ECON 304 Lecture Notes - Landing Vehicle Tracked, Overnight Rate, Foreign Exchange Market

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Published on 21 Apr 2013
School
University of Waterloo
Department
Economics
Course
ECON 304
Economics 304 - Winter 2013
Monetary Theory
Jean-Paul Lam
Monetary Policy in Canada and the US: Part 1
1Introduction
Acentralbankisnotanordinarycommercialbank. Itisagovernment 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 monetarypolicy. Theyhavetremendous
influence on interest rates, the money supply and in some casestheexchangerate,allofwhich
have direct impacts not only on financial markets but also on aggregate demand and inflation.
This lecture will present a brief overview of the functions and importance of the Bank of Canada.
We will also d escrib e the ob jec tives of m onetary p oli cy i n C anada and how monetary policy is
implemented. In the second part, we present an overview of howtheFederalReserveBankconducts
monetary policy.
2OrganizationalStructureoftheBankofCanada
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 Directors 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). They represent dierent 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 Minister of Finance for a period of seven years.
The Board of Directors has the overall responsibility for thebusinessaairs 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 inuence. In the case of the Bank of Canada, it has complete 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.
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3FunctionsoftheBankofCanada
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 will fo cusmostlyonthemainandmost
well-known function of the Bank of Canada which is the conductofmonetarypolicy.
Contrary to popular belief, the Bank of Canada is not responsible for the regulation and su-
pervision of financial institutions (this is done by the Oce 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. Bank notes are designed with many security
features to prevent counterfeiting.
Security features on bank notes are essential to prevent counterfeiting, a problem that can be
important. For example, The Economist magazine in an articlein2001citedoneforensicanalyst
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 doubledsince2001. Thisisoneofthemain
reasons that have prompted the Bank of Canada to move to polymer 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 public 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 General and ensures that the government’s
operating accounts have enough cash to meet daily requirements.
The Bank of Canada also manages the foreign exchange reservesofthegovernment. These
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.
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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 interestatahigherratethandemanddeposits.
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 ecient financialsystems,bothwithinCanadaand
internationally. The Bank of Canada acts as lender of the lastresort. Thisfunctionisoneofthe
oldest and most important function of any central bank. The Bank of Canada provides credit to
financial institutions who are unable to obtain credit elsewhere. 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 Clearing and Settlements 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 thepaymentwillsettle. Itwaslaunched
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 LVTSisatthecoreofhowmonetary
policy operates in Canada.
The Bank is particularly concerned about systemic risk—the potential for problems that aect
one participant in a clearing and settlement system to spreadtootherparticipantsorthroughout
the financial system. In case the LVTS and ACSS may lack liquidity, the Bank may intervene to
provide this liquidity.
4MonetarypolicyinCanada
Since February 1991, the objective of monetary policy has been 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 totargetination. However,this
does not mean that the Bank does not care about GDP and unemployment. The Bank of Canada
believes that an environment of low, stable and predictable inflation promotes low unemployment
and helps to raise standard of living in Canada. Prior to inflation targeting, the Bank of Canada
implemented a number of dierent 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 afixedexchangeratesystem.
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. Ination was not an important priority at the time.
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Document Summary

Monetary policy in canada and the us: part 1. A central bank is not an ordinary commercial bank. It is a government agency that stands at the centre of a country"s nancial system. Central banks play a crucial role in the monetary/ nancial system and are responsible mainly for the conduct of monetary policy. They have tremendous in uence on interest rates, the money supply and in some cases the exchange rate, all of which have direct impacts not only on nancial markets but also on aggregate demand and in ation. 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 policy in canada and how monetary policy is implemented. In the second part, we present an overview of how the federal reserve bank conducts monetary policy. 2 organizational structure of the bank of canada.

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