Monetary Policy & Bank of Canada

• The lecture covers Monetary Policy and the Bank of Canada for an Introduction to Macroeconomics course in Winter 2025.
• The notes were created by Jean-Paul Lam on February 28, 2025.

Learning Objectives

• Understand the functions of the Bank of Canada.
• Understand the objective of monetary policy.
• Learn how the Bank of Canada implements monetary policy.

Introduction to the Bank of Canada

• Central banks are crucial in the monetary/financial system, mainly conducting monetary policy.
• The Bank of Canada's primary role is to promote the economic and financial welfare of Canada, according to the Bank of Canada Act.
• The Bank of Canada uses the overnight rate to maintain low, stable, and predictable inflation.
• Bank of Canada decisions impact interest rates, financial markets, aggregate demand, and inflation.
• The Office for the Superintendent of Financial Institutions (OSFI) is responsible for supervising and regulating financial institutions in Canada, not the Bank of Canada.

Organizational Structure

• The Bank of Canada was established in 1935 after the Great Depression.
• It was initially a private institution but became nationalized in 1938.
• Compared to other central banks, the Bank of Canada is relatively young. Other central banks include:
  • Sweden (1656)
  • U.K. (1694)
  • France (1800)
  • Japan (1882)
  • U.S. (1913).
• The Board of Directors has 15 members with overall responsibility:
  • The Governor
  • Senior deputy governor
  • Deputy Minister of Finance
  • Twelve other members are appointed by the Minister of Finance for three-year terms, representing various occupations and regions of Canada (excluding banking).
• The Board of Directors oversees management and administration, such as strategic planning, officer recruitment, and budget.
• The Governing Council is responsible for the management of the Bank, especially the implementation of monetary policy and financial stability.
• The Governing Council is composed of:
  • Governor
  • Senior deputy governor
  • Four deputy governors
• The Governor and Senior Deputy Governor are appointed by the Board of Directors with the Finance Minister's approval for seven-year terms.
• The Bank of Canada is a crown corporation and an independent institution.
• There is complete independence in how monetary policy is conducted, with the objective of low and stable inflation.
• The objective of monetary policy is agreed upon with the Minister of Finance and reviewed every five years (next in 2026).
• Since 1991, the Bank of Canada's target has been to maintain the rate of change in the consumer price index (CPI) between 1% and 3%, aiming for 2%.

Functions of the Bank of Canada

• The Bank of Canada has five main functions:
  • Currency management
  • Financial system management
  • Funds management
  • Monetary policy
  • Retail payments supervision
• The Bank of Canada is NOT responsible for:
  • Regulating and supervising financial institutions (OSFI)
  • Issuing coins (The Mint)

Currency Management

• A monopoly exists for the Bank of Canada on issuing banknotes.
• Bank is in charge of banknote design, production, and distribution.
• The bank supplies banknotes to financial institutions to meet public demand and oversees their distribution.
• Commercial banks exchange reserves with the Bank of Canada for new banknotes as needed.

Funds Management

• The Bank of Canada manages funds for the government, other governments, central banks, and itself.
• It acts as a fiscal agent and banker for the Government of Canada, managing the accounts of the Receiver General and ensuring the government's operating accounts have enough cash for daily needs.
• The Bank of Canada provides services to the Government of Canada including:
  • Management of borrowing and investment of surplus reserves.
  • Advice on managing federal debt for stable, low-cost funding.
  • Buying foreign exchange to meet departmental requirements.
  • Hedging foreign currency positions.
  • Engaging in gold transactions.
• The Bank supplies banking facilities to participants in Canada's payment systems.
• Financial infrastructure is overseen, including clearing and settlement and securities settlement systems.
• Canada's clearing and settlement system provides infrastructure for financial institutions to settle payments on behalf of clients with each other.
• The securities and settlement system facilitates the exchange of securities, derivatives, and other financial assets.
• Lynx is central to Canada's clearing and settlement system, enabling real-time transaction settlements with guaranteed transactions.
• Systemic risk is a particular concern for the Bank in clearing and settlement systems.

Financial System

• The Bank promotes safe, sound, and efficient financial systems within Canada and internationally.
• Liquidity is provided to financial institutions when needed as the lender of last resort.
• Providing is a crucial function of any central bank.
• Credit is provided to financial institutions that need liquidity but cannot borrow from other financial institutions or capital markets.

Objective of Monetary Policy in Canada

• Since February 1991, monetary policy aims to maintain the 12-month rate of change in the headline CPI within 1-3%, targeting 2%.
• This goal does not signify that the Bank is indifferent to GDP and unemployment.
• The Bank of Canada is under the belief that low, stable, and predictable inflation promotes low unemployment and raises the standard of living.

Tools and Framework

• The Bank of Canada believes it can influence aggregate demand by changing the overnight rate.
• The overnight rate, the rate at which banks borrow from each other overnight, is the main instrument.
• The overnight rate will increase (decrease) to reduce (stimulate) aggregate demand if the inflation rate is above (below) the target rate.
• The Bank of Canada decides on the appropriate level of the overnight rate eight times per year.

Inflation Targeting in Canada

• Policy regimes such as fixed exchange rate and monetary targeting were enforced before inflation targeting
• The 1980s were a transitional period when a monetary target was not set.
• The interest rate was valued more as a policy instrument rather than the overall money supply, which gave more importance to price stability
• The GST introduction, coupled with the economic boom and a rise in oil prices created an agreement to target the CPI
• The plan to target inflation began at the end of the 1980s, which was fully implemented in February 1991.
• Canada was the second country, after New Zealand, to formally implement a system.
• Over 70 countries formally adopted such a framework
• A more transparent implementation of monetary policy followed the implementation
• Independence, accountability, and more transparency resulted from inflation targeting
• Greater independence implies implementing monetary policy freely from political inference
• Accountability and transparency are achieved through publications and regular speeches.

Central Bank Independence

• An independent central bank is more likely to be trusted because they are free from political interference
• Maintaining low and stable inflation expectations is maintained by this trust.
• This independence ensures monetary policy is separate from fiscal policy
• Independence helps central banks focus on long-term goals
• Politicians may favor policies for short-term political gains.
• Empirical studies suggest that central bank independence decreases inflation in advanced economies.

Inflation Targeting

• It anchors inflation expectations in the long run and is simple to implement reducing real costs of inflation.
• Consumers and firms can easily plan long-term investment decisions if it is predictable.
• Low and stable inflation makes wage settlements simple avoiding a wage-price spiral.
• Stable and low inflation improves a country’s economy.
• Volatility is reduced, easing economic agent expenditure planning,
• Figure 1 shows that inflation in Canada before and after.
• The Bank of Canada set inflation target was set at 4% with a band of +/-3 percent.
• A 2% target would need a significant increase and would not be credible since inflation was around 7% requiring an interest rate increase
• The 12-month CPI was set to 2% with a band of +/-1 percent in December 1995 after it was lowered gradually
• Inflation fell into the 1-3% band sooner than 1995.
• It has remained low and predictable until 2020 rarely deviating
• From January 2021 until recently, it has persistently deviated.
• It reduces the average level and volatility
• It has also anchored the inflation expectations in Canada around 2%
• Inflation expectations are an essential determinant of actual inflation, so it's vital to anchor expectations around 2%.
• Inflation fell significantly from 1980 to 2020 and so did expectations with measures through surveys and the yield between long-term nominal and real bonds
• The success in inflation fell and anchoring reflects the credibility achieved by sticking to commitments
• Economic research has indicated that costs become important when exceeding 2-3% and very costly over 3% for long term.
• The Bank of Canada doesn't target zero for 3 reasons:
  • Downward nominal rigidity - wages are downward rigid so it is required for adjustments.
  • Zero-lower bound - the nominal interest rate can't fall when in need of stimulus
  • Bias in CPI - tends to overstate the cost of living and result in some negative rates.
• The banks' main policy is the overnight rate (borrowing from financial institutions)
• QE and FG(forward guidance are additional tools when reaching bound
• QE is security purchases
• FG is communication of future rate plans
• The Bank of Canada used FG (Financial Guidance) in the 2008-2009 crisis and QE during Covid.
• 2% inflation 8 times a year is the objective which is known as the Monetary policy in CA.
• Fixed Action Dates (FAD) - make monetary policy more transparent.
• The overnight rate is how the BOAC (Bank of Canada) implements monetary policy.
• The interest rate of overnight loans which is the Lynx rate that financial institutions pay set by the BOAC.
• The overnight rate is determined by settlement balances (or overnight financing)
• The BOAC controls supply while demand from financial institutions needing to borrow
• The BOAC uses tools to make overnight rates stay as close as possible.
• If inflations is expected to exceed 2% then target rate will be increased moving to the market
• Tools used include: Government of Canada's account & one-day reverse repos (selling of government securities with a promise for repos)
• The BOAC increases borrowing, which includes rates for banks, decreasing investment and consumptions
• If expected blow then rates will be decrease, which decreases consumption stimulating expenditures
• The BOC's target is symmetric meaning concern is equal on whether inflation is over or below.

The Lynx System

• This core manages much of the monetary policy.
• This system lets financial institutions send large payments to each other.
• It is electronically wire system that also includes the government.
• Critical to the financial economy- and guarantees payments that are non- refundable.
• The lynx handles most of the payments.

Participants

• There are usually 17 institutions that are all members of the CPA (Canadian Payment Association)
• They participate in the SWIFT system
• Most maintain a settlement account with the bank of Canada.
• Can access the standing liquid facility offered by posting collateral.
• They mostly process 50,000 payments that are about 500 billion per day.
• Lynx handles most of Canada payment

Settlement

• On the daily participants send payments to one another from clients
• They can be known for being in a deficit and short (owed payment and have a shortage) or in a credit position and hold a surplus
• They all participate in a zero-sum game
• Because the BOAC requires payments, members borrow from each other in the market around 6-6:30 by 7 pm.

Regulations

• Banks positions are covered by those of whom maintain a short position and cover it by those with long position (those borrowing from each other) and it is known as the overnight rate
• The BOC (Bank of Canada) has rates and they are close to 3%
• The BOAC can also set a rate by doing this it maintains a level by also influencing where they can or cannot land.
• Banks that have credit can set aside rates that vary from 0.05%
• They also maintain a rate which is known at the bank rate (always 25 points more)

Operative Band

• These are all apart of the operative bank, the target rate is about the same while over is always 25% point.
• Since 2020 BOAC has implemented a floor system where there is a lower limit on the overnight rate.
• This will be achieved by injecting it and maintaining an increase with its control
• BOAC (bank of Canada's) today reduced its rate 3%, Bank rate at 3.25%, deposit at 2.95%.
• There for making CPI (close to 2 and under inflation to 2%) as a broad range. CPI is a constant but eased to expectations.

Implementation

• A floor is to always maintains a lower rate and this requires to obtain or control that overnight rate.
• The rate can always stay in that band, where there's a set bank rate to avoid it.
• BOAC is the "ceiling" when there's too much, that makes you less without overpayment.

Policy Changes

• BOAC influences the cost of borrowing for banks and consumers when inflation runs out of the 2% and needs to increase. It often moves all of it which can decreases the rate 25bps and can increase it to the full operating as 4.5%
• Which controls the settle- and gets the rate to change.

Supply and Adjustments

• If the Boac send to a participant, it increases and when it doesn't the opposite which is the settlement- if there's enough or isn't which affects the rate.
• Changes by BOAC- influence by its followings: Government deposits or SRA - reinforce overnight rate.

Regulation

• BOAC used money from payments to governments to influence settlement- that will make the levels.
• BOAC also increased government deposit/ BOAC can also increase the levels too
• The government of Canada increases banks reducing those in LYNX putting upwards pressure on overnight payments.
• The bank makes deposits if there are tax collections.
• Auctions and removals have the payments that decrease

Repos

• BOAC can't always achieve overnight, also uses REPOS for those. purchase security a
• This agreements allow bank to reach.

Monetary Transmission Mechanism

• Decisions that affect the price are known as the transmission mechanism
• Higher rate effect AD influence as well as price
• The is complex through various areas.
• Capital influx increases/ decreases
• Prices tend to fall negative effects
• Cost increase/ investment falls.

Lags

• 4-6 quarters output effects
• 6-8 price fully
• Since it needs to be for looking and not only by today
• It is heavily influenced based on forecasting tools for level increase.

In conclusion

• BOAC and its implement as well as maintaining it.
• Most of this is a tough target as levels go
• The BOAC has maintained close