Academic journal article Economic Commentary (Cleveland)

Canada's Money Targeting Experiment

Academic journal article Economic Commentary (Cleveland)

Canada's Money Targeting Experiment

Article excerpt

Like many countries, Canada experienced historically high inflation rates in the 1970s. At the start of 1975, inflation topped 10 percent. In response, Bank of Canada Governor Gerald Bouey announced in November of that year the policy which became known as gradualism: The Bank would target the growth rate of the narrowly defined monetary aggregate M1, made up of currency plus demand deposits at chartered banks. Over time, the Bank would set gradually declining M1 growth rates (for these target ranges and actual M1, see figure 1 ). The idea was that as the Bank met its early MI growth targets, it would win credibility for its later targets and would be able to break both high inflation and high inflation expectations without increasing unemployment.

But gradualism was a failure. Although inflation fell in 1975 and 1976,(1) it trended upward again from 1977 on; by the early 1980s, it had passed 10 percent once more.2 In November 1982, the Bank formally abandoned gradualism, although it was clear to many observers that the policy had effectively been dropped by mid-1981.3

This article considers why Canada tried using money targets to curb inflation, what went wrong with that effort, and what lessons policymakers can learn from it. The argument, in brief, is that the relationship between the Bank's intermediate target (money growth) and its ultimate target (inflation) broke down. In February 1991, the Bank implemented a new solution-targeting inflation directly-a policy that has been markedly more successful than gradualism. Since 1991, inflation in Canada has averaged around 2 percent.

In Theory ...

The quantity theory of money states that


where M is the stock of money, V is velocity, P is the price level, and Y is real income. Thus, the right side of the equation is nominal, or current dollar, income. Velocity is the number of times a dollar is used to provide a dollar of final output. This equation can be thought of as defining velocity, since both nominal income and the stock of money are easily measured.

Two important factors affect velocity. First, higher interest rates encourage individuals to conserve on money balances, thus raising velocity. In other words, velocity reflects the interest sensitivity of money demand. Second, velocity can be influenced by financial innovations. Prior to automated teller machines (ATMs), the inconvenience of bank visits made individuals more likely to obtain large amounts of cash each time they went to the bank, and so to hold high average money balances. Following the introduction of ATMs, we would expect people to make more frequent, but smaller, cash withdrawals, since using a machine is more convenient than visiting the bank. As a result, individuals would hold lower average cash balances. Financial innovation turns out to be an important part of the story of Canada's gradualism years. An implication of the quantity theory of money is that

Money Growth + Velocity Growth = Nominal Income Growth,

or, stated another way,

Money Growth + Velocity Growth = Inflation + Real Output Growth.

If changes in velocity are negligible, then (over sufficiently long periods), nominal income growth equals the growth rate of money. If, in addition, long-run real output growth is independent of monetary policy, then money growth translates directly into inflation. For example, if real output expands at a rate of 2% percent, then 10 percent money growth will lead to 72 percent inflation (again, over a long enough horizon). This is the basis of Milton Friedman's often-quoted assertion that "inflation is always and everywhere a monetary phenomenon."

From this perspective, the Bank was clearly responsible for Canada's predicament in 1975: Excessive money growth had led to unacceptably high inflation. From 1970 to 1975, Ml grew at a 14.5 percent annual rate, while real output grew 5.5 percent; the result was an average yearly inflation rate of 7. …

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