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Elemental Economics

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Competitiveness of Nations

Cultural Econom


Elemental Economics

World Cultural Intelligence Network


Dr. Harry Hillman Chartrand, PhD

Cultural Economist & Publisher

Compiler Press


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Launched  1998




5.0 Fiscal & Monetary Policy (cont'd)


5.2.5 Monetary Policy

a) Objectives

The central bank is a relatively new institution.  For those interested in its hstory, please see Observation #6: A Brief History of the Central Bank - UK, USA & Canada.  Today the primary objective of every central bank is preservation of the value of the currency – internally with respect to domestic inflation and externally with respect to the exchange rate.  Secondary objectives include acting as the government’s banker and debt manager (particularly internationally), moderating the business cycle as well as fostering economic growth and full employment.

The primary objective goes to the heart of economic expectations.  The expected price level is the basis of aggregate expenditure including consumption, investment, government and export/import decisions.  The uncertainty created by inflation affects the present value of future 'real' earnings, i.e., how much one is willing to pay today for a future stream of earnings tomorrow. Change the expectation and a different outcome will be reached.  If prices rise or fall too fast choices must be hastily re-calculated.  Uncertainty increases and uncertainty is the great and costly enemy of investment. 

Rising prices also affect asset values and hence wealth with a corresponding 'wealth effect'.  In a capitalist society or plutocracy wealth is the measure of one’s worth.  Wealth owners – large and small - have a vested interest in price stability and the value of their assets. The central bank serves their interests.  In a sense, the Central Bank is a fourth order of government beyond the executive, legislative and judicial.  It represents an institutional marriage of the political and financial worlds in a capitalist society.  The Great Depression taught that the animal spirits of the investment community could not be trusted to operate in society's best interest; long history had already taught that letting the State control the printing press leads to similarly bad outcomes.  A balance was struck: the modern Central Bank, a post-Great Depression institution.

The logic of control goes like this: by manipulating the money supply the Central Bank changes interest rates; by changing interest rates the central bank can control investment; by controlling investment the central bank can manipulate aggregate demand; and, thereby, the central bank controls the aggregate price level, i.e., inflation.  Similarly, control of interest rates allows the Bank to raise or lower the exchange rate to encourage or discourage foreign investment.  Discretionary change in monetary policy suffers from policy lag - is there an emerging problem - recession/inflation?  Recognition then requires decision-making - what tools should we use?  Having the tools in hand how long will it take to nudge the system to a low inflation, full employment AD/AS equilibrium? 

Control of interest rates, of course, allows the Central Bank to achieve both its primary objective of stabilizing the value of the currency and, in some jurisdictions, secondary objectives including moderating the business cycle and fostering economic growth and full employment.

b) Tools

The question arises: How does the central bank manipulate the money supply and thereby interest rates and thereby investment and thereby aggregate demand?  It uses five principal tools.

i - Required Reserve Ratio (C10/230-33: 215-18; 224-225)

First, there are reserve ratio requirements.  By law or moral suasion chartered banks and other deposit taking institutions may be required to increase or decrease a percentage of their deposits held in reserve in case of  a ‘run’, i.e., many if not all depositors asking for their money back at the same time.  If the reserve ratio is 10% then 90% of deposits may be loaned to earn interest and thereby increase the money supply, i.e., banks make money by making money.   If the ratio is lowered more loans are made, interest rates fall and investment increases, etc.  If the ratio is raised loans are called in (so-called demand loans first) and the money supply shrinks, interest rates go up and investment falls, etc

This describes the situation at the retail level which was the subject of post-Great Depression banking reforms.  At the wholesale level, however, the shadow banking system is not currently subject to reserve requirements as such.  Leverage of some investment banks leading to the Great Recession was in some cases as high as 300:1.  In effect reserve requirements act as tax on lending institutions by imposing an opportunity cost measured by interest income foregone on reserves.  How reserve requirements may be applied to the wholesale or shadow banking system in the post-Great Recession period remains to be seen.

ii - Bank Rate and Banker’s Deposit Rate

Second, like all businesses deposit taking institutions experience short-run cash flow problems.  The central bank acts as “the banker’s bank”.  When an institution borrows from the central bank the rate is the ‘bank rate’.  As lender the central bank can charge more or less than last time indicating the direction it wishes interest rates to go and thereby add or subtract from reserves of lending institutions.  In Canada, the Bank of Canada also uses the 'over night' rate to commercial banks for short term borrowing.

The central bank also holds deposits by chartered banks and other lending institutions on which it pays interest.  Again it can raise or lower that rate signally its policy.  The rate paid is “the banker’s deposit rate”.

iii - Open Market Operations (C10/237-38: 222-23; 230-232)

Third, there is an array of government securities that can be bought and sold on financial markets as income earning assets, e.g., Treasury Bills and Canada Savings Bonds.  By varying their rates, terms and conditions deposit taking institutions are encouraged to buy or sell them thereby increasing or decreasing reserves.  The money supply increases or decreases, interest rates move, investment changes, etc.

Treasury Bill auctions are a favoured instrument.  Usually 90 days in duration they are backed by the sovereign power of the State.  Treasury Bills are the safest investment and command no risk premium.   The central bank requests bids for a certain amount usually offered to meet the government’s short-term cash flow needs.  The central bank then decides which bids to accept.  If it wants rates to rise it accepts higher bids; to fall, lower bids; if stable, the existing market rate.  If rates go up, investment goes down, etc. and vice versa.

iv - Government Deposit Shifting

Fourth, the government maintains deposit accounts with the Bank of Canada and other lending institutions.  These accounts are managed by the central bank.  By shuffling government accounts it can increase or decrease deposit taking institutions’ reserves.  The money supply expands or contracts; interest rates fall or rise; investment grows or declines, etc.

v - Moral Suasion

Just as animal spirits capture the emotional depths of investment, moral suasion captures the emotive power of the central banker.  What and the way a chairman of the Federal Reserve, or Governor of the Banks of Canada or England say or how they raise their eyebrows in public is intensely studied.  This is similar to back in the USSR when photos of who stood next to whom on Lenin’s tomb during the May Day parade became an academic career, a.k.a., the dark art of Kremlinology.

Kenneth Boulding captured the mystery and magic of the central bank when he wrote in his 1972 article “Towards a Cultural Economics”:

I have argued for years that bankers were a savage tribe who should be studied by the anthropologists rather than by the economists, and I once tried to persuade Margaret Mead to do a book on “Coming of Age in the Federal Reserve,” with, I regret to say, no response at all!  The culture of bankers, indeed, is more mysterious than that of the Dobuans or the Chuk-Chuks.  The Navaho indeed may have a Harvard anthropologist in every family, but the Federal Reserve Board has, to my knowledge, never allowed a single one to attend the ceremonials in its marble hogan.  Nobody really knows what bankers are like, what kinds of images of the world they have, what they talk about, what kind of gossip they follow, what taboos they have, and how their decisions are made.  The economics of money and banking is almost entirely a matter of the analysis of published statistics and the attempt to find correlations among them.  It is pure “black box” analysis with practically no attempt to pry off the lid to see what are the actual processes which produce the often very peculiar outputs.

Arguably, moral suasion is the most efficient tool of the central bank.  At the top of the financial food chain, a simple nod or a wink is usually sufficient to elicit an appropriate response from the chartered banks and other financial intermediaries.

It is important to note that with deregulation of much of the US banking system during the 1990s a new 'shadow banking' system arose outside the direct control of the central bank.  For those interested, please see Observation #7: Shadow Banking & the Great Recession of 2008.


c) Interaction with Fiscal Policy

Before considering monetary policy’s application in lowering unemployment or inflation respectively in a recessionary or inflationary gap it is important to note that a central bank may pursue one of two alternative ‘target’ strategies.  The first is a money supply target that remains fixed while the shifting demand for money curve increases or decreases interest rates.  Monetarist policy publicly promises to increase the money supply only to match real growth in the economy and thereby avoid price inflation.  What happens to investment is left to the market. 

The second is an interest rate target that shifts the vertical inelastic money supply curve to match increases in the demand for money in order to maintain a targeted interest rate.  This publicly announced strategy increases investment confidence.

While a secondary objective the central bank can use its powers to increase employment and shift the economy from a recessionary gap into full employment.  By increasing the money supply it lowers interest rate.  By lowering interest rates it increases investment.  By increasing investment it shifts the aggregate demand curve up to the right into full employment equilibrium between aggregate demand, short-run aggregate supply and potential – the Keynesian Double Cross.

Fighting inflation and maintaining the value of the currency is the primary objective of the central bank.  When the economy enters an inflationary gap market forces will eventually raise factor prices and shift the short-run aggregate supply curve up to the left until equilibrium between aggregate demand, short-run aggregate supply and potential is achieved.  This will, however, include a significant increase in the aggregate price level, a.k.a., inflation.  If, however, the central bank tightens the money supply thereby raising interest rates and decreasing investment before factor prices can increase then it can shift the aggregate demand curve down to the left until equilibrium is achieved at a lower price level.


5.2.6 AD-AS Model 

4. Influencing Interest and Exchange Rates
a) Interest Rate (P&B Fig 28.10; R&L 13th Ed Fig. 28-3, Fig. 29-1)
b) Exchange Rate

5. Ripple Effects of Monetary Policy
a) Interest Rate Fluctuations
b) Exchange Rate Fluctuations

6. Money in the AD-AS Model
a) Unemployment (P&B Fig. 28.6)
b) Inflation (P&B Fig. 28.7)
c) Real GDP



4.2.8 Quantity Theory of Money
- GDP = PY
- V = PY/M
- MV = PY
- P = (V/Y)M

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