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Roles of the Bank of Canada

November-24-08
8:22 AM

1. Regulate Economic Activity: - The governor of the Bank of Canada (Mark Coolly) and the minister of
finance (Jim Flaherty) set the monetary policy of Canada, The Bank of Canada can use monetary policy
to help stimulate the economy during a recession or to try and slow the economy during a period of
boom.

Interest Rates

High interest rates are better known as tight credit or tight monetary policy. Low interest rates are
better known as loose credit or easy monetary policy.

During period of easy monetary policy Canadians tend to start spending more. During periods of tight
monetary policy Canadians tend to save more.

Money Supply

The Bank of Canada can also increase of decrease the money supply available in Canada to Canadians to
try and affect their spending habits.

The Canadian Economy with Tight Monetary Policy

AS
AD0
Income Price

AD1

Equilibrium 2
Y0 P0

Y1 P1
Full Employment, Full Output
Equilibrium 1

Q1 E1 Q0 E0

OUTPUT EMPLOYMENT

Economic model : how will a tight monetary policy effect the economy. To start we must show some
kind of connection between money supply and Aggregate Demand.

At this point the economy is in equilibrium where the : Out level is Q0, Employment E0, Income Level Y0,
Price Level P0

Now lets assume there is a decrease in money supply. How will the affect the graph?

M ↓ then C ↓

Therefore

As C ↓ AD ↓ to AD1 because AD = C + I + G + X + M

This will cause the curve to shift to the left

Now there will be a new equilibrium where AD 1 crossing the AS where the point in the economy is in
equilibrium where the output level decreases to Q1, employment decreases to E1, Income Level
decreases to Y1 and Price level decreases to P1.

Unit 4 - Monetary Policy Page 1


decreases to Y1 and Price level decreases to P1.

M ↓ C ↓ AD ↓ Q ↓ EMPLOYMENT ↓ Y ↓ P ↓

The Canadian Economy with an Easy Monetary Policy

AS
AD1
Income Price

AD0

Equilibrium 2
Y1 P1

Y0 P0
Full Employment, Full Output
Equilibrium 1

Q0 E0 Q1 E1
OUTPUT EMPLOYMENT

Economic Model: How will a change in interest rates effect the Economy.

At that point the economy is in equilibrium where the output level is Q0, employment level E0, income
Y0, price level P0.

Now lets assume there is a decrease in interest rates how will the effect the graph?

As R ↓ S ↓ C ↑ AND THEREFORE AD ↑ TO AD1 BECAUSE AD = C + I + G+ X + M

This will cause the curve to shift to the right.

Now there will be an new equilibrium where AD1 crossing the AS at that point the economy is in
equilibrium where the:

• Output level increases from q0 to q1


• Employment increases from E0 to E1
• Income level increases from Y0 to Y1
• Price level increase P0 to P1

In conclusion

As R ↓ S ↓ C ↑ AD ↑ Q ↑ Employment ↑ Y ↑ P ↑

2. Fight Inflation: The B of C is set up to keep an eye on inflation. The B of C is truly set up as a watch dog
to make sure inflation rates do not go up that much. Currently Canada has a policy to maintain inflation
below 2-3% per year. In the late 80's and early 90s B of C wanted inflation to be 0.

Again B of C can use interest rates or money supply to try and maintain control of inflation. To control
inflation they will use tight money policy by increasing interest rate or decreasing money supply. See
graph one.

3. Regulation Foreign Exchange Rates : Canada has a floating exchange rate. This means the value of the
Canadian currency is decided on the world market. It is determined by the supply of the Canadian
dollars and the demand for Canadian dollars. However, at times the B of C feels that it is in the best

Unit 4 - Monetary Policy Page 2


dollars and the demand for Canadian dollars. However, at times the B of C feels that it is in the best
interest of Canadians to regulate this activity. If the Canadian dollar falls too much this might create a
panic in Canadians, so B of C steps in to prevent huge drops. Also B of C also realizes that if the Canadian
dollar increases too much in value this will hurt Canadian Export market so they don't allow huge gains
either. For this reason Canada does not have a free float. It has a dirty float.

Example:

Dirty Float the Canadian Exchange with the Bank of Canada Intervention

S0
S1

Prices of one
Canadian Dollar in
terms of US

E0

E1
D0

Q0 Q1

As S0 = D0

The exchange is E0 at this exchange the Bank of Canada feels the exchange is too high and will hurt the
Canadian export sector, therefore they get involved and try to increase the supply of Canadian dollars
which will bring the exchange rate down to E1 which is more acceptable exchange rate.

4. Regulates the Banking System: the B of C is also known as the banker's bank. The B of C is the central
bank in Canada, and it holds some deposits from the Chartered banks in Canada (RBC, CIBC, BMO, TD,
HSBC). The B of C also sets the laws and rules that regulate the Chartered Banks, Trust companies,
Mortgage companies, and credit unions. Some of the laws that are created deal with cash reserves if the
banks, lending policies of bank, service charge policies, who can become a chartered bank and etc.
5. Government's Bank : The B of C is also known as the Government of Canada's Bank. The government
deposits its money with the B of C. The bank of Canada issues government bonds to be sold. It looks
after the Canadian Mint, printing of Canadian money. It also covers the paying of government expenses
and the collection of government revenues.

Unit 4 - Monetary Policy Page 3