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EC140 (400)
Lecture

chapter 30.doc


Department
Economics
Course Code
EC140
Professor
Rizwan Tahir

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Chapter 30: Monetary Policy
Tuesday, March 05, 2013
12:59 PM
Objective of monetary policy is to control quantity of money and interest
rates to avoid inflation
oPrevent excessive swings in real GDP growth and unemployment
Bank of Canada conducts monetary policy- an "arms-length" organization
oNot a government department, but is owned by them
oMinister of Finance can still order Bank of Canada to change policy
Policy is implemented with less political influence
oMakes them better able to manage economy
Official Monetary Policy of Canada
Bank of Canada operates inflation rate targeting policy
Alters interest rates and money supply to keep inflation in given
range
Policy is:
Inflation is kept in band between 1-3% a year
Inflation is targeted at 2% midpoint
Recently, Bank of Canada has signalled it will depart from this
policy if needed
Inflation target uses CPI as measure of inflation
Bank also pays close attention to core inflation (operational
guide)
Bank believes core inflation is better measure of underlying
inflation trend and better predicts future CPI inflation
Actual inflation rate sometimes falls out of accpetable range (very fast
recessions of expansions)
Occurs due to timing and administrative lags
Why Control Inflation Specifically?
Two main benefits:
Fewer surprises and mistakes on part of savers and investors -
called "transparency"
Businesses are better able to anticipate future rates and
inflation, make better investments
Anchors expectations about future inflation
Promotes stable, consistent economic growth
Downsides to inflation targeting
Unemployment rate might rise
Real GDP growth might be slow
Value of dollar might rise on foreign exchange market- makes
exports suffer
The Conduct of Monetary Policy
Bank of Canada achieves its objectives mainly by altering money
supply
Has the option to set any of the following by altering money supply:
Quantity of money (monetary base)

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Exchange rate
Short-term interest rate
Bank of Canada cannot set more than one of these at one time (must
let the other two vary)
Bank of Canada sets short-term interest rates
Exchange rates, quantity of money to find their own equilibrium
value
Rate that Bank of Canada targets is overnight loan rate
Overnight loan rate: interest rate on overnight loans that big
banks make to each other
They announce their targets 8 times yearly
Banks lend to each other to maintain cash reserves
If they have too much, they lend
If they have too little, they borrow
Rate is high in good times to slow inflation, low in bad times to
boost economy (avoid recession)
Judgments of interest rate based on sophisticated models based
on economic data
Regional, national, international macro data
Financial market data
Inflation expectations
Governor and governing council ultimately decide
Bank of Canada uses two tools to meet their targets:
Operating band: target overnight rate plus or minus 0.25
percentage points
oOperating band becomes 0.5 percentage points wide
oBank creates operating band by settng:
Bank rate: interest rate that Bank of Canada
charges big banks on loans
Acts as cap on overnight loans rate
Settlement balances rate: interest rate the Bank
of Canada pays on reserves
Acts as lower bound on interest paid on
overnight loans
Open market operations: purchase or sale of government
securities by Bank of Canada from or to chartered bank or public
oWhen bank buys securities, it pays for them with
newly created reserves held by banks
oWhen bank sells securities, they are paid for with
reserves held by banks
oOpen market operations influence banks' reserves
Changes in amount of reserves affect
overnight loans rate
oDemand of Reserves
Less reserves when overnight rate is higher
Opportunity cost of holding funds in reserve
is larger when overnight loans rate is higher
Better to lend out reserves
Reserves <= 0 when:
Overnight rate = bank rate
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Can just get loan from Bank of Canada to meet all
reserve needs
No loss ince it's also earning same rate lending on
market
If overnight rate = settlement balance rate
Banks indifferent between holding reserves and
lending reserves
Banks will hold any amount of reserves at that rate
Overnight rate cannot exceed bank rate
Bank could earn profit by borrowing from Bank of
Canada and lending to another bank
Overnight rate cannot fall below settlement balances rate
Bank could profit by borrowing from another bank
and increasing its reserves at Bank of Canada
Supply of Reserves
Bank of Canada's open market operations determine supply of
reserves in banking system
A vertical line at level set by bank of Canada
Equilibrium in market for reserves determines overnight rate
Monetary Policy Transmission
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