Chapter Six

Structure of Central Banks and the Bank of Canada

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The Bank of Canada (The Bank)

• The Bank was created by the Bank of Canada Act in 1934 and started operations on March 11, 1935

• Initially the Bank was a private institution but was nationalized in 1938, so is now a national institution with headquarters in Ottawa

• The Bank also has regional offices in Toronto, Vancouver, Calgary, Montreal, and Halifax

• 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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Formal Structure of the Bank of Canada

• Responsibility for the operation of the Bank rests with a Board of Directors, which consists of fifteen members

• the Governor (who is the chief executive officer and chairman of the Board of Directors). Is currently David Dodge.

• the senior deputy governor, • the deputy minister of finance, and • twelve outside directors• 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.

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David Dodge, Governor of the Bank of Canada

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The Bank’s Commitment to Canadians

• Conduct monetary policy in a way that fosters confidence in the value of money

• Supply quality bank notes that readily accepted and secure against counterfeiting

• Promote the safety and efficiency of Canada’s financial system• Provide efficient and effective funds-management services• Communicate our objectives openly & effectively and stand

accountable for our actions

Source: About the Bank, Bank of Canada publication

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The Functions of the Bank of Canada

 The functions of the Bank of Canada include:• Monetary policy• Currency• The financial system• Funds management• Retail debt services

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Monetary Policy

• Monetary policy is the management of the flow of money and credit in the economy, in order to preserve confidence in the value of money

• The ultimate objective of monetary policy is to promote solid economic performance and a higher standard of living

• The best way to achieve that objective is to keep inflation low, stable & predictable, thereby giving Canadians confidence in the future value of their money, so that they can make sound economic and financial decisions.

• Low & stable inflation also helps to prevent inflationary “boom & bust” cycles that lead to painful recessions and higher unemployment

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Monetary Policy

• The cornerstone of Canada’s monetary policy framework is a target for inflation – as measured by the Consumer Price Index (CPI) – set jointly by the Bank of Canada and the Government of Canada.

• The Bank is publicly committed to keeping the trend of inflation at 2%, the midpoint of a target range of 1 – 3%

• The inflation target works hand-in-hand with Canada’s flexible exchange rate. The exchange rate of the dollar is determined by the market and is influenced by many factors, primarily:

– Economic conditions in Canada and abroad, – World commodity prices, – Conditions in international money markets

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Monetary Policy

• A floating currency is a key component of Canada’s monetary policy framework, helping the economy adjust to shocks

• Neither the government nor the Bank of Canada targets any particular level for the value of our currency, believing that this should be determined by market forces

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Monetary Policy

• The Bank carries out its monetary policy by influencing very short term interest rates.

• It does this by changing the target for the overnight interest rate – the rate that financial institutions charge each other for overnight loans.

• The overnight interest rate is maintained within a 50 basis point band around the target for the overnight rate. This is known as the operating band

• The top of the operating band is the Bank Rate – the rate that the Bank of Canada charges to large financial institutions that borrow from it during the clearing process

• The bottom of the operating band is the rate that the Bank of Canada pays to Financial Institutions on positive balances held overnight

• The midpoint of the band is the Bank’s target for the overnight rate

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Monetary Policy: Target for the Overnight Rate

Date Target (%) Change (%)

24 January 2006 3.50 +0.25

6 December 2005 3.25 +0.25

18 October 2005 3.00 +0.25

7 September 2005 2.75 +0.25

12 July 2005 2.50 ---

25 May 2005 2.50 ---

12 April 2005 2.50 ---

1 March 2005 2.50 ---

25 January 2005 2.50 ---

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Currency

• The Bank of Canada is responsible for the design, production & distribution of paper currency

• The difference between the cost of printing a note and its market value is known as seignorage

• The Bank of Canada monetizes the debt of the government [it exchanges a liability that is not money (a T Bill) for a second liability that is money (a bank note)]

• Visit the Currency Museum at www.currencymuseum.ca

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Currency

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The Financial System

• Canada’s financial system consists of – Financial institutions, such as banks, credit unions, securities firms and

insurance companies– Financial markets, such as securities and foreign exchange markets– Clearing & settlement systems, through which funds or securities flow

from one financial institution to another and transactions are settled

• The Bank of Canada works with other agencies and market participants to promote the safe and efficient operation of these key elements of the financial system

• Publishes the Financial System Review twice annually to update Canadians on new developments & research

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The Financial System

• All direct clearers maintain accounts at the Bank of Canada

• At the end of each day, the net claims of each direct clearer are calculated and transfers of funds then occurs among their accounts at the Bank of Canada

• The Bank of Canada provides loans to participants in the clearing system, when required

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Funds Management

• The Bank of Canada is the federal government’s fiscal agent. It acts as banker and manager for Canada’s debt and reserves, and manages the government’s exposure to financial risk

• The Bank handles the deposit accounts for the Receiver General. Almost all money collected by the government flows through these accounts.

• The Bank maintains foreign currency accounts at other central banks around the world and it maintains accounts for other central banks & international financial institutions

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Funds Management

• The federal government finances most of its operations through taxation & borrowing.

• Most of the borrowing is done by issuing Government of Canada bonds and Treasury Bills.

• The Bank of Canada advises on, and manages, these issues of securities

• The Bank also makes sure that the government has sufficient cash balances to meet its daily cash requirements and invests any excess balances

• The Bank advises the government on its investment policy for foreign exchange reserves and manages those reserves

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Retail Debt Services

• The federal government also issues – Canada Savings Bonds (CSB),

– Canada Premium Bonds (similar to a CSB but with a higher interest rate & is only cashable once a year) and

– Canada Investment Bonds (ceased to be issued in 2004)

to the retail public• The Bank acts as fiscal agent for this retail debt

program and oversees its operations and systems support

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Bank of Canada Independence

Factors making Bank of Canada independent

1. Bank has ‘operational’ (or ‘instrument’) independence

2. Bank has moved towards greater ‘transparency’ in its operations

Factors making Bank of Canada dependent

1. Joint responsibility system

2. Minister of Finance can issue a directive to the Bank indicating the specific policy changes that the Bank must follow

Overall: Bank of Canada is quite independent but not on paper

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Central Bank Independence

• Other Central Banks

1. Bank of Japan (like the Bank of Canada) —fair degree of independence, but not all on paper

2. Bank of England and Bank of Japan made more independent in 1997 and 1998, respectively.

3. European Central Bank most independent

4. Trend to greater independence

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Explaining Central Bank Behaviour

• Theory of Bureaucratic Behaviour

1. Is an example of principal-agent problem

2. Bureaucracy often acts in own interest

• Implications for Central Bank Behaviour

1. Act to preserve independence

2. Try to avoid controversy—often plays games

3. Seek additional power over banks

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Explaining Central Bank Behaviour

• Should the Bank of Canada be independent?

• Case for1. Independent Bank likely has longer run objectives,

politicians don't—evidence is that get better policy outcomes

2. Avoids political business cycle

3. Less likely budget deficits will be inflationary

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Explaining Central Bank Behaviour

• Case against1. Bank of Canada may not be accountable

2. Hinders coordination of monetary and fiscal policy

3. Bank of Canada has often performed badly

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Central Bank Independence and Macroeconomic Performance in 17 Countries