Economics 304 - Winter 2013
Monetary Policy in Canada and the US: Part 1
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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
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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
• 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
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.
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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
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
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.
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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.
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