The Economics of Money, Banking, and
Financial Markets
Seventh Canadian Edition
Chapter 14
Central Banks and the Bank of
Canada
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Learning Objectives (1 of 2)
1. Recognize the historical context of the development
of the Bank of Canada
2. Describe the key features and functions of the Bank
of Canada.
3. Assess the degree of independence of the Bank of
Canada.
4. Summarize the arguments for and against the
independence of the Bank of Canada.
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Learning Objectives (2 of 2)
5. Identify the ways in which the theory of bureaucratic
behavior can help explain central bank actions.
6. Assess the degree of independence of other major
central banks around the world.
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Origins of the Bank of Canada
• The Bank was created by the Bank of Canada Act
in 1934 and started operations in 1935
• Initially the Bank was a private institution but was
nationalized in 1938, so is now a national institution
with headquarters in Ottawa
• Unlike a private bank that operates in pursuit of
profit, the Bank of Canada is responsible for the
country’s monetary policy and for the regulation of
Canada’s deposit-based financial institutions
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Structure of the Bank of Canada (1 of 2)
• Responsibility for the operation of the Bank rests
with a Board of Directors, which consists of fifteen
members:
– The Governor (who is also the chief executive officer
and chairman of the Board of Directors)
– The Senior Deputy Governor
– The Deputy Minister of Finance
– Twelve outside Directors
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Structure of the Bank of Canada (2 of 2)
• The Board appoints the governor and senior
deputy governor with the government’s approval,
for a renewable term of 7 years
• The outside directors are appointed by the minister
of finance, with cabinet approval, for a 3-year term
• The Governing Council is chaired by the governor
and is composed of the senior deputy governor and
four deputy governors
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Functions of the Bank of Canada
• The functions of the Bank of Canada are:
– Currency
– Funds Management
– Financial System
– Monetary Policy
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Currency
• Before the creation of the Bank, the federal
government and the early banks issued notes
• By 1945 the Bank had a monopoly over note issue
in the country
• The Bank also conducts ongoing research
– To improve cost-effectiveness
– Increase the durability of bank notes
– Reduce counterfeiting
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Funds Management
• As the federal government’s fiscal agent, the Bank:
– Provides debt-management services for the federal
government such as:
advising on borrowings
managing new debt offerings
servicing outstanding debt
– Manages the government’s foreign exchange reserves
held by the Exchange Fund Account
– Engages in international financial transactions to
influence exchange rates
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Financial System
• As Canada’s central bank, the Bank of Canada:
– Serves as the lender of last resort if a bank faces a
liquidity crisis (thereby preventing bank runs and panics)
Has power to create base money
– Has explicit responsibility for the regulatory oversight of
the national payments system, operated by the CPA
– Acts as the holder of deposit accounts for:
the federal government
the directly clearing members of the CPA
international organizations such as the IMF
other central banks
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Monetary Policy
• The Bank employs such tools as:
– Open market operations
– Shifting of government balances between it and the
direct clearing members of the CPA to implement
changes in the money supply
• The Bank’s ultimate objective is to keep inflation
low
– Low inflation is closely related to the goal of steady
economic growth
– Low inflation protects the purchasing power of
pensioners and those on fixed incomes
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How does the Central Bank Manages Money
Supply?
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Three Players in the Money Supply Process
1. The central bank
– The government agency that oversees the banking
system and is responsible for the conduct of monetary
policy
2. Banks (depository institutions)
– The financial intermediaries that accept deposits from
individuals and institutions and make loans
3. Depositors
– Individuals and institutions that hold deposits in banks
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The Bank of Canada’s Balance Sheet
Bank of Canada
Assets Liabilities
Securities Currency in circulation
Loans to financial institutions Reserves
• Liabilities
– Currency in circulation: in the hands of the public
– Reserves: deposits (settlement balances) at the Bank of Canada and
vault cash – these are particularly important for our analysis
• Assets
– Government securities: holdings by the Bank of Canada that affect money
supply and earn interest
– Loans to financial institutions: provide loans (advances) to banks and
charge the bank rate
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Increase Money Supply
• Corporation and the public sells security to the
Central Bank (Open market operation)
• Increased loan to financial institutions - reduce
interest rates
• Decrease in Reserve Ratio
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Decrease Money Supply
• The central bank sells security to corporations
and the public (Open market operation)
• Increase interest rates to Financial institution
• Increase the Reserve Ratio
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Open market operations
• What happens to the money supply when the
central bank purchases securities ?
• And when the central bank sells securities?
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Open market operations
• When the Central bank sells securities- money
supplies decrease
• When the Central bank purchases securities
money supply increases
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Open Market Purchase from a Bank
Banking System Bank of Canada
Assets Liabilities Assets Liabilities
Securities $100m Securities +$100m Reserves +$100m
Reserves +$100m
• Bank of Canada purchases $100m of bonds from a bank
and pays them with a $100m cheque
• Liabilities increase by $100m
• Net result is that reserves have increased by $100m
• No change in currency
• Monetary base hasCopyright
risen©by $100m
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Open Market Purchase from the Nonbank
Public
Banking System Bank of Canada
Assets Liabilities Assets Liabilities
Reserves +$100m Chequable +$100m Securities +$100m Reserves +$100m
deposits
• Central bank purchase from Non bank public $100m of
bonds and deposits the Bank’s cheque in the local bank
• Person selling bonds to the Bank of Canada deposits the
Bank’s cheque in the bank
• Identical results as the purchase from a bank
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Open Market Purchase from the Nonbank
Public (cont’d)
Nonbank Public Bank of Canada
Assets Liabilities Assets Liabilities
Securities -$100m Securities +$100m Currency in +$100m
circulation
Currency +$100m
• The Central bank purchase bonds and cheque is cashed
• Reserves are unchanged
• Currency in circulation increases by the amount of the open
market purchase
• Monetary base increases by the amount of the open market
purchase
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Open Market Sale
Nonbank Public Bank of Canada
Assets Liabilities Assets Liabilities
Securities +$100 Securities -$100 Currency in -$100
circulation
Currency -$100
• Bank of Canada sells $100 of bonds to a bank or the non-
bank public
• Reduces the monetary base by the amount of the sale
• Reserves remain unchanged
• The effect of open market operations on the monetary
base is much more certain than the effect on reserves
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Loans to Financial Institutions
Banking System Bank of Canada
Assets Liabilities Assets Liabilities
Reserves +$100m Advances +$100m Advances +$100m Reserves +$100m
• When the Bank makes a $100m loan to a bank, the bank is
credited with $100m of reserves (settlement balances) from the
proceeds of the loan
• Monetary liabilities of the Bank of Canada have increased by
$100m
• Monetary base also increases by this amount
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Reserved Ratio Banks
• If the desired reserve ratio is 10%, then loan out
$90 from the initial $100 increase in deposits
– Earn profit from the higher interest rate on the load
First National Bank
Assets Liabilities
Reserves +$10 Chequable deposits +$100
Excess Reserves +$90
First National Bank
Assets Liabilities
Reserves +$10 Chequable deposits +$100
Loans +$90
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Reserved Ratio at Banks
• If the desired reserve ratio is 20%, then loan out
$80 from the initial $100 increase in deposits
– Earn profit from the higher interest rate on the load
First National Bank
Assets Liabilities
Reserves +$20 Chequable deposits +$100
Excess Reserves +$80
First National Bank
Assets Liabilities
Reserves +$10 Chequable deposits +$100
Loans +$90
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Should the Bank of Canada Be
Independent?
• The Bank of Canada is probably the most
independent government agency in Canada
• The question arises whether the independence
given to the Bank of Canada should be curtailed
• Politicians who strongly oppose a Bank policy often
want to bring it under their supervision in order to
impose a policy more to their liking
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The Case for Independence
• Political pressure would impart an inflationary bias
to monetary policy
• Should avoid political business cycles, where
before elections expansionary policies are pursued
• Avoids using the Bank to facilitate government
financing of large budget deficits: accommodation
• Monetary policy is too important to leave to
politicians — the principal-agent problem is worse
for politicians
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The Case Against Independence
• Undemocratic
• Unaccountable
• Difficult to coordinate fiscal and monetary policy
• Some may feel the Bank has not used its
independence successfully
• Internationally, while countries with independent
central banks have lower inflation, they don’t have
very different unemployment rates or output
fluctuations
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Question
• If the Bank of Canada sells $2 million of
bonds to the First National Bank, what
happens to reserves and the monetary
base? Use T-accounts to explain your
answer.
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Solution
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Question
• If the Bank of Canada lends five banks a
total of $100 million, but depositors
withdraw $50 million and hold it as
currency, what happens to reserves and the
monetary base? Use T-accounts to explain
your answer.
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Solution
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Solution
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Question
• Using T-accounts, show what happens to
chequable deposits in the banking system
when the Bank of Canada sells $2 million of
bonds to the First National Bank.
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Solution
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Any questions ?
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Factors Making Bank of Canada Dependent
• Joint responsibility system
• Minister of Finance can issue a directive to the
Bank indicating the specific policy changes that the
Bank must follow
– Published, set out new policy, period that it applies
• While the ultimate authority rests with the
government, Bank of Canada is quite independent
and no government directives have ever been
issued
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How Independent Is the Bank of Canada?
• Instrument but not goal independence
• Two main principles reflecting Louis Rasminsky’s
view of Bank of Canada independence
– “ .. 1) in the ordinary course of events, the Bank has the
responsibility for monetary policy, and 2) if the
government disapproves of the monetary policy being
carried out by the Bank, it has the right and
responsibility to direct the bank as to the policy which
the Bank is to carry out.” (Louis Rasminsky, July 24,
1961)
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The Changing Face of the Bank of Canada
• Bank desires to explain and build confidence in the
Bank’s actions
• Bank has moved towards greater transparency and
accountability in its operations
• The Bank’s Governing Council publishes the Monetary
Policy Report
• Increased the number of press conferences/releases
and speeches, and reorganized its regional offices,
with the objective of improving communication
• Has a comprehensive website: www.bankofcanada.ca
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Explaining Central Bank Behaviour (1 of 2)
• Theory of bureaucratic behaviour
– Is an example of principal-agent problem
– Bureaucracy often acts in own interest
• Implications for Central Banks:
– Act to preserve independence
– Try to avoid controversy
– Seek additional power over banks
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Explaining Central Bank Behaviour (2 of 2)
• Theory of bureaucratic behaviour:
objective is to maximize its own welfare which is
related to power and prestige
– Fight vigorously to preserve autonomy
– Avoid conflict with more powerful groups
• Does not rule out altruism
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Federal Reserve System
• U.S. central bank, the Federal Reserve System
– “the Fed”
• Includes:
– Board of Governors of the Federal Reserve System
– Federal Reserve Banks
– Federal Open Market Committee (FOMC)
– Federal Advisory Council
– 2500 member commercial banks
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Figure 14-1
Structure and Responsibility for Policy Tools in the Federal Reserve System
The relationships of the Federal Reserve banks, the Board of Governors of the Federal Reserve System,and the FOMC
to the three policy tools of the Fed (open market operations, the discount rate, and reserve requirements). Dashed lines
indicate that the FOMC “advises” on the setting of reserve requirements and the discount rate.
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Board of Governors of the Federal Reserve
System
• Seven members headquartered in
Washington, D.C.
• Governors are appointed by the president and
confirmed by the Senate
• Serve 14-year non-renewable term
• Required to come from different districts
• Chairman is chosen from the governors and serves
four-year term
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Federal Reserve Banks
• Each of the twelve Federal Reserve districts has
one main Federal Reserve bank
• The three largest Federal Reserve banks in terms
of assets are those of New York, Chicago,
and San Francisco
– They hold more than 50% of the assets of the
Federal Reserve System
– The New York bank, with around one-quarter of the
assets, is the most important of the Federal Reserve
banks
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Figure 14-2
Federal Reserve System
The locations of the Federal Reserve districts, the Federal Reserve banks, and their branches.
Source: Federal Reserve Bulletin
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Federal Open Market Committee (FOMC)
• Meets eight times a year
• Consists of seven members of the Board of
Governors, the president of the Federal Reserve
Bank of New York and the presidents of four other
Federal Reserve banks
• Chairman of the Board is also chair of FOMC
• Makes decisions regarding:
– The conduct of monetary policy
– The setting of the policy interest rate
(the federal funds rate)
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How Independent Is the Fed?
• The Federal Reserve appears to be remarkably
free of the political pressures that influence other
agencies
• The power of the U.S. President in appointing
members to the Board is limited
– The term of the Chairman of the Board is not necessarily
concurrent with that of the president
• Not entirely free of politicial pressures
– To understand the Fed’s behaviour, we must recognize that
public support for the actions of the Federal Reserve plays a
very important role in its decisions
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The European Central Bank
• European Central Bank (ECB)
– The central bank of the euro area countries
– Conducts monetary policy for countries that are members of
the European Monetary Union
– Monetary operations of the Eurosystem are conducted by all
the National Central Banks in each country
– The ECB is the most independent central bank in the world
• Maastricht Treaty
– Established Eurosystem
– Makes the ECB instrument-independent
– Specifies that the goal of the ECB is price stability
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ECB Governing Council
• Monthly meetings at ECB in Frankfurt, Germany
• Twelve National Central Bank heads and six
Executive Board members
• Operates by consensus
• ECB announces the target rate and takes
questions from the media
• To stay at a manageable size as new countries
join, the Governing Council will be on a system of
rotation
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How Independent Is the ECB?
• Most independent in the world
• Members of the Executive Board have long terms
• Determines own budget
• Less goal independent
• Charter cannot by changed by legislation; only by
revision of the Maastricht Treaty
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Structure and Independence of Other
Foreign Central Banks
• Bank of England
– Has some instrument independence
– Government can overrule the Bank and set interest rates
• Bank of Japan (Nippon Ginko)
– Has some degree of instrument and goal independence
– The objective of monetary policy is to attain price stability
– Government can request delays in monetary policy decisions
• Growing international trend towards greater Central
Bank independence
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