Monetary Policy

Money Supply

The money supply is that portion of the financial wealth of Canadian households which has enough 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, such as 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 Canadian households and firms and then lending these funds, the commercial banks, in essence, "create" money because, in theory, the new funds will be re-deposited in the banking system. However, the money-creation powers of the commercial banks are constrained by two 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 their ability to expand loans 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 three to six months or longer).

One method of manipulating the money supply, called 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.

Wider Economic Goals

Control of the money supply is a powerful tool for influencing the general behaviour of the Canadian economy. For example, stimulative monetary policy — 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-United States 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 one per cent decline in short-term interest rates is equivalent to a three per cent decline in the value of the Canadian dollar.

Limitations

Monetary policy also has limitations. It cannot stimulate economic demand to reduce unemployment and at the same time 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. 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 conflicts can be complicated by a third limitation — ignorance — for there are still many unresolved questions about the mechanisms whereby changes in monetary policy affect the economy 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 — decisions about government spending 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 two 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 per cent 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 judgments about current economic circumstances (eg, whether or not a recession has started), or because of conflicting value judgments (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 viewpoints, two general approaches can be distinguished.

Keynesianism

English economist John Maynard Keynes developed concepts about the use of monetary and fiscal policy during the Great Depression. Although considerably modified by his followers, Keynes's ideas remain highly influential (see Keynesian Economics). Keynesians stress 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, 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.

Low-Inflation Debate

The low-inflation policy of the ​Bank of Canada in the 1990s rekindled the dispute between Keynesians and monetarists. The latter welcomed the shift to inflation rates averaging two per cent 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.

In 1988, Bank of Canada Governor John Crow delivered a speech at the University of Alberta that has been dubbed the "Edmonton Manifesto," in which he announced the central bank was adopting the doctrine of price stability as the cornerstone of monetary policy. That is, inflation would be kept to negligible levels that would not affect economic decisions by Canadians. Price stability was a controversial policy because many people believed interest rates were being kept far too high for the economy to continue healthy growth.

In 1991, the central bank, with the government’s approval, adopted inflation targets of 1-3 per cent as official monetary policy. The Bank of Canada believed inflation targets would help consumers and financial markets better understand its policy goals. At the time, the aim was to lower inflation from five per cent, a 1990 high, to two per cent by 1995. The policy worked well and the two per cent target was reached several years early. Two per cent remained the Bank of Canada’s inflation target as of 2014.

Central Bank Governors

By practice the ​Bank of Canada has vigorously maintained its independence from the government on monetary policy, beyond the powers of the finance minister to issue written instructors to the Governor. This practice of independence has included the selection of its governors. When the governor’s post traditionally came open, it was almost a certainty that the senior deputy governor would assume the post. Even when the Liberal government of Prime Minister Jean Chrétien decided not to appoint John Crow to a second term in 1994, the job went to Crow's deputy, Gordon Thiessen, for the standard seven-year term, despite some criticism that the central bank had become inbred.

But things began to change in 2001, when the ​federal government appointed former deputy finance minister David Dodge to the governor's job, over the bank’s senior deputy governor Malcolm Knight — to the surprise of financial markets and of official Ottawa. When Dodge retired from the job in 2008 he was succeeded by another outsider, Mark Carney, a senior official at the Department of Finance. When Carney left the job two years early in 2013 to become Governor of the Bank of England, the federal government chose Stephen Poloz, head of the Export Development Corporation, to take his place.