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Lecture 19

ECO105Y1 Lecture Notes - Lecture 19: Phillips Curve, Government Failure, Quantitative Easing


Department
Economics
Course Code
ECO105Y1
Professor
Avi Cohen
Lecture
19

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ECON 105
2015/2016
Lecture 18
14 March 2016
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2BANK OF CANADA’S JOB
The Bank of Canada changes the money supply
and interest rates, aiming for an inflation control target that ach
ieves steady growth, full employment, and stable prices.
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·Bank of Canada is responsible for monetary policy — adjusting the
supply of money and interest rates to
achieve steady growth, full employment, and price stability
·Price stability
means inflation rate is low enough to not significantly affects peo
ples’ decisions
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·Inflation-control target
range of inflation rates set by a central bank as a monetary policy
objective
·Bank of Canada’s target is an annual inflation rate of 1 to 3 perce
nt as measured by the CPI
·Monetary policy aims for 2 percent
·Bank of Canada uses core CPI as an operational guide about underlyin
g inflation trends
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5OPEN MARKET OPERATIONS
The Bank of Canada uses open market operations to change interest ra
tes. Buying bonds increases the money supply and raises bond prices,
lowering interest rates. Selling bonds decreases the money supply an
d lowers bond prices, raising interest rates.
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·Interest rates are determined in money and
loanable funds (bond) markets
·Central banks influence short-run interest rates,
but not long-run interest rates
·Bank of Canada’s main policy tool is the
overnight rate —
interest rate banks charge each other for one-day loans
·Overnight rate determines all other short-run
interest rates

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ECON 105
2015/2016
Lecture 18
14 March 2016
2
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·Lower interest rates
borrowing and spending, saving
·In a recessionary gap, Bank of Canada lowers
interest rates to increase aggregate demand and accelerate the econ
omy
·Higher interest rates
borrowing and spending, saving
·In an inflationary gap, Bank of Canada raises
interest rates to decrease aggregate demand and
slow down the economy
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·Bank of Canada changes the target interest rate through open market
operations —
buying or selling government bonds on bond market
·Money and bond markets are interconnected
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9Initial Demand and Supply in the Money Market
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To lower interest rates and accelerate economy
·Money market story
BoC changes money supply using open market operations to influence
quantity of demand deposits (part of M1+)
·Bank of Canada buys bonds, increasing bank reserves, loans, demand d
eposits, money supply
·Bond market story
BoC changes money supply using open market operations to influence
bond prices and interest rates
·Bank of Canada buys bonds,
demand for bonds increases, raising bond prices, lowering interest
rates
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11 Demand and Supply in the Money Market after Bank of Canada Buys Bond
s
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ECON 105
2015/2016
Lecture 18
14 March 2016
3
12
12
To raise interest rates and slow down economy
·Money market story
BoC changes money supply using open market operations to influence
quantity of demand deposits (part of M1+)
·Bank of Canada sells bonds, decreasing bank reserves, loans, demand
deposits, money supply
·Bond market story
BoC changes money supply using open market operations to influence
bond prices and interest rates
·Bank of Canada sells bonds,
supply of bonds increases, lowering bond prices,
raising interest rates
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13 Demand and Supply in the Money Market after Bank of Canada Sells Bon
ds
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·When Bank of Canada changes overnight rate,
most short-run interest rates change in same direction
·Prime rate
interest rate on loans to lowest-risk borrowers
·Long-run interest rates determined in the
loanable funds (bond) market
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15 Short-Run and Long-Run Interest Rates
in Canada, 1979 - 2013
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16 TRANSMISSION MECHANISMS
Monetary policy affects aggregate demand
by reinforcing domestic and international
transmission mechanisms connecting interest rates, exchange rates,
and spending.
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·Open market operations and interest rates affect
aggregate demand (C + I + G + X – IM) through
·Domestic monetary transmission mechanism
(red paths on next slide)
·International transmission mechanisms
(blue paths on next slide)
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18 Enlarged GDP Circular Flow of Income
and Spending ($) with Banking System
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