Money in Canada typically comes from two sources. Canada's central bank, called the Bank of Canada (BOC), can expand monetary supply by engaging in asset purchases, such as government and corporate bonds. Money is also created by financial institutions through lending to businesses and consumers.
Both measures increase the amount of money available to spend by companies and citizens designed to stimulate economic growth measured by gross domestic product (GDP), which is a metric that measures the goods and services produced in an economy.
However, too much money can lead to excessive spending, increased demand for goods, and inflation, which is the pace of rising prices in an economy.
- The Bank of Canada creates new money through asset purchases of corporate and government bonds or securities.
- The Bank of Canada also creates new money by issuing notes and currency.
- The Bank of Canada can influence monetary conditions by changing the capital requirements banks need to hold as reserves.
- The Bank of Canada also sets interest rate policy, which controls the amount of money lent throughout the economy.
- Private and commercial banks also create new money by issuing new loans to consumers and businesses.
The Bank of Canada
The Bank of Canada (BOC) was chartered under the Bank of Canada Act of 1935, initially as a privately owned corporation. It was legally deemed a federal Crown corporation in 1938, and its shares are owned by the Canadian government.
The central role of the BOC is to maintain the financial and economic health and stability of Canada. Specifically, it is responsible for formulating monetary policy and managing funds and banking services for the federal government. It is the sole authorized issuer of Canadian currency, among other things.
The Bank of Canada helps the government expand the economy by purchasing newly issued federal securities, such as Treasury bills. When the BOC creates money through asset purchases, the federal government can utilize the funds for various programs, including education, health, and defense. The funds can also be spent on the reduction of debt.
When the economy is underperforming or in a recession, the BOC may purchase additional government assets, or bonds, through a stimulative process called quantitative easing (QE). The Bank of Canada's QE program also includes buying corporate bonds.
If a corporation issues a bond, the central bank essentially becomes the customer by buying a bond and, in exchange, gives cash to the corporation to spend as needed. The corporation might spend the money by purchasing equipment, expanding its operations, or paying down debt to increase its financial stability. As a result, asset purchases lead to an increased amount of money in the economy, designed to be spent by consumers and businesses as a stimulus to improve economic conditions.
Setting Interest Rates
The Bank of Canada also manages interest rate policy by lowering or increasing the key policy rate, which is the rate banks use to lend to each other and is used as a benchmark for establishing loan rates to customers. If the key policy rate is lowered, it ultimately reduces lending rates in the financial markets, leading to an increased demand for credit and more bank lending to satisfy that demand.
Capital Requirements for Banks
Another way that the Bank of Canada can influence monetary conditions is by changing the capital requirements that banks need to hold as reserves. Although it can vary depending on the size of the bank, typically, the minimum capital requirement is approximately 8% of the total assets held by the bank.
It's important to remember that for a bank, a loan is an asset. When a bank issues a loan to a company, it gets paid back the interest and principal. The interest received is income, and the loan is considered an asset on a bank's balance sheet. A specific percentage of a bank's total assets, including loans, is held as a cash reserve.
The assets are weighted based on a risk assessment (called risk-weighted assets) of how likely the loans might default or go into nonpayment. The capital reserves required for banks help reduce the risk of economic and financial shocks during a financial crisis or recession.
Domestic Stability Buffer (DSB)
In addition, a capital conservation buffer of 2.5%—also called the Domestic Stability Buffer (DSB)—is required of Canadian banks. The DSB helps to ensure the stability of the financial system by allowing some wiggle room so that there are funds held (in addition to the capital reserves) by banks in case of a crisis.
The Office of the Superintendent of Financial Institutions (OSFI ) manages the buffer. The OSFI is an independent agency of the government of Canada, which helps protect depositors and creditors by supervising financial institutions, their level of risk, and monitor their financial condition.
During the early days of the coronavirus pandemic in March of 2020, the OSFI lowered the DSB to 1% from 2.25%. This provided an additional C$300 billion into the economy for which banks could use to lend to businesses and consumers. Some of these loans included commercial loans and home mortgage loans.
In June of 2021, the OSFI increased the Domestic Stability Buffer to 2.5% from the 1% level set in March of 2020 since the Canadian economy had rebounded from the coronavirus pandemic and the resulting recession.
Domestic Systemically Important Banks
The largest financial institutions, called domestic systemically important banks, must also maintain an additional 1% of assets held as capital reserves. Examples of domestically systemically important banks include the Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Royal Bank of Canada, National Bank of Canada, and the Toronto Dominion Bank of Canada.
By implementing these monetary measures, including asset purchases by the Bank of Canada and lowering the capital buffer by the OSFI, the amount of money was increased, helping the Canadian economy weather the financial difficulties due to the pandemic.
Private banks create new money by issuing new loans to consumers and businesses. For example, when a bank grants a new mortgage loan to a homebuyer, the seller of the home receives the cash from the sale of the home at the mortgage closing. The money is deposited into the seller's bank account, which increases the amount of money in the economy.
Similarly, if a commercial bank extends a loan to a corporation and the newly created money is used to expand its manufacturing facility, it stimulates economic activity due to the construction of the facility and the hiring of new workers. As a result, private bank lending has a multiplier effect on the economy since it can lead to lower unemployment, higher wages for workers, and increased business spending.
However, the amount of money a bank can lend is limited since it must have enough deposits to make the loans and cannot violate the previously-mentioned capital reserve requirements. Also, loans from private banks are issued based on a borrower's creditworthiness, meaning there is a limit as to how much money a bank is willing to lend each borrower.
New Money and Inflation
The creation of money can be inflationary, meaning it can lead to rising prices in an economy. A certain amount of inflation is considered necessary to allow for an expanded economy to function.
A steady or gradual rate of inflation can be helpful since it allows businesses the ability to charge prices above the cost of manufacturing their goods and services, ensuring a profit. However, a significant rise in prices can damage an economy because it reduces the purchasing power of consumers and businesses.
The Bank of Canada adjusts its key policy interest rate if inflation is above the bank’s inflation target of 2%, which is the midpoint of its target range of 1% to 3%. In other words, the bank will increase interest rates if prices rise too quickly. Higher interest rates discourage borrowing and spending, which cools down the economy, reducing inflationary pressures.
Conversely, if inflation is below the Bank of Canada’s inflation target, the central bank may lower its key policy rate. The lower rate encourages financial institutions to reduce their loan rates and increase the number of new loans, stimulating economic activity. The additional spending by consumers and businesses will increase the demand for goods, raising prices in the economy. The Bank of Canada actively monitors inflation to ensure that prices don’t rise too quickly and that prices don’t decrease by too much, called deflation.
The Bottom Line
The Bank of Canada creates new money by issuing notes and currency but also through asset purchases of corporate and government securities. The Bank of Canada also sets interest rate policy to manage the amount of money being lent throughout the economy to help promote stable economic growth while simultaneously ensuring price stability.
Commercial and private banks also create new money by issuing new loans. With the Bank of Canada and the banking sector working together to create new money, stable monetary policy and favorable economic conditions can be achieved.