Monetary Policy

Monetary policy refers to any of a number of government measures undertaken to affect financial markets and credit conditions with the ultimate objective of influencing the overall behaviour of the economy. In Canada, monetary policy is the responsibility of the BANK OF CANADA, a federal crown corporation that implements its policy decisions largely through its ability to alter the Canadian money supply. The money supply is that portion of the financial wealth of Canadian households which has sufficient liquidity to be considered money. At the least it includes coin, currency, and chequing-account deposits in chartered banks, all of which have perfect liquidity in that they represent, at face value, an immediate means of payment for purchases made. Some economists broaden the money-supply definition by including additional chartered-bank deposits (eg, savings accounts) or deposits in other financial institutions such as trust companies or credit unions.

The Bank of Canada is not able to control the money supply directly, because the deposit portion of the money supply results from decisions made within the private BANKING system. By taking deposits from individual Canadian households and firms and then lending these funds, the commercial banks, in essence, "create" money because, in theory, the new funds will be redeposited in the banking system. However, the money-creation powers of the commercial banks are constrained by 2 factors. First, if INTEREST yields on other financial assets rise, Canadians will probably choose to hold a relatively smaller portion of their wealth as coin, currency and (largely low-yield) money deposits. Second, the banks are limited in loan expansion by the need to retain reserves (basically cash in the vault, and deposits of the individual banks at the Bank of Canada) to meet possible withdrawal needs. By altering interest rates and the level of banking reserves, or both, the Bank of Canada can manipulate the money supply indirectly with a high degree of precision (particularly over periods of 3 to 6 months or longer).

One method of manipulating the money supply, termed open-market operations, involves the trading of Canadian government securities in the secondary bond and treasury bill markets. A purchase of government bonds by the Bank of Canada represents an immediate increase in the stock of money held by the general public, raises banking system reserves, and therefore has a multiplied indirect effect on the total money supply. The added demand for bonds also puts downward pressure on bond yields and hence on the overall level of interest rates. Through a sequence of opposite effects, a sale of bonds will decrease the money supply and raise interest rates.

Control of the money supply is a powerful tool for influencing the general behaviour of the Canadian ECONOMY. For example, stimulative monetary policy (ie, a higher rate of money-supply expansion) will put downward pressure on interest rates, strengthen business investment and housing demand, and hence raise the overall level of demand in the economy. During a cyclical downturn, when there is heavy unemployment and idle plant capacity, this stronger demand should in theory lead to a rise in output and increased jobs. Reduced money growth, on the other hand, acts as a restraining force on the economy - causing upward pressure on interest rates and reducing both investment and total demand. At a time of high INFLATION, such restraint will help reduce price and wage increases.

Because of the strong links between Canadian and American financial markets, monetary policy also has a major impact on the Canadian-US dollar EXCHANGE RATE. If Canadian monetary policy is significantly more expansionary than US policy, the value of the Canadian dollar will tend to depreciate in relation to the US dollar. A more contractionary Canadian policy will result in the reverse effect. Canadian monetary policy, therefore, tends to work through a combination of interest rate effects and exchange rate effects. The Bank of Canada attempts to measure the combined impact of both through its monetary conditions index in which a 1% decline in short-term interest rates is equivalent to a 3% decline in the value of the Canadian dollar.

Despite its important effects, monetary policy also has limitations. It cannot, for example, simultaneously stimulate economic demand to reduce unemployment and restrain demand to combat inflation. Nor can the Bank of Canada increase money growth rates to reduce interest rates below US levels while at the same time successfully stabilizing the Canadian-US exchange rate. Therefore, monetary policy decisions often require painful choices ("trade-offs"). Sometimes these trade-offs involve conflicts between the short-term and long-term effects of a particular policy. For example, a sustained rise in money-supply growth may cause an initial increase in both jobs and production, but eventually it will lead to a correspondingly higher inflation rate with little or no permanent effect on employment or output.

Similarly a major reduction in the rate of money-supply expansion ultimately will reduce even strongly entrenched inflation, but this accomplishment may take several years during which output and employment both fall. These intertemporal conflicts can be complicated by a third limitation - ignorance - for there are still many unresolved questions concerning the mechanisms whereby changes in monetary policy affect the economy, the nature of the interrelations between real and financial variables, and the exact determinants of wage- and price-setting decisions.

Finally, monetary policy is restricted by the impact of other government actions, especially FISCAL POLICY, ie, decisions about government expenditures and taxation. Fiscal policy also influences overall economic demand, and if fiscal and monetary policy are not co-ordinated, they can work at cross-purposes. In Canada the minister of finance and the governor of the Bank of Canada consult regularly. Furthermore, since 1961 there has been an explicit agreement that if any irreconcilable conflict between the 2 arises, the governor must either follow the written (and publicly released) directive of the minister or resign office. In the federal budget of 1991 the then Conservative government and the Bank of Canada jointly agreed on a set of inflation-reduction targets as a cornerstone of both monetary and fiscal policy. An inflation target of 1-3% for 1995-98 was subsequently reaffirmed by Bank of Canada and the Liberal government elected in 1993. Nonetheless, despite such evidence of co-operation, there is also a strong tradition that, except in such acute circumstances, the Bank of Canada should be able to set an independent monetary policy, free from political pressures. Therefore the potential for conflicting policies does exist.

The creation of monetary policy is often a highly contentious issue. Disagreements sometimes occur because of differing factual judgements about current economic circumstances (eg, whether or not a recession has started), or because of conflicting value judgements (eg, whether it is more unfair to have inflation erode the value of fixed pensions or to have recession cause the loss of jobs). Frequently, however, debate reflects broad conceptual differences about the appropriate strategy for monetary policy. Although there are many alternative (and intermediate) viewpoints, 2 general approaches can be distinguished.

Keynesianism
Although considerably modified and refined by his followers, English economist John Maynard Keynes's concepts of the use of monetary and fiscal policy, developed during the GREAT DEPRESSION, remain highly influential (see KEYNESIAN ECONOMICS). Keynesians place considerable stress on the many influences that tend to destabilize the economy, including shifts in business and consumer confidence, dynamic investment cycles, and international trade, financial and price shocks. Keynesian policy, therefore, tends to be highly activist or discretionary, in the sense that the nature of monetary (and fiscal) actions alters significantly in response to perceived or anticipated shifts in overall economic circumstances.

Keynesians recognize the risk that the policy chosen may sometimes worsen rather than improve economic performance. Some Keynesians, therefore, cautiously argue that while major cyclical swings should be countered by an appropriate policy change, minor fluctuations should be largely ignored. As a group, however, Keynesians are especially concerned that complete failure to react to economic downturns could lead to episodes of prolonged and severe economic stagnation - characterized by falling output and high unemployment - which can and should be avoided.

Monetarism
The most important distinguishing characteristic of monetarists is their strong skepticism about the use of discretionary monetary policy to offset business-cycle fluctuations. Instead they advocate a neutral policy in which money-supply growth rates would be set and maintained at low levels, except in extreme economic circumstances. Monetarists assert that in practice Keynesian monetary policy will be too stimulative, aiming at immediate employment and output gains and ignoring the potential for higher inflation in the long run.

In the 1960s and early 1970s, the Keynesian approach was dominant, and the generally strong economic performance of the Canadian economy and many other economies was attributed, in part, to the implementation of Keynesian monetary and fiscal policy. However, the frequent bouts of double-digit inflation from the mid-1970s through the early 1980s, coupled with new theoretical analysis by a number of monetarists, greatly increased the influence of monetarist ideas on both academic economists and central bankers, including the Bank of Canada. The low-inflation policy of the Bank of Canada in the 1990s rekindled dispute between Keynesians and monetarists. The latter welcomed the shift to inflation rates averaging 2% or less, arguing this laid the foundation for strong future Canadian growth. Keynesians remained skeptical about any long-run gains while lamenting the high UNEMPLOYMENT costs of the anti-inflation policy.

Author RONALD G. WIRICK

Links to Other Sites
Bank of Canada
The official website for the Bank of Canada. A great information source about monetary policy, the role of the Bank, the history of money, security features in Canadian bank notes, and much more. Check out the fact sheets, online glossary, and educational resources.

The Inflation Calculator
Check out the Bank of Canada’s Inflation Calculator. This program uses monthly “consumer price index” data from 1914 to the present to determine changes in the cost of a fixed "basket" of consumer purchases. An increase in this cost is called inflation. For example, $100 in 1920 was worth $812.14 in 2000. The “Backgrounders” provide details about related topics.

Economic and Fiscal Information
This site offers information about the economy and Canadian government finances, including the economies of the regions and the financial situations of provinces. From the Government of Canada.

Open Data Project
The website for the Open Data Project in which the public can search for, access, and download a wide range of data produced by the Government of Canada.

Department of Finance Canada
Information about the federal budget, the economy, financial institutions, and other financial issues of interest to Canadians. Check the glossary for definitions of frequently used financial terms. From the Department of Finance Canada.

Former Bank of Canada Governor James Coyne Dies, CP Says
An obituary for former Bank of Canada Governor James Coyne. From bloomberg.com.

James Coyne: A father, Rhodes scholar and Bank of Canada governor
This obituary for James Coyne chronicles his career as Bank of Canada governor and other notable accomplishments. From the Globe and Mail.