In: Economics
Bank of Canada |
||
Assets |
Liabilities and Net Worth |
|
Chartered Banks |
||
Assets |
Liabilities and Net Worth |
|
a. In the below balance sheets, the securities are shows in the asset side for both the Central Bank of Canada and for the Chartered banks. If the bank of Canada sells $50 million of securities to chartered bank the below effects takes place in the 2 balance sheets:
- For Bank of Canada, there is a decrease in the total security assets by $50 Million
- For chartered bank, there is an increase in the total security assets by $50 Million, however the reserves of the bank falls.
Bank of Canada |
||||
Assets |
Liabilities |
|||
Securities ( - ) $50 Million |
||||
Chartered Bank |
||||
Assets |
Liabilities |
|||
Total Reserves ( - ) $50 Million Canadian Government Securities ( + ) $50 Million |
||||
b. This is an example of Contarctionary Policy, because when central bank sells its securities to the chartered bank it leads to a fall in its reserves. This means it tightens the ability of the commercial bank to make loans which in turn reduces the money supply in the economy. In the money market, graphically a reduced money supply leads to a leftward shift of the real money supply curve. For an unchanged demand for money the real interest rates rises.
c. The sale of securities is used to eliminate Inflationary gaps faced by the economy. Such a gap arises, when the economy produces at level higher than the full potential output. Such a contractionary policy is generally used to control inflation rates. A fall in money supply increases the interest rates and lowers the pending capacity of the economy. This shift the aggregate demand curve downwards leading to a fall in price level and a fall in Real GDP.
d. Monetary Transmission Mechanism: As the bank of Canada sells government securities in the open market, it reduces the money supply in the economy. A fall in the money supply causes the bank rate/ real interest rates to rise. This makes the cost of borrowing expensive, so households and business enterprises are induced to lower their aggregate expenditure. Also, assuming this is an open economy with international capital mobility, a rise in interest rate also means an in increase in the expected returns on the Canadian assets/deposits. This increases the demand for Canadian dollars leading to an increase in foreign currency price of Canadian dollars. A stronger or an appreciated Canadian dollar means the price of goods and services produced in Canada rises. Thus exports from Canada become expensive and its export supply falls. This leads to a fall in Canada’s Net Exports and hence a fall in Aggregate Demand.