CHAPTER 18 The Conduct of Monetary Policy: Strategy and Tactics 485 An important lesson from the subprime financial crisis is that central banks and other regulators should not have a laissez-faire attitude and let credit-driven bubbles proceed without any reaction Appropriate macroprudential regulation can help limit credit-driven bubbles and improve the performance of both the financial system and the economy BAN K O F CAN ADA P OL ICY P RO CE DU RES: HI STO RICA L PE RSP E CTI VE The well-known adage The road to hell is paved with good intentions applies as much to the Bank of Canada as it does to human beings Understanding a central bank s goals and the strategies it can use to pursue them cannot tell us how monetary policy is actually conducted To understand the practical results of the theoretical underpinnings, we have to look at how the Bank of Canada has actually conducted policy in the past This historical perspective not only will show us how our central bank carries out its duties but also will help us interpret the Bank s activities and see where Canadian monetary policy may be heading in the future The Early Years From the end of World War II in 1945 until the early 1970s, the world economy operated under a system of fixed exchange rates, known as the Bretton Woods system (to be discussed in detail in Chapter 20) Initially, Canada opted out of this system, but joined in 1962 and participated with the exchange rate fixed at 92.5 U.S cents Even before 1962, Canadian monetary policy had been driven by the goal of maintaining a stable exchange rate with the United States and the Bank of Canada therefore kept short-term interest rates more or less in step with U.S interest rates This meant that short-term interest rates, or the differential between U.S and Canadian rates, were the intermediate target of monetary policy As a result, inflation rates and interest rates followed generally similar patterns in the two countries (see, for example, Figure 18-6) In 1971, Canada switched to a flexible exchange rate regime, but the Bank of Canada continued to adjust short-term interest rates to keep the foreign exchange and domestic bonds markets functioning smoothly, and paid no attention to the growth rate of money As a result, monetary policy was quite expansionary in the early 1970s and the inflation rate increased to double digits in fact, the price level increased by 11% in 1974 compared to only 3% in 1971 By the mid-1970s there was little doubt that one consequence of the policy of using interest rates as the intermediate target was that the Bank of Canada did not concern itself with the rate of growth of the money supply, as measured by the monetary aggregates By the end of this period there was also a wide consensus among central banks around the world that fluctuations in money contained useful information about income and prices This evidence contributed to the rise of monetarism, a theory that emphasizes a steady, predictable rate of growth in the monetary aggregates, to be discussed in Chapter 24 It led the Bank of Canada and many other central banks, including the Federal Reserve, the Bank of England, the Bundesbank, the Swiss National Bank, and the Bank of Japan, to adopt key monetary aggregates as the intermediate targets of monetary policy Monetary Targeting, 1975 1981 In response to rising inflation in the early 1970s, in 1975 the Bank of Canada introduced a program of monetary gradualism, under which M1 growth would be controlled within a gradually falling target range (see Table 18-2) The change in monetary strategy did not extend to a change in operating procedures the Bank continued to use an interest rate as its operating target The idea was to announce