Monetary Policy Objectives
BoC Act of 1935:
o “Regulate credit and currency in the best interests of economic life of the nation … and to mitigate by its
influence fluctuations in general level of production, trade, prices, and employment, so far as may be possible
within the scope of monetary action …”
o To control the quantity of money and interest rate to avoid inflation and prevent excessive swings in real GDP.
Joint Statement of Government of Canada and BoC of 2011
o Inflation rate targeting: Monetary policy strategy in which the central bank commits to an explicit inflation
target and explain how its actions will achieve that target
The target will continue to be defined in terms of the 12-month rate of change in the total CPI.
The inflation target will continue to be 2% midpoint of the 1-3% inflation control range.
The agreement will run for 5 years, ending December 31, 2016.
o Bank also keeps watch on core inflation (operational guide), which it believes to have a better measure of
underlying inflation and CPI trends, and on the eight volatile elements.
o Since the mid-1990s, Canada has rarely missed the target inflation and CPI range of 1 – 3%.
o Has benefits that:
The purpose of the BoC’s policies is more clearly understood by financial market traders.
The target provides an anchor for expectations about future inflations.
o Is criticized for:
The focus on inflation permits the unemployment rate to rise or the real GDP growth rate to suffer.
BoC created a recession in the 1990s while facing a double digit inflation rate.
Governing council of the BoC: Governor, senior deputy governor, and four deputy governors that are all exports in -
monetary economics and monetary policy making.
o Responsible to follow the BoC Act regulations in conducting monetary policy
o Have regular consultation with the minister of Finance. When they are in disagreement, the Minster would
direct the Bank, which it is then required to oblige (with possible resignation of the Governor)
Conducts of Monetary Policy
As the sole issuer of money, the BoC can decide to control the monetary base (quantity of money), the exchange rate
(price of Canadian dollar on the foreign market), and the short-term interest rate (opportunity cost of holding money).
Only one of the above variables can be set; the other two variables are set as a consequence of the value that’s been set
o If the quantity of money is lowered, the interest rate and the exchange rate is raised.
o If the interest rate is raised, the quantity of money is lowered and the exchange rate is raised.
o If the exchange rate is lowered, the quantity of money is raised and the interest rate is lowered.
Overnight loans rate: Interest rate on overnight loans that the big banks make to each other
o Specific interest rate that the BoC targets
o After an interest rate decision is made, using an AS-AD model, it is achieved using: Operating band: Target overnight rate ± 0.25% points
o Created by the BoC by setting two other interest rate: bank rate, settlement balances rate
o Bank rate: Interest rate that the BoC charges big banks on loans
Set at target overnight rate + 0.25% point
Acts as a cap on the overnight interest rate, since they will not borrow elsewhere unless it is lower.
o Settlement balances rate:
Set at target overnight rate – 0.25% point
Banks will not make overnight loans to other banks unless they can get a higher interest rate than this
o If overnight rate equals bank rate or settlement balances rate, banks are indifferent from lending and holding.
o Overnight rate cannot exceed bank rate. A bank could earn a profit from borrowing from the Boc and lending
to another bank, but since all banks can do the same, no bank is willing.
o Overnight rate cannot be below settlements balances rate. A bank could earn a profit from borrowing from
other banks and increasing reserves at the BoC, but since all banks can do the same, no bank is willing.
Open market operation: Purchase or sale of government securities (treasury bills and government bonds) by the BoC
from or to a chartered bank or the public
o When the BoC buys securities, it injects reserves into the bank
o When the BoC sells securities, it removes reserves from the bank
o When the BoC buys securities in an open market operation, the monetary base increases, banks increase their
lending, and the quantity of money increases. The overnight rate falls.
o When the BoC sells securities in an open market operation, the monetary base decreases, banks decrease their
lending, and the quantity of money decreases. The overnight rate rises.
o If the overnight rate is at target level, the Bank neither buys nor sells.
Monetary Policy Transmissions
When the BoC lowers the overnight loans rate
o Other short-term interest rates and the exchange rate also fall
o Quantity of money and supply of loanable funds increase
o Long-term real interest rate falls
o Lower real interest rate increases consumption expenditure and investment
o Lower exchange rate makes Canadian exports cheaper and imports more expansive. Net exports increase.
o Aggregate demand increases from increased aggregated expenditure.
o Real GDP and price level relative increase and real GDP and inflation rate rise.
When the BoC raise the overnight loans rate:
o Other short-term interest rates and the exchange rate rises
o The quantity of money and supply of loanable funds decrease
o Long-term real interest rate rises
o consumption expenditure and net exports decrease