Obviously, the conduct of monetary policy is extremely important to the nation’s economy. A properly conducted monetary policy can be very beneficial, whereas errors in monetary policy can have severe effects on the economy, either due to the creation of too much or too little money.
Who should make such important decisions? Some people believe that the financial experts at the Bank of Canada, who possess specialized knowledge of monetary matters, should have the responsibility and the power to decide the nation’s monetary policy. Other people disagree. They argue that such important policy decisions should not be made by the appointed officials at the Bank of Canada, but rather by the government, which was elected by (and is ultimately responsible to) the people.
The question of who possessed the final responsibility and authority for monetary policy remained somewhat vague until 1960, when matters came to a head in the celebrated “Coyne affair.” James Coyne, governor of the Bank of Canada, was pursuing a tight-money policy at the same time as the federal government was trying to stimulate the economy with budget deficits. When Coyne refused to alter the Bank of Canada’s policies, the government in effect dismissed him by introducing legislation declaring his position vacant. By this act, the government established itself as the final authority in the area of monetary policy. This was given legislative authority in amendments to the Bank of Canada Act in 1967, which stated that in the event of disagreement between the government and the Bank of Canada, the government can direct the central bank in writing as to the monetary policy to be followed.
Supporters of the government’s authority over the Bank of Canada argue that, without this authority, the government cannot ensure that the Bank of Canada’s monetary policy is consistent with the federal government’s fiscal policies, and point to the Coyne affair as evidence on their behalf. Critics of the government’s authority over monetary policy have little faith in the economic judgement of politicians.
In Chapter 9, we saw how the federal government’s Department of Finance uses fiscal policy to influence the level of aggregate demand in the economy. Since the monetary policy of the Bank of Canada discussed in this chapter also influences aggregate demand, we should review briefly how monetary and fiscal policies can interact so as to affect the performance of the economy.
During a recession, when aggregate demand is inadequate, a budget deficit (achieved through increased government spending and/or tax reductions) is usually combined with an easy-money policy consisting of lower interest rates and increased availability of loans. The objective of these policies is to increase the demand for goods and services by households and businesses. This increase in spending will be added to by the respending effect of the multiplier, and will be in large part financed by increases in the money supply resulting from increased bank lending. Also, it is possible that increased consumer spending may cause businesses to increase their investment spending (the accelerator effect), a process which would also be financed by the increased money supply through bank lending, encouraged by reductions in interest on loans. The overall result would be to stimulate output and employment in the economy.
During a period of inflation, aggregate demand for goods and services is so high that the supply of them cannot keep pace, with the result that prices rice with unusual rapidity. To combat inflation, a combination of a budget surplus (tax revenues in excess of government spending) and tight money, with loans relatively scarce and interest rates high, is appropriate. The objective of these policies is to depress the demand for goods and services, so as to relieve the pressure of excess demand on the supply and on the prices of goods and services. Government spending will be held down, while tax increases and high interest rates will restrain borrowing and spending by consumers and businesses. With total demand depressed in these ways, the rate of inflation will tend to decrease.
By combining the the fiscal policy of the Department of Finance and the monetary policy of the Bank of Canada in these ways, the effect can be considerably stronger than if either were used by itself.
In summary, then, tight-money policies are used to combat inflation by depressing the level of aggregate demand. While these policies will slow down inflation, they also tend to slow down the economy and increase unemployment, and they have particularly severe effects upon certain industries.
A more recent, but very serious problem for government policy-makers is the strong “inflation psychology” which has developed since the mid-1970′s, which causes people to seek large wage and salary increases in attempts to protect themselves against inflation. By adding substantially to cost-push inflationary pressures, “inflation psychology” creates special problems for monetary and fiscal policy.
First, by steadily increasing the cost of the GNP, these cost-push pressures force the Bank of Canada to continue to increase the money supply at inflationary rates in order to avoid an economic downturn due to inadequate demand, thus maintaining inflation at high rates. Furthermore, “inflation psychology” is strong risks touching off an explosion of wage demands and price increases, while strong cost-push pressures on prices make inflation very resistant to policies that depress aggregate demand.
Thus, “inflation psychology” tends to significantly reduce the effectiveness of monetary and fiscal policies in dealing with both inflation and recession. It is ironic that this problem resulted from excessive use of these policies in the late 1960′s and early 1970′s, when excessive monetary and fiscal stimulation in many nations generated the strong “inflation psychology” that has undermined the effectiveness of monetary and fiscal policies themselves.
Easy-money policies are used to stimulate bank lending and spending by consumers and businesses at times when the economy is in a recession and unemployment is unusually high. If the easy-money policies cause aggregate demand to increase, real output will rise more rapidly and unemployment will decline.
These beneficial effects of easy money are, however, not automatic. If the economy is in quite severe recession and expectations regarding the future are gloomy, consumers and businesses may be reluctant to borrow and spend money. Also, the banks may choose to hold some excess reserves rather than make loans that might prove risky due to poor economic conditions. Thus, easy money merely increases the banks’ reserves and makes more loans possible; it does not automatically create money and boost aggregate demand. This problem has been likened to “pushing on a rope,” which suggests that easy money by itself may not always be sufficient to lift the economy out of a recession. For this reason, many people believe that easy money should be combined with federal budget deficit, which can provide a more direct boost to aggregate demand and can thereby start the economy on its way toward recovery.
When easy money does generate higher aggregate demand, the results are not totally beneficial: a side effect of the increased total spending may be more rapid inflation. While the reduced unemployment from the easy money policies may make some additional inflation acceptable, this side effect does place a limit on the use of easy money.
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During a period of “easy money,” when the banks have plentiful reserves and are ready to make numerous new loans, interest rates tend to fall, to encourage borrowers to borrow additional funds. Thus, “easy money” tends to involve two characteristics – increased availability of loans and lower interest rates – both of which tend to stimulate borrowing and spending by consumers and businesses.
During a period of “tight money,” the scarcity of loans causes interest rates to rise, so that the available loans tend to go better credit risks and the highest bidders among them. These two characteristics of “tight money” – reduced availability of loans and higher interest rates – both tend to depress borrowing and spending by consumers and businesses.
Thus, monetary policy can influence the money supply through either the supply of loans or the demand for them. By increasing or reducing the banks’ reserves, the Bank of Canada can influence the availability (or supply) of loans, and by altering interest rates, the Bank of Canada operates in both ways, influencing both the availability and the cost of credit.
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“Moral suasion” refers to attempts by the Bank of Canada to persuade the managements of the chartered banks to voluntarily cooperate with the central bank’s objectives regarding lending policies, interest rates or any other aspect of monetary policy. Due to the fact that there are so few banks in Canada,it is relatively simple for the Bank of Canada to discuss its objectives with the banks with a view to enlisting their support, which they are expected to provide.
In summary, the Bank of Canada influences the nation’s money supply through various policy approaches including “open-market operations”, changes in the secondary reserve ratio, changes in the Bank Rate and “moral suasion.” By using these policy measures, the Bank of Canada can generate “easy money”, in which lending by the banks and the money supply expand more rapidly, or “tight money”, in which loans are scarce and the money supply rises slowly or even declines.
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