Chapter 15 The Money Supply Process

The Bank of Canada Balance Sheet

Assets Liabilities
Securities Currency in circulation
Loans to financial institutions Reserves

BOC Balance Sheet – Liabilities

Currency in circulation – the amount of notes in the public and the depository institutions
Reserves – All banks participate Large Value Transfer System (LVTS) have an account at he
Bank in which they hold deposits (also known as settlement balances) and vault cash
 Settlement balances – deposits held by LVTS participants in the BOC
 Vault cash – physical currency held by the banks (Cash tills, cash in banking machines)
 Reserves are assets for banks but liabilities for the BOC because the banks can demand
payment on them at anytime and BOC is required to satisfy its obligations
Thus, an increase in either or both will increase the money supply.
 The sum of the Bank’s liabilities is the monetary base:
Monetary Base = Currency in circulation + Reserves
MB = BOC Liabilities = C + R

BOC Balance Sheet – Assets

Securities – Includes Bank holdings of securities issued by the Canadian government, and
other
 The Bank provides reserves to the banking system by purchasing securities
 An increase in security holdings by the Bank increases the money supply
Loans to Financial Institutions – Issuance of loans by the Bank, referred to as borrowings
from the Bank of Canada or borrowed reserves
Borrowed Reserves – Loans provided by the Bank to chartered banks
 Loans are an asset on BOC balance sheet, and liabilities on banks’ balance sheet
 Increase in loans to financial institutions may lead to an increase to the money supply
Importance of BOC’s assets: (1) Changes in asset items lead to changes in reserves and the
monetary base, and thus, the money supply, (2) these assets (government securities and Bank
loans) earn higher interest rates than liabilities (Currency in circulation, which pays no interest,
and reserves)

Control of the Monetary Base

Monetary base (also called high-powered money) is the currency in circulation (C) plus he
total reserves in the banking system (R).
MB = C + R
Open market operations – BOC’s purchases or sales of securities in the open market to
control the monetary base

Open Market Purchase from BOC

Example: BOC purchases $1,000,000 of bonds from the banks and pays for them with a
cheque.
Net Result: Reserves increase by 100 million, and thus, monetary base increases by 100
million.

Open Market Purchase from the Nonbank Public (Individual or corporation)

Example: Individual sell $100 million bonds to BO, deposit the BOC cheque in their local bank.
Nonbank Public (Individual)
 Assets Liabilities
Securities (-100m)
Chequable deposits (+100m)
Once the bank received the cheque.
Banking System
Assets Liabilities
Reserves (+100m) Chequable deposits (+100m)
Once the individual sells bonds to BOC and deposits cheque in the bank.
Bank of Canada
Assets Liabilities
Securities (+100m) Reserves (+100m)
Net Result: Reserves increase by the amount of the open market purchase, and the monetary
base increases by $100 million.

However, if the cheque is cashed, and not deposited in the local bank. The following occurs:
Nonbank Public (Individual)
Assets Liabilities
Securities (-100m)
Currency (+100m)

Bank of Canada
Assets Liabilities
Securities (+100m) Currency in circulation (+100m)
Net Result: Reserves are unchanged, and currency in circulation increases by 100 million, thus
the monetary base also increases by 100 million from the open market purchase.

During an open market purchase, if the nonbank public deposits the cheque, the reserves
increase, if the nonbank public cashes the cheque, the currency in circulation increases.
 The effects of an open market purchase on reserves depends on whether the seller of
the securities keeps the cheque as currency (Cash) or in deposit (chequable deposit)
 But, the effects of an open market purchase on the monetary base is always the same

Open Market Sale

Example: BOC sells $100 million bonds to banks or nonbank public
Nonbank Public (Individual)
Assets Liabilities
Securities (+100m)
Currency (-100m)

Bank of Canada
Assets Liabilities
Securities (-100m) Currency in circulation (-100m)
Net Result: Reserves remain unchanged, but the monetary base decreases by 100 million.

However, given that the nonbank public pays for the bonds with a cheque, the following occurs:
Nonbank Public (Individual)
Assets Liabilities
Securities (+100m)
Chequable deposits (-100m)
 Banking System
Assets Liabilities
Reserves (-100m) Chequable deposits (-100m)

Bank of Canada
Assets Liabilities
Securities (-100m) Reserves (-100m)
Net result: Reserves decreased by $100 million and likewise, the monetary base. Note: The
effects of an open market sale on the monetary base is certain, and the effects of reserves
depends on source (deposit – reserve, cash – currency in circulation)
Shifts from Deposits into Currency
 Even without open market operations, a shift from deposits to currency will impact
reserves in the banking system. However, the shift has no affect on the monetary base.
Thus, the BOC has more control over the monetary base than reserves.
Example: Individual withdraws $100 million in cash.
Nonbank public (Individual)
Assets Liabilities
Chequable deposits (-100m)
Currency (+100m)

Banking System
Assets Liabilities
Reserves (-100m) Chequable deposits (-100m)

Bank of Canada
Assets Liabilities
Currency in circulation (+100m)
Reserves (-100m)
Net Result: No impact on monetary base (MB = 100m – 100m = 0). But reserves decrease
from the shift from deposits to currency. Thus, the monetary base is a more stable
variable.

Loans to Financial Institutions

Example: BOC makes a 100 million loan to First National Bank.
First National Bank/Banking System
Assets Liabilities
Reserves (+100 m) Loans (Borrowings from BOC) (+100m)

Bank of Canada
Assets Liabilities
Loans (Borrowings from BOC-A/R) (+100m) Reserves (+100m)
Net Result: Monetary liabilities of the Bank increase by 100 million from reserves, thus, the
monetary base also increases.

Once the loan is repaid:

First National Bank/Banking System
Assets Liabilities
Reserves (-100 m) Loans (Borrowings from BOC) (-100m)

Bank of Canada
Assets Liabilities
Loans (Borrowings from BOC-A/R) (-100m) Reserves (-100m)
Net Result: Monetary liabilities of BOC decreases by 100 million in reserves, thus, the monetary
base falls. Thus, the monetary base changes in the borrowings from the Bank.
Other Factors that Affect the Monetary Base
 Thus far, open market operations and loans to financial institutions directly impact the
monetary base
 Other factors affecting the monetary base include: (1) float, and (2) government
deposits at the BOC (These factors are NOT controlled by the BOC)

Overview of the Bank of Canada’s Ability to Control the Monetary Base

 Monetary base controlled by open market operations and loans to financial institutions
o Non-borrowed monetary base (Open market sale of purchase or sale) is
completely controlled by BOC
o Whereas, borrowed reserves (loans to financial institutions) depends on the set
bank rate, thus it is not completely controlled by the BOC
Therefore, we can split the monetary base into two components: (1) complete control by BOC,
and (2) less tight control by BOC.
Monetary Base = Non-borrowed monetary base + Borrowed Reserves
MB = MB(n) + BR
Floats and government deposits also impact the monetary base, however, fluctuations are
predictable and can be offset by open market operations.

Multiple Deposit Creation: A Simple Model

Multiple Deposit Creation – The multiplier effect of deposits when the BOC supplies the
banking system with $1 of additional reserves
 An increase in reserves results in excess reserves and a change in the desired
reserve ratio. Thus, the bank decides to issues loans in full amount to achieve
their desired reserve ratio
Critiques of the Simple model
 Loans held as currency and not deposited – the creation process ceases
o Thus, currency has no multiple deposit expansion
 Banks do not make loans or buy securities in the full amount of excess reserves
o Thus, if this occurs, then the model prediction amount is overestimated

Factors that Determine the Money Supply – Relationship to Money Supply

Overview of the Money Supply Process
Money Multiplier
Money Multiplier (m) – Tells us how much the money supply changes for a given change in the
monetary base (also known as, high-powered money)
Money Supply = Money Multiplier x Monetary Base
M = m x MB
Money Multiplier Derivation

Summary
 The money multiplier is less than the simple deposit multiplier
o Reason: Although there is a multiple expansion of deposits, there is no
such expansion for currency
 Thus, if some portion of the increase in high-powered money finds its way into currency,
this portion does not multiply.
o Simple deposit multiplier undergoes maximum expansion of deposit creation,
since it did not consider all factors
o In the current money multiplier model, the increase in M, given an increase in
MB, is smaller than the simpler model

Application – Quantitative Easing and the Money Supply (2007 – 2014)

 Chartered banks hit the lowest bound of the overnight rate, and the banks could no
longer lower the interest rate. Thus, conventional monetary policies were restricted. With
restrictions, banks started using an unconventional approach – quantitative easing –
banks started purchasing large volumes of risky long-term bonds.
Why were banks using quantitative easing?
 Inverse relationship between long-term bonds and interest rates
o Lower interest rate = HIGHER long-term bond rate
 Thus, banks used quantitative easing to indirectly increase interest rates.
 Large purchase of long-term bond = Increase in demand of bond = Decrease bond rates
= higher interest rates
However, banks bought risky long-term bonds and MBS.
 During quantitative easing in 2008, monetary base increase by over 370%, but the
money supply increased by less than 110%.
Why was MB > M?
 Recall: M = m x MB
 Therefore, money multiplier was less than 1.
How can we explain this?
 Recall: m = (1+c) / (r(d) + e + c)
1. Currency ratio (c) decreased
o People started to hold less currency. When c decreases, then m and M
increases, when everything remains constant. But celeabis parabis did not exist,
and there was a major change in excess reserves.
2. Excess reserves (ER) increased significantly more
o Prior to 2008, banks did not hold any ER since they were issuing loans to
homeowners with poor credit.
o When the housing crisis hit, all banks started to hold excess reserves to avoid
bankruptcy. Thus, the money multiplier was very weak.
o The change in ER offset and exceeded the decrease in currency holding.
This explains why the money supply increased by less than the monetary base.
Chapter 16 – Tools of Monetary Policy
BOC uses three policy tools to manipulate the interest rate and the money supply: (1) Open
market operations, (2) settlement balance management, and (3) BOC advances
Overnight interest rate (reference rate) – shortest term rate
Policy rate – the target overnight rate
Operating band – Overnight rate band of 50 basis point (today)
 Bank rate - Upper limit of the operating band (interest rate BOC charges to LVTS
participant that require an overnight loan (advance) to cover negative settlement
balances
 Policy rate – mid-point of the band (target rate)
 Lower limit is the interest rate that BOC pays to LVTS for positive settlement balances

 If the overnight rate increases towards the upper limit, then the Bank will lend at a bank
rate to put a ceiling on the overnight rate, since banks will not borrow at a higher rate.
 If the overnight rate declines towards the lower limit then the Bank has a floor, since
banks will not deposit funds for a lower rate
 Excess reserves’ opportunity cost is the interest that could have been earned lending
reserves (Bank rate – 0.5)
 Overall, BOC limits the fluctuations in the overnight interest rate with the band
o Increase in the target and operating band, and thus, the bank rate signals that
the BOC would like to see higher interest rates and less money in the economy

Monetary Policy Tools

1. Open Market Operations
Open market purchases
 expand bank reserves and the monetary base, thus, lowering the short-term interest
rates and increasing money supply

Open market sales

 shrinks bank reserves and the monetary base, thus, raising short-term rates and
lowering the money supply

2. Repurchase Transactions
 Bank of Canada has stopped conducting open market operations, and now, BOC
conducts repurchase transactions with major banks and investment dealers.
Special Purchase Resale Agreements (SPRAs, or special PRAs, “repos” or “specials”)
 Reduces undesired upward pressure on overnight interest rates
 BOC special purchase pf securities then resells securities back to same dealer the next
day
o Day 0: BOC buys securities and pays cash (increases money supply)
o Day 1: BOC sells back securities and receives cash+interest
 SPRA relieves undesired upward pressure, since bank reserves and the monetary
base increases, thus interest rate and falls as the money supply increases
Sale and Repurchase Agreements (SRAs, “reverse repos” or “reverse”)
 Reduces undesired downward pressure on overnight rate
 BOC sells securities then repurchases same securities next day
o Day 0: BOC sells securities and receives cash (lower money supply)
o Day 1: BOC repurchases securities and pays cash
Application: Monetary Control in the Channel/Corridor System
 There is inflationary upward pressure and the Bank tightens monetary policy by increases
the target overnight rate
 Then, if the overnight rate is below the target, the banks will enter SRAs.
 Sale of securities will decrease the settlement balance which will increase interest
rates to remove downward pressure on overnight rate

 Now there is a negative shortage of settlement balance. Thus, BOC must neutralize the
effects of issuing SRA. BOC will auction off $100m of government deposits and paying
LVTS taking government deposits with settlement balances
 This brings the amount of settlement balances back to zero:

Increase in demand for reserves – Shift Right

Results
 Demand curve shifts to the right
 Initially BR = NBR, thus, no borrowed reserves exist. Now, at the new equilibrium, there
are borrowed reserves
 Overnight rate increases to the operating band ceiling (i(b))
Advantages and Disadvantages of the Bank’s Lending Policy
 BOC can stabilize the financial system as a lender of last resort
 Disadvantage is that setting lending policies does not guarantee that banks will borrow
from BOC
Non-Conventional Monetary Policy Tools During the Global Financial Crisis
 Narrowed operating band to 0.25% (0.25 to 0.5)
 Lowered target operating rate to the lower limit (0.25%)
 Since interest rates reach the lowest bound, the BOC lost its ability to lower long-term
rate by lowering the short-term rates. Thus, non-conventional policies were used globally.
 Zero-lower-bound problem lead to the non-conventional monetary policy tools:
 Conditional statements about future path of the policy rate
 Quantitative easing
 Credit easing

Quantitative Easing
Quantitative Easing – the purchase of financial assets by the central Bank to create excess
reserves in the banking system for banks to lend out

 Using quantitative easing, limits BOC from using monetary policy on overnight rate
 HOWEVER, if the overnight rate is = i(er) = excess reserve holding rate, BOC
can issue as many reserves AND meet the overnight target rate
 Leads to an expansion of settlement balances

Credit Easing
Credit easing – the purchase of private-sector assets by the central Bank in critical markets that
are considered important for the effective functioning of the economy
 Objective: To reduce risky spread and improve liquidity and trading in these markets and
increasing economic activities
 Can reduce market risk premium
 However, effectiveness of credit easing depends on the substitutability between asset
classes (Low substitutability = greater affect)

Discretionary Liquidity Operations

 BOC introduced term repos (term Purchase and Resale Agreements – term PRAs,
term securities lending
 Term PRAs – similar to special PRAs but term is longer than 1 day (28 days)
 Term securities lending – increase supply of high-quality securities that could be
used for collateral by banks