How does the Bank of Canada increase or decrease the supply of money in the economy? How does this affect interest rates? How does this affect our exchange rate? Do reserve requirements effectively sanction the private creation of more money? This article will answer those questions.
As previously noted, we can consider M2 to be a measure of the money in the Canadian economy.
When the Bank of Canada mints new physical currency, it is used to replace older bills and coins as they are retired. This occurs as a part of normal operations when a commercial bank takes deposits of physical currency. So simply by printing money the Bank of Canada does NOT necessarily expand the money supply. Instead, the Bank of Canada has three main (“policy instruments”) of influencing the supply of money:
- Open market operations
Conducted with primary dealers – in the US a group of 20 banks.
Buy and sell government securities on the open market to change the supply of money. BUT: Aren’t government securities considered to BE money (i.e. M2)?
Banks typically conduct open market operations on securities in order to influence their yield. By trading government securities they can affect the Bank Rate, resulting in it being:
1. Set directly by the bank
- Floating, usually at 25 points above the yield on 3-month T-bills.
- Since 1996: 50-point “operating band”.
The Bank of Canada affects the interest rate by using its infinite power to create money to buy and sell instruments at the rate of its choosing. This effectively forces other market participants to follow the same rate, since they would not be able to make a successful transaction at a less desirable price.
To affect the Bank Rate, the bank uses SRAs and PRAs.
SRA (Sale and Repurchase Agreement): If government securities are generally trading below the target rate, at 11:45am the BoC offers to sell overnight securities at the target rate of interest.
a. This means the BoC is taking money out of the economy.
SPRA (Purchase and Resale Agreement): If government securities (T-bills or bonds (?)) are trading generally above the target rate, at 11:45am the BoC offers to buy from designated counterparties (i.e. primary dealers) overnight securities at the target rate of interest.
b. By buying (with money it just conjured up), the BoC is injecting money into the economy.
Note that there is no one interest rate in an economy. The interest rate on a loan is the sum:
r = risk free rate (pure time preference) + nonpayment risk + liquidity risk + maturity risk
Notice that a central bank can control either the interest rate or the exchange rate, but not both. This is a consequence of the Mundell-Fleming model’s trilemma, in which it is possible to have only 2 of: Free Capital Flow, Independent Interest Rate Policy, and Fixed Exchange Rate. The Impossible Trinity became the foundation of open economy macroeconomics in the 1980s. Notice that in the modern economy capital controls are easily evaded, so in practice a country can only choose either to smooth exchange rate volatility or run a stabilizing monetary policy. To see the mechanism behind this, please study the Mundell-Fleming model.
A central bank has different responsibilities for a currency on the gold standard. In particular, it must uphold the value of gold. This can be regarded as a special case of having fixed exchange rates.
2. Reserve Requirements
Central banks rarely change their reserve requirements because it would immediately cause liquidity problems for banks with low excess reserves. Instead they prefer to use open market operations.
With a deposit of X and required reserves of r%, the bank can use the deposit to create a maximum of X+X/r money. Here’s the process.
Bank takes deposit of $100. Then they loan out $90 of this money. This creates $90 of new money. Now imagine that the borrower deposits his loan. The bank can then loan out $81 of this money. Continue this process to see that the total $100 + $100(.9)+$100(.9)^2 +… = $100 + $100 / .9 = $1000.
In the US the required reserve is 10% on M1. In the UK reserves are voluntary and stand at about 3%.
reserves held at the fed do not pay interest, so can reserve requirements be thought of as a kind of tax?
Reserve requirements vs. capital adequacy (set mostly by the BIS, not individual central banks)
3. Moral suasion
