Money is an important part of every country’s economy. The availability of it is influenced by multiple factors, which will be explored in this paper. First, we will delve into the role money has played in a economies from the beginning of time. Secondly, the formal definition of a financial system will be explored. The third factor to be studied is the role of government in monetary policy. To fully uncover the extent of a government’s role, a few sub-factors to be considered, specifically, what monetary policy is, how markets influence monetary policy and what the Bank of Canada can do in response to those markets. The fourth and final aspect to be scrutinized will be the most recent global recession, known as The Great Recession. Understanding the ins and outs of each component is critical to determining how central banks, such as the Bank of Canada, can use The Great Recession as a teaching tool to minimize the damage done by future recessions.
What is the role of money in an economy?
Money has taken different forms throughout human history. The Public Broadcasting System (1996) reports that bartering was the first way people in different territories exchanged goods. Paper money was first developed in 500 B.C. when China created lumps of silver. Over time, money, became tied to precious metals as a way of limiting the amount that was available. This was known as the Gold Standard and became prominent in 1816 to prevent the inflation of standard bank notes (Public Broadcasting System, 1996). Fast forward to the 21st century and money continues to evolve. Digital forms of money, cryptocurrency, specifically bitcoin, have been established for a variety of reasons that will not be discussed in this paper. Essentially, money is the conduit for the selling and purchasing of goods in an economy, regardless of a point in history. Now that you know what money does for an economy, we must understand the bigger framework, known as a financial system.
What is a financial system?
The International Monetary Fund (IMF) is a non-profit organization, comprised of almost 200 members, countries around the world, that work in concert to protect the solvency of the global financial system. That said, the IMF (2019) defines a financial system as the complete network of a country’s “banks, securities markets, pension and mutual funds, insurers, market infrastructures and central bank, as well as its regulatory and supervisory authorities.” These components work together to create a foundation for completing economic transactions within the country. A fast example is a person using their bank account to make a payment on a credit card. The money has to be released by the bank to the credit card company. Once the credit card company receives the payment, they lower the consumer’s balance and use that money to make other investments, by either extending credit to other consumers or buying stock in a solid organization such as Apple, Inc. When these different branches of the system are properly maintained through monetary policy, economic growth in that country is supported.
Why are governments important to monetary policy?
What is monetary policy?
Before exploring the government’s role in monetary policy, it is critical to understand what it is. The Corporate Finance Institute (2019) characterizes monetary policy as an economic policy that controls the size and expansion rate of a country’s money supply. It is also noted that this policy muse regulate variables, specifically inflation and unemployment, to insure that the country’s financial system remains solvent. Lastly, this policy is created through the use of certain tools, namely interest rates and the purchase/sale of government securities, to dictate the amount of money circulating in an economy.
How markets influence monetary policy?
Merriam-Webster (2020) defines a free market as one where an “economy [is] operating by free competition.” In layman’s terms, that means that private businesses are in control of the pricing of different parts of the economy such as the housing market, the lending market, the consumer market, and the like. In this type of market, the government has no say in what the individual businesses can do to conduct business. For example one bank can charge a 5% interest rate on loans while another can charge an 8% interest rate. In the free market, consumers would have to choose between the two based on the options provided by the banks and nothing else. Products and services in a free market economy are vulnerable to exploitation of corporations whose sole mission is to maximize their profit margins. Central banks, such as the Bank of Canada, plays an important role in mitigating this potential issue.
How does the Bank of Canada figure into this puzzle?
Amadeo (2019) reports that central banks in any country deploy two specific tools, depending on the state of a country’s economy. Tool number one is known as expansionary monetary policy, and that is when a country’s central bank, such as the Bank of Canada, works to make money more readily available. That is done through the printing of more money, changing of interest rates and increasing combined demand. The second tool is a contractionary monetary policy and it does the exact opposite of its counterpart.
An example of contractionary monetary policy occurred in 2017 when the Bank of Canada raised interest rates for the first time since 2010 (McKenna, 2017). Mayers (2013) gives more detail by stating that the massive borrowing economy started in 2000 when the “dotcom” bubble began to burst. Central bankers in the United States and Canada hoped to cushion the blow citizens in both countries would feel by implementing an expansionary monetary policy. This policy was bolstered by what would become known as The Great Recession of 2007-2008. Details about this crisis will be explore in the next section if this paper.
What was the Great Recession?
The Great Recession was a financial crisis brought on by an under-regulated free market. When President Bill Clinton repealed the Glass-Steagall Act of 1933, international banks such as JP Morgan Chase, Lehman Brothers, American Insurance Group (AIG) and others took advantage. This piece of legislation was passed in the midst of the Great Depression and it had multiple parts. First, it separated commercial and investment banks; the former is where the average Canadian Citizen stores money earned from their paychecks and the latter is where financially well-off individuals invest in new products a services to make as much money as possible. Part two of the Glass-Steagall Act prohibited the commercial and investment arms of a bank, like JP Morgan Chase to intermingle funds when creating new investment options (Burnette, 2019).
What impact did The Great Recession of 2008 have on interest rates?
As mentioned in a previous section of this paper, interest rates were at historically significant lows in the 2000s thanks to the “dotcom” bubble bursting. The section of the economy which benefited most from low interest rates was the housing market. Amadeo (2020) reports that at this time large banking institutions were creating derivatives for wealthy people to invest in with home loans as the collateral. As these derivatives became more popular, the large banks needed more and more people to secure home loans. They were so desperate that they issued loans to virtually anyone, even people without jobs. When consumers began to cash out, there was not enough money and the large banks were failing and needed to be bailed out to the tune of $1.4 trillion! Countries around the world, including Canada, kept the interest rates very low to accommodate for the fallout of big banks collapsing. These extremely low rates were kept in place for nearly 20 years. Most people would think that keeping interest rates at near-record lows would create an unstable market for the average consumer. Canada, however, used lessons of the past to prevent the Great Recession from impacting its economy too negatively. The next sections will explore how.
How did the Great Recession affect monetary policy in Canada?
It cannot be overstated that The Great Recession of 2008 had many similarities to the Great Depression. Banks were failing at staggering rates because of their barely regulated investments. Consequently, it had a domino effect that hit many countries. It started in the United States and spread to countries such as Ireland, Spain, Greece, German and Italy to name a few. Canada, however seems to have been largely spared of the devastating effects from this financial crisis. Let’s explore why.
Canada implemented a command economy after World War II
Earlier in this paper, we discovered that a free market is a system where an economy is largely controlled by the private businesses that provide various products and services to consumers. The opposite of this system is a command economy. Market Business News (2020) defines a command economy is one where the government controls multiple aspects of it including the supply of goods and services along with their prices. Throughout the government, planners mot only determine which goods and services are offered, but how they are distributed. As relates to the banking industry, it is also under the control of the Canadian government. Unlike the United States and other free market economies, Canada subjects its banks and the laws they follow to regular assessments. Government officials then adjust the rules based on the findings of those assessments.
Money has always been an important part of human life. Throughout the millennia, it has taken on several forms as humans evolved. As governments began to form, there were debates about how money should be handled. Many countries around the world have adopted free market economies where private enterprise maintains a great deal of control over various components of their frameworks. The United States is a prime example as it maintains a free market to this day. Government officials Canada, however, paid close attention to the market conditions that led up to World War I and the Great Depression. Rather than sticking with a free market economy, the country began shifting into a command economy. As a result, the Canadian government was able to implement tools such as expansionary monetary policy for a longer period of time, with minimal adverse consequences. Not only do consumers in Canada have more protection against the greed of private enterprise, the government has built in consistent checks to the current system to further safeguard its citizens from financial ruin as seen by their American neighbors in the Great Recession.
Amadeo, K. (2019, December 20). Expansionary Monetary Policy: How Low Interest Rates Create More Money for You. Retrieved from https://www.thebalance.com/expansionary-monetary-policy-definition-purpose-tools-3305837#expansionary-versuscontractionary-monetary-policy.
Amadeo, K. (2020, January 22). What Caused the 2008 Financial Crisis and Could It Happen Again? Retrieved from https://www.thebalance.com/2008-financial-crisis-3305679.
Burnette, M. (2019, March 21). The Glass-Steagall Act: What It Is and Why It Matters. Retrieved from https://www.nerdwallet.com/blog/banking/glass-steagall-act-explained/.
Corporate Finance Institute. (2019, December 2). Monetary Policy – Objectives, Tools, and Types of Monetary Policies. Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/economics/monetary-policy/.
International Monetary Fund. (2019, March 27). Financial System Soundness. Retrieved from https://www.imf.org/en/About/Factsheets/Financial-System-Soundness.
Market Business News. (2020). Command economy – definition and meaning. Retrieved from https://marketbusinessnews.com/financial-glossary/command-economy-definition-meaning/.
Mayers, A. (2013, April 27). Why Canadians are stuck in a low interest rate trap. Retrieved from https://www.thestar.com/business/personal_finance/2013/04/27/why_canadians_are_stuck_in_a_low_interest_rate_trap.html.
McKenna, B. (2017, July 12). Bank of Canada raises interest rates for first time in seven years. Retrieved from https://www.theglobeandmail.com/report-on-business/economy/bank-of-canada-interest-rate-decision/article35662991/.
Merriam-Webster. (2020). Definition of FREE MARKET. Retrieved from https://www.merriam-webster.com/dictionary/free%20market.
Public Broadcasting System. (1996, October 26). The History of Money. Retrieved from https://www.pbs.org/wgbh/nova/article/history-money/.