An inquiry into why the Bank of Canada was unable to bridle the inflation of the 1970s by controlling money growth.Monetary policy - Canada ; Canada ; Inflation (Finance)

Paul Gomme

English

Research Papers in Economics

Like many countries, Canada experi-
enced historically high inflation rates in
the 1970s. At the start of 1975, inflation
topped 10 percent. In response, Bank 
of Canada Governor Gerald Bouey an-
nounced in November of that year the
policy which became known as gradu-
alism: The Bank would target the
growth rate of the narrowly defined
monetary aggregate M1, made up of
currency plus demand deposits at char-
tered 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 M1 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 interme-
diate target (money growth) and its ulti-
mate target (inflation) broke down. In
February 1991, the Bank implemented 
a new solution—targeting inflation di-
rectly—a policy that has been markedly
more successful than gradualism. Since
1991, inflation in Canada has averaged
around 2 percent.
n n  In Theory ...
The quantity theory of money states that
MV = PY,
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 bal-
ances, thus raising velocity. In other
words, velocity reflects the interest sen-
sitivity 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. Fol-
lowing the introduction of ATMs, we
would expect people to make more fre-
quent, but smaller, cash withdrawals,
since using a machine is more conve-
nient 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 out-
put growth is independent of monetary
policy, then money growth translates
directly into inflation. For example, if
real output expands at a rate of 2½ per-
cent, then 10 percent money growth will
lead to 7½ percent inflation (again, over
a long enough horizon). This is the basis
of Milton Friedman’s often-quoted asser-
tion that “inflation is always and every-
where a monetary phenomenon.”
From this perspective, the Bank was
clearly responsible for Canada’s predica-
ment in 1975: Excessive money growth
had led to unacceptably high inflation.
From 1970 to 1975, M1 grew at a 14.5
percent annual rate, while real output
grew 5.5 percent; the result was an av-
erage yearly inflation rate of 7.5 percent.
If excessive money growth was the cause
of high inflation in the early 1970s, the
cure was obvious: Slow money’s growth
rate. With gradualism, Governor Bouey
was in effect declaring a policy of slowly
reducing the inflation rate: The Bank
would publish growth rate bands—or
target ranges—for M1,4  and the average
growth rate target would fall over time.5
The Bank would gain credibility by
meeting its early targets, so future
February 1, 1998
Federal Reserve Bank of Cleveland
Canada’s Money Targeting Experiment
by Paul Gomme
Historical relationships between
money growth and inflation suggest
that controlling money growth
should tame inflation. In the mid-
1970s, the Bank of Canada targeted
M1 growth, yet inflation continued.
What went wrong?
ISSN 0428-1276announcements would moderate inflation
expectations. In this way, the Bank hoped
to avoid large real output losses.
As an alternative, the Bank could have
gone cold turkey, reducing money
growth to its lower long-run value
immediately instead of over several
years. Using my earlier example to
achieve zero inflation, the Bank would
have reduced money growth to 2½ per-
cent to match long-run real output
growth. The Bank rejected the cold
turkey approach (at least in the 1970s),
fearing that entrenched high inflation
expectations would adjust sluggishly 
to such a policy, causing large losses in
real output and correspondingly high
unemployment rates.6
Notice that Canada used monetary target-
ing as a means to an end: low inflation.
In other words, money growth rates were
an intermediate target of monetary policy
and inflation was the ultimate target.
n n  ... But in Practice
During the late 1970s, Canada’s inflation
rate remained high. In fact, by the start
of 1980, it had regained its 1975 level
and was still rising. The experiment
ended with Governor Bouey’s official
renunciation of gradualism in 1982.7  It
was only when the Bank effectively took
the cold turkey approach, dramatically
reducing money growth, that inflation
finally fell.
The Bank’s biggest problem was a series
of downward shifts in M1 demand, start-
ing in 1976 and continuing throughout
the gradualism period.8  By one estimate,
these shifts amounted to 28 percent of
M1 by 1982,9  implying that monetary
policy was much looser than the Bank
had intended. One can think of these
shifts as increases in velocity. According
to the quantity theory of money, a 1 per-
cent increase in velocity has the same
effect on the inflation rate as a 1 percent
increase in money growth.
One set of shifts in M1 demand affected
corporations.10  First, banks offered them
preferable loan rates, provided that part of
the loan was held in a demand deposit
(known as a compensating balance).
Since the demand deposit paid no inter-
est, this practice increased the effective
loan rate. In the mid-1970s, banks started
eliminating compensating balances and
raised corporate loan rates. As a result,
the level of demand deposits fell.
Second, banks started unbundling their
products. For example, they had previ-
ously offered a package of free services
to corporate clients who maintained a
minimum level of demand deposits.
When banks began charging for these
services, clients reduced demand
deposits further.
Third, banks introduced corporate cash-
management strategies. For example, at
the end of a day, they would place a
firm’s demand deposits in an overnight
account that earned interest. This de-
creased reported M1, since it is end-of-
day demand deposits that banks report to
the Bank of Canada.
Two important innovations affected
personal deposits: the introduction of
daily interest savings accounts (DISAs)
in 1979 and daily interest checking 
accounts (DICAs) in 1981. Before
DISAs, savings account interest was
based on a minimum monthly balance.
Thus, if a customer had $1,000 in a
savings account for 30 days of a month
and $10 in it on the thirty-first day, that
month’s interest would be paid only on
the $10. This practice gave depositors
little incentive to move funds between
savings accounts (outside M1) and
checking accounts (inside M1). By pay-
ing interest on daily balances, DISAs
encouraged people to make such trans-
fers, thus reducing average M1 bal-
ances. By allowing checking, DICAs
obviated the need to move funds in and
out of M1 deposits, although techni-
cally, DICAs were notice deposits and
so were excluded from M1.11
The net result of these institutional
changes was higher velocity. This meant
that while M1 growth moderated under
gradualism, inflation remained high.
Some analysts argued that the continued
high growth of broader monetary aggre-
gates like M2 and M3 was a truer re-
flection of monetary policy during this
period (see figure 2).12  Evidently, the
Bank of Canada was running a loose
monetary policy at a time when it be-
lieved policy was fairly tight.
n n  Why M1?
Perhaps it was merely bad luck that the
financial innovations just described
coincided with the Bank’s gradualism
policy. Many of these innovations would
have occurred in any case. For example,
the corporate cash-management strate-
gies were adopted from U.S. practices.
DISAs and DICAs were initially offered
by credit unions and later by trust com-
panies; the chartered banks surely had to
follow their competitors’ lead.
A more pessimistic view is that chartered
banks changed their behavior because
the Bank’s new policy gave them an
incentive to reduce M1 deposits.13  If
M1 growth was above target, the Bank
would raise interest rates. The chartered
banks, in turn, would have to increase
loan rates and so curtail loan activity.
Although this incentive to reduce M1
deposits affected the banking system as
a whole rather than individual institu-
tions, the Canadian system is highly con-
centrated, dominated by six large char-
tered banks.14  It is not difficult to
imagine that they acted in concert.
The Bank chose M1 as its target for
operational reasons: It implemented its
policy by first setting the Bank rate that
would determine the growth rate of
money, followed by nominal income
growth.15  This meant that the Bank
needed a highly interest-sensitive mone-
tary aggregate (that is, one for which
small interest rate changes would pro-
duce large changes in money demand).
FIGURE 1 ACTUAL AND TARGETED M1 GROWTH
a
a. Data are seasonally adjusted.
SOURCE: Bank of Canada.M1 was such an aggregate. Most of its
components paid either zero or very low
interest rates, so any increase in rates
would elicit a large response as deposi-
tors shifted funds out of demand deposits
and into interest-bearing deposits, which
are excluded from M1.16
Before, during, and after gradualism,
some economists advocated targeting a
broader monetary aggregate like M2,17
whose actual behavior suggests it would
have been a sound choice. M2 grew
strongly through the late 1970s, as infla-
tion remained high, then dropped sharply
in the early 1980s, before inflation fell
(see figure 2). From the Bank’s perspec-
tive, M2 would have been a poor choice
because of its low interest sensitivity. It is
composed chiefly of interest-bearing de-
posits, and most of the substitution of M1
deposits that resulted from a change in
interest rates was within the M2 aggre-
gate. Thus, large interest-rate movements
would have been needed to bring M2
growth into its target range. Alternative-
ly, the Bank could have set a level for the
reserve base that would have allowed a
particular M2 growth rate.18  This brings
the Bank’s operating procedures into
question: There was no particular reason
why it should use interest rates rather
than reserves to implement policy.
Another possibility would have been for
the Bank simply to target reserves, let-
ting the interest rate adjust freely to clear
the money market. The virtue of this
policy would have been that reserves are
clearly controllable because they are the
Bank’s liability.
n n  Lessons
Targets certainly make it easier for cen-
tral bankers to explain their policy deci-
sions to the public. For example, the
Bank raised interest rates when money
growth was above target, and lowered
them when money dropped below target.
However, Canada’s experience illus-
trates some of the drawbacks of mone-
tary targets. The basic problem was that
the relationship between the intermedi-
ate target (M1 growth) and the final tar-
get (inflation) broke down during the
M1 targeting period.
An optimistic assessment of the Cana-
dian experiment would be that the basic
policy of controlling money growth 
was sound, but its implementation was
flawed. The Bank chose M1 for its high
interest sensitivity because it imple-
mented policy through interest rates. Lat-
er events showed that M2, which others
had advocated as a target, reflected actual
inflation much better than did M1.19
A pessimistic conclusion is that the rela-
tionship between an intermediate target
and the ultimate target is likely to break
down just when the monetary authority
is trying to use that relationship. This
interpretation of events suggests that the
use of any intermediate target is doomed
to failure. The Bank’s choice of M1 as
an intermediate target was unimportant.
If it had chosen M2, M3, or reserves,
monetary targeting would have failed
just the same.
An even more pessimistic view, known
as Goodhart’s Law,20  holds that any
statistical relationship is likely to break
down when policymakers try to exploit
it. For example, the information content
of any aggregate—or, indeed, of any
leading indicator—is likely to vanish
if the central bank tries to use this infor-
mation, whether it formally announces
that aggregate as an intermediate target
or not.
One way to bypass Goodhart’s Law is 
to dispense with intermediate targets,
focusing directly on the final target
instead. This was the solution eventually
adopted in Canada when, in February
1991, the Bank and the government of
Canada announced inflation targets.
Thus far, this policy has met with better
success than gradualism in producing
low inflation rates.
n n  Footnotes
1.  In October 1975, the Canadian government
announced a policy of wage and price controls
that lasted three years. It is difficult to separate
its effects from those of gradualism.
2.  Of course, gradualism may have kept infla-
tion lower than it would have been otherwise.
3.  Two important external events placed
downward pressure on the exchange rate in
1981. First, the National Energy Program en-
couraged the takeover of foreign-owned com-
panies in an effort to Canadianize the oil and
gas industry. Second, tight U.S. monetary pol-
icy opened large interest-rate differentials
between Canada and the United States (see
the Bank of Canada’s 1981 annual report, 
pp. 8–9).
4.  The M1 target ranges did not imply that
Canadian monetary policy was on autopilot.
For example, the Bank let M1 exceed its up-
per target range during postal strikes, which
increased the demand for M1 balances (see
figure 1).
5.  The plan to wind down inflation through
gradually lower money growth was evident in
the Bank of Canada’s 1975 annual report.
6.  One recent study identifies two reasons
why inflation expectations may be important
—long-term labor contracts and imperfect in-
formation about prices throughout the econo-
my. See Owen F. Humpage, “Monetary Policy
and Real Economic Growth,” Federal Reserve
Bank of Cleveland, Economic Commentary,
December 1996. See also the Bank of
Canada’s 1975 annual report.
7.  One analyst questions whether the commit-
ment to gradualism faltered as early as 1978,
when the Bank started placing more emphasis
on exchange rate movements. See Thomas J.
Courchene, No Place to Stand? Abandoning
Monetary Targets: An Evaluation, Toronto:
C.D. Howe Institute, 1983, pp. 20–21. See
also the Bank of Canada’s 1978 annual report.
8.  Governor Bouey was clearly aware of the
possibility of shifts in M1 demand, which he
discusses in the Bank of Canada’s 1975 an-
nual report.
9. See Stephen S. Poloz, “Unstable Velocity
and the Monetary Approach to Exchange
Rate Determination,” paper prepared for the
Economic Research Institute, Economic Plan-
ning Agency, Tokyo, December 1984.
FIGURE 2 INFLATION AND MONEY GROWTH RATES
SOURCE: Statistics Canada.10.  The discussion of shifts in M1 demand
summarizes the description in Courchene
(footnote 7), pp. 42–8.
11. Both DISAs and DICAs were initially of-
fered by credit unions (caisses populaires in
Quebec), followed by trust and mortgage loan
companies. Since these institutions are not
chartered banks, their deposits are not in-
cluded in the monetary aggregates.
12.  See the following studies, published by
the  C.D. Howe Institute, Montreal: Thomas J.
Courchene:  Money, Inflation, and the Bank of
Canada: An Analysis of Canadian Monetary
Policy from 1970 to Early 1975 (1976); The
Strategy of Gradualism: An Analysis for Bank
of Canada Policy from Mid-1975 to Mid-1977
(1977); No Place to Stand? (see footnote 7);
and Peter Howitt: Monetary Policy in Transi-
tion: A Study of Bank of Canada Policy,
1982–85 (1986).
13. This behavior change is consistent with
the “Lucas critique,” which states that eco-
nomic agents will alter their behavior in
response to changes in their environment,
including shifts in government policy.
14.  The Bank of Canada reports an M2+
monetary aggregate that, in addition to M2,
includes deposits at trust and mortgage loan
companies, credit unions, and caisses popu-
laires, individual annuities at life insurance
companies, personal deposits at government
savings institutions, and money market
mutual funds. In 1975, M2 was just over 70
percent of M2+, which gives some idea of
the size of chartered banks relative to other
financial institutions in Canada.
15. If money demand is stable, setting the
interest rate is equivalent to setting the mon-
ey supply. A particular setting for the money
supply will imply an interest rate; a judi-
ciously chosen interest rate will, via money
demand, imply a particular value for the level
of money balances.
16. This money demand explanation is con-
sistent with the quantity theory of money if
we recognize that velocity is affected by the
interest rate. Broadly speaking, the Bank set
an interest rate that, via money demand, de-
termined the level of money balances. Inter-
est rate adjustments allowed the Bank to
manipulate the level of M1 to ensure that it
would stay within its target ranges.
17. See Courchene (footnote 12).
18. Such a policy would have been compli-
cated by the fact that M1 deposits were sub-
ject to a 12 percent required reserve ratio, but
other deposits to only 4 percent. A uniform
requirement would have greatly simplified
such a policy. For details, see Courchene
(footnote 12).
19.  See Courchene (footnote 12).
20. C.A.E. Goodhart is a member of the
Monetary Policy Committee of the Bank of
England and a professor at the London
School of Economics and Political Science.
He explains his law in Monetary Theory and
Practice: The UK Experience, London:
Macmillan, 1984, p. 96.
Paul Gomme is an economist at the Federal
Reserve Bank of Cleveland.
The views stated herein are those of the
author and not necessarily those of the Fed-
eral Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.
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Canada's money targeting experiment

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Canada's money targeting experiment

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