2. Outline
10.1 Central banking & the Bank of Canada
10.2 Central banking operating techniques
10.3 Monetary policy targets & instruments
10.4 Monetary policy rules
10.5 Monetary policy indicators
3. Introduction
The central bank is responsible for monetary policy.
Its monopoly control of the supply of cash, or monetary
base, gives it a powerful influence in financial markets.
Other times it controls short-term interest rates.
In either case, central bank actions are designed to affect
inflation, output, and employment.
They work through the transmission mechanism that links
monetary policy to aggregate demand.
5. Central bank: an institution that conducts monetary policy
using its control of monetary base and interest rates.
Private banks are profit-oriented businesses providing
financial services to businesses and households. Profits are
not the motive behind central banks’ operations, although
they do make profits.
Monetary policy: central bank action to control inflation
and support economic growth through control of the
money supply, interest rates, and exchange rates in order to
change aggregate demand and economic performance.
7. The money supply—currency in circulation plus the deposits of the
commercial or chartered banks—is partly a liability of the central bank
(currency) and partly a liability of the commercial banks (deposits).
Money multiplier ties the size of the money supply to the size of the
monetary base. The money multiplier is larger when
1. the reserve ratio (rr) banks hold is smaller; and
2. the amount of currency the non-bank public wishes to hold is small
and constant.
If these two ratios are constant, the central bank can change the size of
the money supply by changing the size of the monetary base.
In general, central banks have three main techniques for the control of
the monetary base and the money supply. These are:
1. Establishing reserve requirements
2. Using open-market operations
3. Adjusting central bank lending rates
‘Quantitative Easing’ techniques is one of the additional techniques
developed.
8. Reserve requirements
Required reserve ratio: a legal minimum ratio of cash reserves to
deposits. Banks can hold more than the required reserves but not less.
If their reserves fall below the required amount, they must borrow
cash, from the central bank to restore their required reserve ratio.
Banks usually hold slightly larger reserves than required to avoid the
costs of falling short.
A rise in the rr ratio reduces the size of the money multiplier and the
money supply. A reduction in the reserve ratio has the opposite effect.
It is not widely used because changing rr ratios affect the reserve
positions of all banks in a system and require large adjustments in
financial markets.
In some countries, it’s no longer a legal requirement and banks decide
the size of their reserve ratios based on their own assessments of their
9. Open market operations
Open market operations are central bank purchases or
sales of government securities in the open financial
market.
They are the main technique used by central banks to
manage the size of the monetary base.
They provide the monetary base needed to meet the
demand for money at the interest rate set by the central
bank.
Open market purchases increase the monetary base and
increased bank lending increases the money supply. OM
sales have the opposite effect.
10. The bank rate
The bank rate (lending rate) is the interest rate the central
bank charges the commercial banks if the commercial
banks borrow reserves. It’s part of monetary policy
operations.
A bank can cover a shortage by borrowing from other
banks with unexpected excess reserves. This takes place on
an overnight basis—you borrow today and repay tomorrow,
at the overnight interest rate.
If no other bank in the system has excess reserves to lend,
the bank with shortage borrows from the central bank. The
bank rate is charged , which is set higher than the
overnight rate, to encourage banks to borrow and lend
reserves in the overnight market.
12. A central bank can pursue any one of 3 possible instrument
targets; 1. Control the foreign exchange rate, or 2. Control
the money supply, or 3. Control the inflation rate.
It purchases or sales in the foreign exchange market. The
domestic money supply and interest rates change until the
difference is eliminated.
To maintain a fixed exchange rate target, it matches
domestic interest rates to those set in the subject country.
Alternatively, it can fix the size or growth rate of the
domestic money supply.
13. The effective lower bound (ELB)
The financial crisis and recession of 2008-09 led to
new cuts to basic policy rates as their first response
but these lower rates were not sufficient to
stimulate borrowing and expenditure.
Effective lower bound (ELB): A Bank’s policy
interest rate cannot be set below a small positive
number.
14. Moral suasion: an increase in communications
with financial market participants to emphasize
the central bank’s longer-term support for markets
and its actions to promote stability.
Quantitative easing: the large scale purchase of
government securities on the open market.
Credit easing: the management of the central
bank’s assets designed to support lending in
specific financial markets.
16. Monetary policy indicators: variables that provide
information about the stimulus or restraint
coming from the central bank’s policy. They are
two; interest rates and exchange rates.
Many economists also regard the money supply as
a policy indicator.
