Question

Describe the two things that limit the precision of the Bank of Canada’s control of the money supply and explain how each limits that control.

Answer 1

Increase in money supply depends on value of the money multiplier (MM), where

MM = (1 + CD) / (CD + ER + RR), where

CR: Currency-deposits ratio,

ER: Excess reserves ratio and

RR: Required reserves ratio.

Increase in money supply = Increase in monetary base x MM

Therefore, the higher (lower) the MM, the higher (lower) the increase in money supply.

Bank of Canada's control of money supply is limited by:

(1) Value of CD

CD is the ratio of currency to deposits, and is the proportion of new deposits that is held by the public as currency. Central banks cannot control the proportion of deposits held by public as currency, therefore CD is outside control of central bank, which limits its control, and

(2) Value of ER

ER measures the proportion of new deposits that commercial banks keep as excess reserves. The higher (lower) the ER, the lower (higher) the MM and the lower (higher) the increase in money supply. Since ER is determined by the commercial banks and not by central bank, the value of ER limits the control by central bank over money supply.