Question

Suppose you are the governor of the Bank of Canada. The economy is experiencing a sharp rise in the inflation rate. What changes would you consider in:

a) Open-market operations

b) The bank rate

c) Explain in each case how the change you advocate would affect chartered bank cash reserves and influence the money supply? Elaborate your ideas with hypothetical examples related to any Canadian charted bank?   

d) Distinguish between the overnight lending rate and the prime interest rate. Why is one higher than the other? Why do changes in the two rates closely track each other? Can we categorize the current monetary policy as an Expansionary Monetary Policy? Why or why not?              

Answer 1

Introduction: -

Governments across the globe, face numerous issues of economic instability and have therefore decided upon monetary sovereignty which allows for setting up of central bank or the bankers bank. Across the globe, these banks allow for easing of critical market situations that are part of the global economy.

In this case, we will highlight the functioning of critical aspects of a central bank the specifics are as follows: -

Case Specifics: -

Answer to Part A, B & C: -

1) Open Market Operations: -

In the situation of an inflated economy, in which there is a sudden impact on the availability of cash in the hands of the public, the Central bank would sell government bonds in the market. These bonds are bought by private banks and this in turn reduces their supply of money.

For example, in the current scenario, when the inflation rate is relatively higher the Bank of Canada would sell bonds which private banks would purchase with their reserves and available cash. As a result of this, the cash available for giving out as loans would decline. This would mean that interest rates would go up and consumer and producer loans would decline. The end result would be that the demand in the economy would decline and the markets will begin to stabilize. Any inflation takes place when people of the economy have excess cash. Open Market operations to sell government bonds regulate the same.

2) The Bank Rate: -

The bank rate is also known as the discount rate. This is the rate at which the federal reserve grants loans to the commercial banks. Regulating this changes, the interest rates for banks this has been explained as follows: -

In the currents situation for example if the government increases the bank rates, it would mean that the banks would be charged a higher interest rates on their borrowings. In turn, they would increase the loan rates for commercial as well as consumer loan types which in turn would allow easing of the markets as people would find it increasingly difficult to take loans and would delay buying which would reduce aggregate demand and cause lesser inflation.

Part D)

The overnight rate is the rate that banks charge between one another usually to maintain cash reserve requirements. The Federal Bank of any country has a reserve requirement which means that a minimum amount of cash has to be maintained at all times by the commercial bank with the Federal Reserve.

When commercial banks lack the money to maintain the cash reserve requirements, they borrow money from one another at the rate known as overnight rate.

On the other hand, the prime rate is the rate at which top credibility consumers are given out loans. These are usually industrialists and private companies with a high credibility of repayment.

The overnight rate will always be lesser than the prime rate as commercial banks need to make higher profits from industrialists than from one another. Private banks do not take loans from companies or industries. Maintaining lower interest rates between banks makes it possible for them to demand for a loan at agreeable rates.

Further, we cannot consider the current monetary policy as expansionary but it is rather contracting in nature as we are reducing the supply of money to contain the inflation rates in the economy. An expansionary monetary policy does just the opposite.

Please feel free to ask your doubts in the comments section if any.