P R E V I E W
Of the three players, the central bank, the Bank of Canada, is the most impor- tant. Its conduct of monetary policy involves actions that affect its balance sheet (holdings of assets and liabilities), to which we turn now.
T H E B A N K O F C A N A DA S B A L A N C E S H E E T
The operation of the Bank of Canada and its monetary policy involve actions that affect its balance sheet, its holdings of assets and liabilities. Here we discuss a sim- plified balance sheet that includes just four items that are essential to our under- standing of the money supply process.1
C H A P T E R 1 6 The Money Supply Process 405
The two liabilities on the balance sheet, notes in circulation and reserves, are often referred to as the monetary liabilities of the Bank of Canada. They are an important part of the money supply story, because increases in either or both will lead to an increase in the money supply (everything else being constant).
The sum of the Bank s monetary liabilities (notes in circulation and reserves) and the Canadian Mint s monetary liabilities (coins in circulation) is called the monetary base. When discussing the monetary base, we will focus only on the monetary liabilities of the Bank of Canada because the monetary liabilities of the Canadian Mint account for a very small fraction of the base.2
1. Notes in circulation. The Bank of Canada issues notes (those blue, purple, green, red, and brown pieces of paper in your wallet that say Bank of Canada ). The Bank of Canada notes in circulation is the amount of these notes that is in the hands of the public and the depository institutions. Coins issued by the Canadian Mint are not a liability of the Bank of Canada. The coins and Bank of Canada notes that we use in Canada today are collectively known as currency.
Bank of Canada notes are IOUs from the Bank to the bearer and are also liabilities, but unlike most liabilities, they promise to pay back the bearer solely with Bank of Canada notes; that is, they pay off IOUs with other IOUs.
Accordingly, if you bring a $100 bill to the Bank of Canada and demand pay- ment, you will receive two $50s, five $20s, ten $10s, or twenty $5 bills.
People are more willing to accept IOUs from the Bank of Canada than from you or me because Bank of Canada notes are a recognized medium of exchange;
that is, they are accepted as a means of payment and so function as money.
Bank of Canada
Assets Liabilities
Government securities Notes in circulation
Advances to banks Reserves
1A detailed discussion of the Bank s balance sheet and the factors that affect the monetary base can be found in the appendix to this chapter on this book s MyEconLab atwww.pearsoned.ca/myeconlab.
2It is also safe to ignore the Canadian Mint s monetary liabilities when discussing the monetary base because the Canadian Mint cannot actively supply its monetary liabilities to the economy because of legal restrictions.
Liabilities
406 PA R T V Central Banking and the Conduct of Monetary Policy
Unfortunately, neither you nor I can convince people that our IOUs are worth anything more than the paper they are written on.3
2. Reserves. All banks that participate in the Large Value Transfer System (LVTS), to be discussed in detail in Chapter 17, have an account at the Bank of Canada in which they hold deposits (also called settlement balances).4Reserves con- sist of settlement balances at the Bank of Canada plus currency that is physi- cally held by banks (called vault cash, because it is held in bank vaults, cash tills, and automated banking machines). Reserves are assets for the banks but liabilities for the Bank of Canada because the banks can demand payment on them at any time and the Bank of Canada is required to satisfy its obligation by paying Bank of Canada notes. As you will see, an increase in reserves leads to an increase in the level of deposits and hence in the money supply.
As already noted in Chapter 13, Canadian banks are no longer required to hold reserves (see the Global box, The Worldwide Decline in Reserve Requirements). Banks, however, hold some reserves in order to manage their own short-term liquidity requirements and respond to predictable clearing drains and across-the-counter and automated banking machine drains. We call these reserves prudential or desired reserves. For example, banks might desire that for every dollar of deposits, a certain fraction (say, 5 cents) must be held as reserves. This fraction (5%) is called the desired reserve ratio. Reserves in excess of the desired amounts are called unwanted or excess reserves.
The two assets on the Bank of Canada s balance sheet are important for two reasons.
First, changes in the asset items lead to changes in reserves and consequently to changes in the money supply. Second, because these assets (government securities and advances to banks) earn interest while the liabilities (notes in circulation and settlement balances) in general do not, the Bank of Canada makes millions of dollars every year its assets earn income and its liabilities cost little. Although it returns most of its earnings to the federal government, the Bank does spend some of it on worthy causes, such as supporting economic research.
1. Government securities. This category of assets covers the Bank of Canada s holdings of securities issued by the Canadian government. As you will see, one way the Bank of Canada can provide reserves to the banking system is by pur- chasing government securities, thereby increasing its holdings of these assets.
In fact, the total amount of securities is controlled by open market operations (the
3The notes item on our balance sheet refers only to notes in circulation that is, the amount in the hands of the public. Notes that have been printed are not automatically a liability of the Bank. For example, consider the importance of having $1 million of your own IOUs printed up. You give out
$100 worth to other people and keep the other $999 900 in your pocket. The $999 900 of IOUs does not make you richer or poorer and does not affect your indebtedness. You care only about the $100 of liabilities from the $100 of circulated IOUs. The same reasoning applies for the Bank of Canada in regard to its notes.
For similar reasons, the currency component of the money supply, no matter how it is defined, includes only currency in circulation. It does not include any additional currency that is not yet in the hands of the public. The fact that currency has been printed but is not circulating means that it is not anyone s asset or liability and thus cannot affect anyone s behaviour. Therefore, it makes sense not to include it in the money supply.
4There are fourteen LVTS participants in addition to the Bank of Canada: the Big Six, Alberta Treasury Branches, Bank of America National Association, BNP Paribas, Caisse Centrale Desjardins du Qu bec, Credit Union Central of Canada, HSBC Bank Canada, Laurentian Bank of Canada, and State Street Bank and Trust Company.
Assets
Bank s purchase and sale of these securities). Government securities are by far the Bank s largest category of assets, accounting for over 80% of the balance sheet.
2. Advances. The second way the Bank of Canada can provide reserves to the banking system is by making advances (loans) to banks. For the banks, the Bank of Canada advances they have taken out are referred to as borrowing from the Bank of Canada or, alternatively, as borrowed reserves. There is a big difference between normal advances and extraordinary advances (to be discussed in detail later) lent by the Bank of Canada to troubled banks to pre- vent bank and financial panics. Normal advances are fully collateralized and generally overnight in duration. The interest rate charged banks for these loans is called the bank rate.
C H A P T E R 1 6 The Money Supply Process 407
The Worldwide Decline in Reserve Requirements GLOBAL
In order to meet the demand for withdrawals by depositors or to pay the cheques drawn on depositors accounts, depository institutions need to keep sufficient reserves on hand. In most countries, banks hold a certain amount of non interest-bearing reserves because of legally imposed reserve requirements. These reserves are called required reserves. The rationale for reserve requirements is that reserves are necessary for monetary control purposes and, to a lesser extent, for the pro- tection of depositors and the stability of the banking system.
In recent years, however, central banks in many countries in the world have been reduc- ing or eliminating their reserve requirements.
In the euro area the required reserve ratio is 2%
of bank deposits, while in the United States it is 3% (rising to 10% for large deposits). Canada has gone a step further: financial market legis- lation in June 1992 eliminated all reserve requirements over a two-year period. The cen- tral banks of Switzerland, New Zealand, and Australia have also eliminated reserve require- ments entirely. What explains the downward
trend in reserve requirements in most coun- tries?
You may recall from Chapter 11 that reserve requirements act as a tax on banks.
Because central banks typically do not pay interest on reserves, the bank earns nothing on them and loses the interest that could have been earned if the bank held loans instead. The cost imposed on banks from reserve requirements means that banks, in effect, have a higher cost of funds than other deposit-based financial institutions not subject to reserve requirements, making them less competitive. Central banks have thus been reducing reserve requirements to make banks more competitive and stronger.
Although central banks have been reduc- ing or eliminating their reserve requirements, banks still want to hold reserves to protect themselves against predictable and unpre- dictable cash and clearing drains. Hence, desired reserves is the appropriate term to describe the reserves of deposit-taking finan- cial institutions in a system without reserve requirements.
408 PA R T V Central Banking and the Conduct of Monetary Policy
C O N T RO L O F T H E M O N E TA RY B AS E
The monetary base (also called high-powered money) equals currency in circu- lation C plus the total reserves in the banking system R.5The monetary base MB can be expressed as
MB * C + R
The Bank of Canada exercises control over the monetary base through its pur- chases or sale of government securities in the open market, called open market operations, and through its extension of loans to banks.
The primary way in which the Bank of Canada can cause changes in the mone- tary base is through its open market operations. A purchase of bonds by the Bank is called an open market purchase, and a sale of bonds by the Bank is called an open market sale.
OPEN MARKET PURCHASE FROM A BANK Suppose that the Bank of Canada pur- chases $100 of bonds from a bank and pays for them with a $100 cheque. The bank will either deposit the cheque in its account with the Bank of Canada (thereby increasing its settlement balances) or cash it in for currency, which will be counted as vault cash. To understand what occurs as a result of this transac- tion, we look at T-accounts, which list only the changes that occur in balance sheet items starting from the initial balance sheet position. Either action means that the bank will find itself with $100 more reserves and a reduction in its hold- ings of securities of $100. The T-account for the banking system, then, is
Bank of Canada Open Market
Operations
Banking System
Assets Liabilities
Securities , $100
Reserves + $100
Bank of Canada
Assets Liabilities
Securities + $100 Settlement balances + $100 The Bank of Canada meanwhile finds that its liabilities have increased by the additional $100 of settlement balances, while its assets have increased by the $100 of additional securities that it now holds. Its T-account is
The net result of this open market purchase is that reserves have increased by
$100, the amount of the open market purchase. Because bank reserves have increased and there has been no change of currency in circulation, the monetary base has also risen by $100.
5Here currency in circulation includes both Bank of Canada notes and Canadian Mint coins.
OPEN MARKET PURCHASE FROM THE NONBANK PUBLIC To understand what happens when there is an open market purchase from the nonbank public, we must look at two cases. First, let s assume that the person or corporation that sells the $100 of bonds to the Bank of Canada deposits the Bank s cheque in the local bank. The nonbank public s T-account after this transaction is
C H A P T E R 1 6 The Money Supply Process 409
Nonbank Public
Assets Liabilities
Securities + $100
Chequable deposits * $100
Banking System
Assets Liabilities
Reserves * $100 Chequable deposits * $100
Bank of Canada
Assets Liabilities
Securities * $100 Settlement balances * $100
When the bank receives the cheque, it credits the depositor s account with the
$100 and then deposits the cheque in its account with the Bank of Canada, thereby increasing its settlement balances and adding to its reserves. The banking system s T-account becomes
The effect on the Bank of Canada s balance sheet is that it has gained $100 of securities in its assets column, while it has an increase of $100 of settlement bal- ances in its liabilities column:
As you can see in the previous T-account, when the Bank of Canada s cheque is deposited in a bank, the net result of the Bank of Canada s open market purchase from the nonbank public is identical to the effect of its open market purchase from a bank. Reserves increase by the amount of the open market purchase, and the monetary base increases by the same amount.
If, however, the person or corporation selling the bonds to the Bank of Canada cashes the Bank s cheque at a local bank, the effect on reserves is different.6
6If the bond seller cashes the cheque at the local bank, its balance sheet will be unaffected because the $100 of vault cash that it pays out will be exactly matched by the deposit of the $100 cheque at the Bank of Canada. Thus its reserves will remain the same, and there will be no effect on its T-account.
That is why a T-account for the banking system does not appear here.
410 PA R T V Central Banking and the Conduct of Monetary Policy
This seller will receive currency of $100 while reducing holdings of securities by
$100. The bond seller s T-account will be
The Bank of Canada now finds that it has exchanged $100 of currency for $100 of securities, so its T-account is
The net effect of the open market purchase in this case is that reserves are unchanged, while currency in circulation increases by the $100 of the open mar- ket purchase. Thus the monetary base increases by the $100 amount of the open market purchase, while reserves do not. This contrasts with the case in which the seller of the bonds deposits the Bank of Canada s cheque in a bank; in that case, reserves increase by $100, and so does the monetary base.
This analysis reveals that the effect of an open market purchase on reserves depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits. If the proceeds are kept in currency, the open market purchase has no effect on reserves; if the proceeds are kept as deposits, reserves increase by the amount of the open market purchase.
The effect of an open market purchase on the monetary base, however, is always the same (the monetary base increases by the amount of the pur- chase) whether the seller of the bonds keeps the proceeds in deposits or in currency. The impact of an open market purchase on reserves is much more uncertain than its impact on the monetary base.
OPEN MARKET SALE If the Bank of Canada sells $100 of bonds to a bank or the nonbank public, the monetary base will decline by $100. For example, if the Bank of Canada sells the bonds to an individual who pays for them with currency, the buyer exchanges $100 of currency for $100 of bonds, and the resulting T-account is
Nonbank Public
Assets Liabilities
Securities + $100
Currency * $100
Nonbank Public
Assets Liabilities
Securities * $100
Currency + $100
Bank of Canada
Assets Liabilities
Securities * $100 Currency in circulation * $100
The effect of the open market sale of $100 of bonds is to reduce the monetary base by an equal amount, although reserves remain unchanged. Manipulations of T-accounts in cases in which the buyer of the bonds is a bank or the buyer pays for the bonds with a cheque written on a chequable deposit account at a local bank lead to the same $100 reduction in the monetary base, although the reduc- tion occurs because the level of reserves has fallen by $100.
The following conclusion can now be drawn from our analysis of open mar- ket purchases and sales. The effect of open market operations on the mone- tary base is much more certain than the effect on reserves. Therefore, the Bank of Canada can control the monetary base with open market operations more effectively than it can control reserves.
Open market operations can also be done in other assets besides government bonds and have the same effects on the monetary base we have described here.
Although open market operations are the most important monetary policy tool for most central banks around the world, in 1994 the Bank of Canada stopped conduct- ing open market operations in Government of Canada bills and bonds. Since then, the Bank s most common open market operations involve repurchase transactions, either SPRAs or SRAs. More recently, and in response to the subprime financial crisis, the Bank of Canada introduced term PRAs, which are similar to special PRAs. As we will discuss in detail in Chapter 17, the Bank of Canada is currently conducting repur- chase transactions to reinforce its operating target the midpoint of the operating band for the overnight interest rate and to address liquidity issues at times of finan- cial instability. The Bank, however, neutralizes the effect on settlement balances of SPRAs and SRAs, so that at the end of the day there is no change in the level of set- tlement balances in the banking system.
Even if the Bank of Canada does not conduct open market operations, including repurchase transactions, a shift from deposits to currency will affect the reserves in the banking system. However, such a shift will have no effect on the monetary base, another reason why the Bank has more control over the monetary base than over reserves.
Let s suppose that Jane Brown (who opened a $100 chequing account at the First Bank in Chapter 13) decides that tellers are so abusive in all banks that she closes her account by withdrawing the $100 balance in cash and vows never to deposit it in a bank again. The effect on the T-account of the nonbank public is
The Bank of Canada, for its part, has reduced its holdings of securities by $100 and has also lowered its monetary liability by accepting the currency as payment for its bonds, thereby reducing the amount of currency in circulation by $100:
C H A P T E R 1 6 The Money Supply Process 411
Bank of Canada
Assets Liabilities
Securities *$100 Currency in circulation *$100
Shifts from Deposits into Currency