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Monetary policy part 1.pdf

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University of Waterloo
ECON 304
Jean- Paul Lam

Economics 304 - Winter 2013 Monetary Theory Jean-Paul Lam Monetary Policy in Canada and the US: Part 1 noi tcu dort1nI Acnlbnki tanriryommriln. i ave rnment agency that stands at the centre of a country’s financial system. Central banks play a crucial role in the monetary/financial system and are responsible mainly for the conduct of monetarci.eyvemnus influence on interest rates, the money supply and in some cashehnet,lfhi have direct impacts not only on financial markets but also on a ggregate demand and inflation. This lecture will present a brief overview of the functions and importance of the Bank of Canada. We will also describe the objectives of monetary policn yaina aad how monetary policy is implemented. In the second part, we present an overview of hederalReserveBankconducts monetary policy. adanafonaehtfoerutcurtS lanoi tazina2 gO The Bank of Canada was established in 1935, following the Great Depression. The Bank of Canada is Canada’s central bank and it is a fairly young central bank compared to other central banks especially Sweden (1656), UK (1694), France (1800), Japan (1882) and the U.S (1913). The overall responsibility of the Bank of Canada rests with the Board of D irectors which is comprised of 15 members: • The Governor • Senior deputy governor • Deputy Minster of Finance • 12 other members appointed by the Minister of Finance (and approved by the Cabinet) for a period of three years. These 12 members appointed by the Minister of Finance come from all regions of Canada and they represent various occupations (except banking). Theyrepresent di▯erent regions of the country and the interest of these regions. The Governor and Senior Deputy Governor are both appointed by the Board of Directors with the approval of the MinistFfinance for a period of seven years. The Board of Directors has the overall responsibility for isab ▯airs of the Bank of Canada, However, the collective responsibility for management of the Bank, especially the crucial tasks of monetary policy and financial stability decisions, remains in the hands of its Governing Council which is comprised of the Governor, the senior deputygovernorandfourdeputygovernors. The Bank of Canada, although a government agency, is independent, thus technically free from political influence. In the case of the Bank of Canada, it hasomplete independence over the instrument used to achieve low and stable inflation but the objective of monetary policy is set in agreement with the Minster of Finance. 1 adanafkonehtfosnoi tcn3uF The Bank of Canada has four main functions: • Monetary policy • Currency management. • Financial system management • Funds management We will look at each of these functions in turn but we wsim llsfonemainandmost well-known function of the Bank of Canada which is the condtofcmoneta.ypolicy Contrary to popular belief, the Bank of Canada is not responsible for the regulation and su- pervision of financial institutions (this is done by th▯ce of the Superintendent of Financial Institutions—OSFI), retail banking services (this is the responsibility of private financial institu- tions) and the issuance of coins (responsibility of The Mint). 3.1 Currency management The Bank of Canada has a monopoly on the issuance of bank-notes.The Bank is responsible for the design, production and distribution of bank notes. Banknotes are designed with many security features to prevent counterfeiting. Security features on bank notes are essential to prevent cou nterfeiting, a problem that can be important. For example, The Economist magazine in an articli 01idoeoninlt who claims that as much as 2 to 3 per cent of the former euro-currencies and 30 per cent of U.S. dollars circulating in Russia, Eastern Europe, Africa, and elsewhere may be counterfeit. In Canada, there is evidence that there was one counterfeit note in circulation for every 290 Canadians in 2001 and that the value of outstanding counterfeits was less than 19 cents per person. However, the incidence of counterfeiting has nearly double21. iinefhemi reasons that have prompted the Bank of Canada to move to polym er bank notes. Not only they are supposed to be more durable but they are much harder to counterfeit. The Bank also oversees the distribution of bank notes to financial institutions and supply these financial institution with enough bank notes to satisfy publ ic demand. Bank notes are obtained through Canada’s Bank Note Distribution System that is managed by the Bank of Canada. 3.2 Funds management In this role, the Bank of Canada is the fiscal agent or banker of the Government of Canada. The Bank of Canada, manages the accounts of the Receiver Generaland ensures that the government’s operating accounts have enough cash to meet daily requirements. The Bank of Canada also manages the foreign exchange reserveso hevmn. se reserves provide liquidity to the government and are used in foreign exchange markets. The Bank of Canada has very rarely intervene directly in the foreign exchange market to support the Canadian dollar. 2 The Bank of Canada also provides advice to the government on the proper way to manage the federal debt which consist mostly of outstanding governmentbondsandsecurities. Indoingso,The Bank of Canada also takes steps to minimize the cost to the government of holding these balances by investing excess funds in term deposits that earn intasahigherratethandemanddeposits. This includes investing the reserves, buying foreign exchange to cover the requirements of gov- ernment departments, managing borrowing to replenish reserves, hedging foreign currency posi- tions, and engaging in gold transactions. Many of these functions are performed by the so-called “trading floor” at the Bank of Canada. 3.3 Financial system The Bank actively promotes safe, sound, and e▯cient financialym ,bhwii aaaad internationally. The Bank of Canada acts as lender of the lao. hinininefhe oldest and most important function of any central bank. The Bank of Canada provides credit to financial institutions who are unable to obtain credit elsew here. It does so to prevent the collapse of the financial institution into question and the risk of triggering a financial crisis and panic. The Bank of Canada also oversees the clearing and settlement systems, the so-called Large Value Transfer System (LVTS) and the Automated CleariS negtlndents System (ACSS). The LVTS is an electronic wire system that lets financial institutions and their customers send large payments securely in real time, with certainty that ametwltltwaslcd in 1999. The ACSS is similar to the LVTS but deals with smaller transaction amounts (residual transactions that are not settled through the LVTS). The LVTSsitteceofwm oay policy operates in Canada. The Bank is particularly concerned about systemic risk—the potential for problems that a ▯ect one participant in a clearing and settlement system to spreoterainsorruhut the financial system. In case the LVTS and ACSS may lack liquidity, the Bank may intervene to provide this liquidity. adanaCyici lo prate4no Since February 1991, the objective of monetary policy has be en to keep the 12-month rate of change in the total consumer price index within a band of 1-3%, targeting the middle of the band at 2 per cent. The objective of the Bank of Canada is very clear. It is rtiai. we,i does not mean that the Bank does not care about GDP and unemplo yment. The Bank of Canada believes that an environment of low, stable and predictabinflation promotes low unemployment and helps to raise standard of living in Canada. Prior to inflation targeting, the Bank of Canada implemented a number of di▯erent policy regimes. 4.1 Monetary targeting The Bank of Canada has undergone through several monetary regimes after the second world war. Much of the 1960s up to the beginning of the 1970, Canada was on afiedxhneaeyem. Most of the Bank’s activities were focussed on maintaining the exchange rate at a given level, which was around 92.5 U.S cents at the time. Inflation was not an imr pant priority at the time. 3 Much of the 1970s was characterized by high inflation and high unemployment. This period of stagflation was not easy to deal with for the Bank of Canada and many other central banks. The Bank of Canada implemented a policy of monetary targeting atthat time, e▯ectively targeting the growth rate of the narrow money, M1, within a certain range. The policy instrument of the Bank of Canada at that time was the money supply and not the interestra t. Monetary targeting was not very successful in Canada and in most other countries that im- plemented such a regime. This policy was deemed a failure as i nflation stayed very high in the 1970s despite achieving the target for M1. This targeting regime also led to a lot of volatility in the interest rate and thus created a lot of uncertainty for financial markets. Because this monetary regime was not successful and the Bank was not able to build co nfidence, monetary targeting was abandoned in November 1982 in Canada. It was evident at that time that the relationship between the growth rate in M1 and prices had broken down. 4.2 Inflation targeting in Canada The 1980s was a period of transition for the Bank of Canada. There was no clear monetary target. Although it did not target the rate of inflation explicitly,vemoreimportancetopyicestabilit and used the interest rate more as a policy instrument ratherthan the money supply. The economic boom at the end of the 1980s coupled with increases in oil prices and the introduction of the GST prompted the Bank of Canada and the Canadian government to ag ree on a strategy to target the CPI. The Bank of Canada o▯cially started to plan for inflation targeting at the end of the 1980s with a full implementation of inflation targeting in February191. Canada was the second country after New Zealand to formally adopt inflation targeting. Since then, over 50 countries have formally adopted such a framework. The main objective of inflation targeting in Canada is to maintain total CPI within one and three percent. The Bank of Canada aims for the middle of the range, that is 2 per cent. The implementation of inflation targeting in Canada and in other countries led to a more transparent monetary policy. Not only was the objective and target of monetary policy clear, inflation targeting also implied greater independence, accountability and transparency for central banks. Greater independence implies that the Bank of Canada has the freedom to implement monetary policy to achieve its objective. Greater accountability and transparency are achieved through regular speeches by senior o▯cers from the Bank, the publications of various periodicals such as the Monetary Policy Report and the Financial System Review. Moreover, the Bank of Canada is accountable for meeting the set target and inflation targeting as a monetary regime is very transparent since the objective and the instrument are known. Gone are the days when central banks were secretive and kept members of the public in the dark. The new era of central banks is aboutopen communications since it is through this channel that they can influence expectations. The rationale for inflation targeting in Canada and in other countries was simple: to make inflation predictable by anchoring inflation expectations int heg-ndtouehel costs of inflation. If inflation is predictable, it is easier for consumers and firms to plan long-term purchases and make decision about investment. Low and stabl en iinmaewgeelns easier and avoid the wage-price spiral that many countries experienced in the 1970s. Low and stable inflation reduce the costs associated with inflation and also improve the economic performance of aonynier.lheim ilinehtlwi flation has reduced the volatility of 4 major economic variables in the long run. Figure 1 shows the inflation rate (CPI in black and core CPI in blue) in Canada prior to and following the implementation of inflation targeting in Canada from 1985 to January 2013. Note that inflation targeting in Canada was implemented in two stages: 1. From 1991 to December 1992, the inflation rate was set at 3% with a band of plus and minus one per cent. 2. The target was lowered gradually until the full implementation in December 1995 where the 12-month CPI target was set to 2% with a band of plus and minus one per cent It is clear from Figure 1 that inflation fell within the 1-3% band sooner than 1995. Inflation has remained low and predictable since the implementation of in flation targeting. Inflation targeting has reduced the volatility of inflation also, thereby reducing u ncertainty. More importantly, inflation targeting has anchored inflation expectations in Canada. Figure 2 shows measures of inflation expectations in Canada from 1990 to 2004. It is clear from Figure 2 that all measures of inflation expectations fell following the implementation of the inflation targeting. This reflects the gain in credibility that the Bank of Canada achieved by sticking toti omindomminto Canadians. Although the operating target is stated in terms of CPI, the Bank is more interested in core CPI, that is total CPI stripped of its eight most volatile components. The Bank believes that core CPI is a better representation of trend inflation (that is where inflation is heading in the medium term) and is less influenced by short term gyrations in prices. Reacting to total CPI would sometimes not be appropriate as total CPI can move a lot because of short -term movements in prices. For example, food and energy prices tend to be very volatile. If the central bank reacts directly to these prices, it would have to change interest rates more frequently, leading to more volatility in its policy rate. This is why the Bank of Canada focusses on coreniainieheerisa better indication of trend inflation. Just looking at the performance of inflation in Canada, it is clear that inflation targeting has been a success in Canada. Not only has the level of inflation fa llen but also the volatility of prices and output. Inflation targeting according to many eco nomists, has contributed to the Great Moderation in Canada. By making prices more predictable and hence investment/consumption decisions more predictable, inflation targeting has contri buted to reduce the volatility of GDP. 4.2.1 Low inflation Attaining low inflation is important because there are cos tosinflation (something we will discuss in more details later in the course). We have already seen that inflation erodes the value of money and acts as a tax on holding money. But this is not the only cost to inflation. There are many others. For example, there are menu and shoe-leather costs. M r,oirntion leads to misallocation of resources since it sends the wrong signals to agents leading to the microeconomic ine▯ciencies and leading individuals to take the wrong decisions. Inflation also creates uncertainty in markets and among decision makers. 5 4.2.2 Policy instrument The Bank of Canada main policy instrument is the short-term interest rate or the so-called overnight rate. This is the rate at which financial institutions pay whe ntheyborrowfromtheBankofCanada. If needed, there are other tools that the central bank can usedsuchasquantitativeeasing,extending credit facilities to financial institutions and commitment to keep rates at a certain level. Some of these tools have been used by the Bank of Canada during the financial crisis after the overnight fell to very to its floor level. Starting in late 2000, the Bank of Canada has adopted a system of eight pre-announced dates per year on which it can adjust its monetary policy instrumen,ettarget overnight rate of interest. These dates are known in advance and are closely watched by market traders and the financial community in general. One of the main reasons to move towards the fixed action dates was to remove some of the uncertainty in financial markets and make t he process of monetary policy more transparent. Before the pre-announced dates were in place, the Bank of Canada had the discretion to change interest rates at any time. It still does under the fixed dates system but has only moved rates outside of the pre-announced dates only on very rare circumstances. adanaCici lo praten fnooi tatnemel5mI The Bank of Canada implements monetary policy through changes to its target for the overnight rate and the operating band. As we have seen in the previous le cture, changes in the overnight rate can influence other interest rates along the yield curve through the term through the term structure of interest rates. Changes in the overnight rate also lead to changes in the exchange rate. The level of interest rates and the exchange rate determine the monetary conditions in which the Canadian economy operates. The Bank of Canada’s primary tool for monetary policy is to influence the overnight rate through the 50-basis point operating band for the overnight rate in the money market. The overnight rate is the middle of the operating band. At the core of how monetary policy is implemented in Canada is the Large Value Transfer System (LVTS). The LVTS is an electronic wire system that lets financial institutions and their customers send large payments securely in real time. The LVTS processnd’leandisnie payments, including Government of Canada payments. In doll ar terms, the LVTS handles the vast majority of payment flows that take place every day. Non-electronic items such as cheques are cleared using the Automated Clearing and Settlements SysteCSS). There are currently 14 institutions who take part directeLVT,iligeBakof Canada. They are all members of the Canadian Payments Association, participate in the SWIFT system, maintain a settlement account with the Bank of Canadaadcncstnig liquidity facility (SLF) o▯ered by the Bank of Canada by posting collateral. The LVTS, which was launched in 1999, was processing an average of more than 21,000 payments a day by 2010, worth more than $180 billion. The total value of the payments processed by the ACSS is small compared to the LVTS. 1 The operating band was reduced to 25 basis points during the financial crisis 6 LVTS participants know their position with certainlt -yiie reda also know their exposure to any other participants. The net amount each participant isalwedtoweissubjecttobilateral and multilateral limits. At
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