that are made by the Bank of Canada more often than not require some type of trade off, some are more painful than others. Sometimes the tradeoffs involve conflicts in the shorter term and long-term effect of a certain policy. For example, a money supply growth that is continuous will initially cause an increase in production and thus jobs, but over the long term it will lead to a higher inflation rate with no lasting effect on production or employment. Equally, if there is a major reduction in the rate of money supply, it will ultimately reduce inflation no matter how strong a hold it has, this can take several years during which time both production and employment falter and fall.
The Bank of Canada really does spend a great deal of time walking a tight rope between what’s good for the Canadian economy today and tomorrow, and what we can endure today for a brighter tomorrow on an economic level. For example, can we afford to put thousands out of work today to fight inflation now and five years from now? Or, if thousands are out of work will this have a more devastating consequence than inflation, such as the loss of homes? Just when you thought you had the full picture, along comes another limitation, the lack of understanding. Even today there are still many questions that remain unanswered relating to the mechanisms of how changes in monetary policy really affect the economy.
The true nature of these interrelationships between real and imagined financial variables and the exact determinants to price setting and wage setting decisions are really not fully understood, and still remain more of a hypothesis than a proven theory. The Bank of Canada’s monetary policy is restricted by the government’s fiscal policy. Decisions made by the government relating to taxation and expenditure will affect the economy. If fiscal and monetary policies are not properly coordinated they can actually be trying to accomplish two different things and if they cross they can end up having little or no effect on the economy, instead damaging it. That is why since 1961 there has been a very detailed agreement between the Bank of Canada and the government that states “if any irreconcilable conflict should arise between the two the governor must either follow the publicly released directive of the minister or resign office. Even with such an agreement in place, tradition shows that except in the most acute situations the Bank of Canada should be able to set monetary policies independent of the government and other political pressures.
There is no question that creating monetary policy is a very contentious matter and disagreements often occur because of different perceptions about current economic conditions. For example, some might argue a recession has started while others see it quite differently. Much debate is undertaken before any changes are made to the monetary policy. The Bank of Canada plays an indirect role in the flow of money and a direct role in creating monetary policy. They may not be able to always make changes that will cause immediate economic results, but they are constantly looking into their crystal ball in an attempt to make the right decisions for the benefit of the economy now, and into the future. If your looking for more information about the Bank of Canada, you can check out their website here.