Most countries have a central bank. Some of these central banks, like the Bank of England, were private firms originally in business for profit, but began to operate in part to promote stability in financial market conditions. The focus of their business shifted to take on an informal role in what is now called monetary policy. As governments also became interested in monetary policy, central banking institutions were established in countries where none previously existed. The Federal Reserve System, the United States central bank, was created under federal law in 1913. It is a system of 12 regional banks, each owned by the commercial banks that are its members. Canada's central bank, the Bank of Canada, was set up and started operations in 1935 as a privately owned institution, but was nationalized in 1938. In the United Kingdom, the Bank of England was nationalized in 1947.
Central bank: an institution that conducts monetary policy using its control of monetary base and interest rates.
In every case, the important distinction between a private bank and a central bank is the purpose that drives the institution's operations. Private banks are profit-oriented businesses providing financial services to businesses and households. Central banks conduct their operations to influence the behaviour of other banks and intermediaries in the financial system. Profits are not the motive behind central banks' operations, although they do make profits. They also serve as banker to the government and to the banks. But their primary role and responsibility is to conduct monetary policy: To control inflation and support economic growth through their control of the monetary base and interest rates, and perhaps the foreign exchange rate.
Monetary policy: central bank action to control inflation and support economic growth through control of the money supply, interest rates, and exchange rates in order to change aggregate demand and economic performance.
The Bank of Canada is Canada's central bank. A visit to its website www.bankofcanada.ca provides detailed information on its structure, operations and monetary policy objectives. The information the bank provides on monetary policy is of particular relevance for this chapter.
See http://www.bankofcanada.ca/core-functions/monetary-policy/.
The current governor, Stephen Poloz, like governors before him, manages the Bank's balance sheet to implement monetary policy. He can expand the Bank's asset holdings and pay for that expansion by creating new Bank of Canada liabilities, which are additions to the monetary base. Alternatively, he can sell some of the Bank's assets, destroying an equal amount of liabilities and monetary base. No reserve requirements (explained in Section 10.2) limit these operations. The management of the Bank's balance sheet and the monetary base depends on the wisdom and judgment of the Governor and management of the Bank. They work to get the monetary base and interest rates that are appropriate for the economy.
There is a further interesting difference between the commercial and central bank balance sheets. Private banks concentrate on their deposit base and loan operations. These are the main entries in their balance sheets and the source of their banking profits as discussed in Chapter 8. The Bank of Canada, by contrast, does very little direct lending, and any it does is of very short duration. Indeed lending to banks and other financial institutions, advances to members of the Canadian Payments Association, which would be central bank loans, were zero at the end of March 2017.
Nor does the Bank of Canada hold many deposits. It does not need deposits as a source of funds. Deposit facilities are provided to the commercial banks and other members of the Canadian Payments Association for their use in settling cheque-clearing balances and transfers among the banks, and to the Government of Canada. Cheques issued by the Government of Canada, like income tax refunds, Old Age Security payments, and Employment Insurance benefits, are drawn on the government's account in the Bank of Canada. This difference in the structure of operations again shows the difference between profit-oriented commercial banks and a central bank with responsibility for monetary policy.
Having the power to conduct monetary policy is one thing; how you use it is another. The Bank of Canada's responsibilities are set out in the Bank of Canada Act, the act of Parliament that established the Bank in 1934. According to the Act, the Bank is to conduct its policy in ways that support the economy by reducing fluctuations in output, prices, and employment while protecting the external value of the currency. In terms of our study of the economy, we can describe these goals of monetary policy as the pursuit of potential output and low, stable inflation rates.
Exactly how the Bank is to achieve those objectives has been, and continues to be, a topic for discussion and debate. Over the years, our understanding of what monetary policy can and cannot do has evolved, as have the Bank's interpretation of its mandate and the techniques it uses to conduct monetary policy. The Canadian economist Robert Mundell has been a major contributor to this work. His explanations of the transmission mechanism and the strength of monetary policy under different foreign exchange rate systems were recognized by his Nobel Prize in economics.
Currently, the Bank works to maintain inflation within a target range of 1 percent to 3 percent, but that has not always been its explicit policy objective. Gordon Thiessen, a recent Governor of the Bank of Canada, provides an interesting overview of the evolution of monetary policy in Canada from the 1930s to the end of the 1990s.
