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EC140 (417)

30. Monetary Policy.docx

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Rizwan Tahir

Chapter 30 – Monetary Policy  On 8 pre-set dates a year, Bank announces whether interest rate will rise, fall, or remain constant  Canada’s monetary policy objectives stem from relationship between the Bank and the Government - The Bank of Canada’s Governing Council is responsible for the conduct of monetary policy. - The Governor and the Minister of Finance must consult regularly. - If the Governor and the Minister disagree in a profound way, the Minister may direct the Bank in writing to follow a specified course and the Bank would be obliged to accept the directive.  Objective of monetary policy is ultimately political - Based on the mandate of the Bank of Canada, which is set out in the Bank of Canada Act 1935 - Bank’s major task is to control the quantity of money and interest rates to avoid inflation - Bank should prevent excessive swings in real GDP growth and unemployment if possible Joint Statement of the Government of Canada and the Bank of Canada 1. The inflation control target is 1-3% a year 2. Keep trend inflation at 2% midpoint 3. Agreements run for 5 years, renewed during 2011 (extended through December 2016)  inflation rate targeting: central bank commits to an explicit inflation target and explaining its actions  Interpretation of the Agreement - Inflation-control target uses the CPI as the measure of inflation  keep CPI at target of 2% a year. - But the Bank pays close attention to core inflation, which it calls its operational guide  core inflation is a better measure of the underlying inflation trend  Actual inflation: the actual CPI inflation rate has only rarely gone outside the target range  2 main benefits flow from adopting an inflation-control target 1. Fewer surprises and mistakes on the part of savers and investors because the purpose of the Bank’s policy actions are more clearly understood by financial market traders 2. The target anchors expectations about future inflation  better economic decisions  Critics of inflation-control target 1. By focusing on inflation, Bank might permit unemployment rate to rise or real GDP growth to slow 2. If inflation rate begins to increase beyond upper limit of the target range, the Bank might reign in AD and push the economy into a recession 3. Bank might permit value of Canadian dollar to rise on foreign exchange market and exports suffer  Supporters of inflation-control target 1. Keeping inflation low& stable= best way to achieve full employment& sustained economic growth. 2. The Bank’s record is good. The last time the Bank created a recession was at the beginning of the 1990s when it was facing inflation seriously above target. The Conduct of Monetary Policy Choosing a Policy Instrument  As the sole issuer of Canadian money, the Bank can control 1. Monetary base: The quantity of money 2. Exchange rate: The price of Canadian money on the foreign exchange market 3. Short-term interest rate: opportunity cost of holding money  Bank can only choose 1 of above instruments; setting one sets the other 2 - If Bank decreases Q money, interest + exchange rate rises (money supply vs. interest rate) - If Bank raises interest rate, Q money decreases and exchange rate rises - If Bank lowers exchange rate, Q money increases and interest falls Overnight Rate  Bank of Canada’s choice of instrument (same as most central banks) = short-term interest rate  Bank targets overnight loans rate: interest rate on overnight loans that members of the Large Value Transfer System (the big banks) make to each other  like a bank-to-bank lending rate  Although the Bank can change the overnight rate by any reasonable amount, usually 0.25%  Interest rates are more meaningful to households and firms than size of the money supply (it is mainly through interest rates that the transmission mechanism works)  Changes in interest rates include effects of both money supply (controlled) and demand (observed) Bank’s Decision Making Process  Instrument/Taylor rule sets instrument at level based on current state of the economy. - Depends on deviation of the inflation rate from target, and the size/direction of the output gap. - For each $ by which inflation is above target, the interest rate is set 1% higher - For every % that real GDP > potential GDP (output gap), interest rate is set another % higher - Instrument: variables that policy maker controls directly.  Targeting rule: Where the ultimate policy target = inflation rate, and instrument = overnight rate, targeting rule sets overnight rate at a level that makes forecast of inflation rate = target for inflation - Central bank must gather and process large amount of information about the economy, the way it responds to shocks, and the way it responds to policy - Bank must then process all data and come to judgment about best level for policy instrument - Bank follows a process that uses a targeting rule - Targets: variables that the policy wishes to influence; real GDP, price levels, exchange rates.  Since the Bank has only one monetary policy instrument and potentially several targets, it is difficult to achieve all goals  main target should be the price level or its rate of change (inflation) Hitting the overnight rate target 1. Operating band: - Target overnight rate +/- 0.25 %  0.5% wide - The Bank creates the operating band by setting A) Bank rate: interest that Bank charges big banks on loans o target overnight rate + 0.25% points o if a bank is short of reserves, it obtains them from the Bank, but pays bank rate o cap: overnight rate cannot exceed bank rate; if it did, a bank could earn a profit by borrowing from the Bank of Canada and lending to another bank. o banks can borrow at bank rate, so no bank pays > bank rate to borrow B) Settlement balances rate: interest the Bank pays banks on reserves at the Bank o target overnight loans rate – 0.25% o The overnight rate cannot fall below the settlement balances rate. If it did, a bank could earn a profit by borrowing from another bank and increasing its reserves at (lending to) Bank of Canada. o Banks can earn the settlement balances rate, so no bank lends at rate below 2. Open market operations - Purchase/sale of government bonds by the Bank from/to other chartered banks or public - Overnight rate above target: Bank purchases securities on the open market, and it pays for them with newly created reserves that are held by banks o Increases supply of overnight funds, lowers overnight rate o Bank of Canada buys $100 of government securities in the open market from CIBC. CIBC has $100 less securities, and Bank has $100 million more.  Bank of Canada pays by placing $100 in CIBC’s deposit account at the Bank  ownership of securities passes from CIBC to the Bank, so CIBC assets decrease and Bank’s asset’s increase by $100  Bank of Canada pays by placing $100 on CIBC’s reserve account at the Bank, so Bank’s assets and liabilities increase by $100  CIBC assets unchanged; it sold securities for reserves o Deposit and reserves increase by the same amount, so the recipient chartered bank has excess reserves, which can be lent, leading to multiplied increase in bank deposits and an increase in Money Supply. - Overnight rate below target: Bank sells securities and the banks pay with their own reserves o Decrease the supply of overnight funds, and raises the overnight rate o When Bank sells securities, CIBC has $100 more and Bank has $100 less securities  CIBC pays by using $100 of its reserves deposit account at the Bank  ownership of securities passes from Bank to CIBC, to CIBC’s assets increase and Bank’s assets decrease by $100  CIBC uses $100 of its reserve at the Bank to pay  Bank of Canada’s assets and liabilities decrease by $100  CIBC total assets are unchanged as it used reserves to buy securities o Reserves of banks decrease  reduction in lending (contract deposits) leads to multiple contraction of money supply - If I sell $100 securities to Bank and puts money under mattress, nation’s supply increase $100 - To reduce market interest rates, the Bank could buy securities  The Bank can also shift government deposits between itself and chartered banks - Transfer of government deposits from Bank to commercial bank increases that bank’s reserves  excess reserves  expansion of bank lending  increases money supply Equilibrium in Market for Reserves  Chartered banks have no required reserve ratio but must balance reserves over 4 week periods.  Chartered banks can also borrow– cost of very short-term loans between financial institutions is called the overnight interest rate  targeted by Bank of Canada—goal to keep within a 0.5% band  Chartered banks avoid holding balances at Bank since negative balances imply interest, while positive balances earn only low interest return  Increases in Bank Rate discourage chartered banks from risking running short of reserves banks reduce lending (money supply) even without open market operations or deposit switching  If banks run out of reserves and must make a payment, they must borrow reserves from the Bank at opportunity cost of a bank rate  hold small reserves because Bank will lend money  The more reserves a bank holds, the less likely that it will need to borrow and pay bank rate. But reserves are costly to hold.  Alternative: lend the reserves. The higher the interest at which reserves can be loaned, the higher the opportunity cost of holding reserves, and greater the incentive to economize on the quantity of reserves.  higher overnight rate = smaller QD of reserves  X axis measures quantity of reserves held, Y-axis measures interest rates Monetary Policy Transmission  When the Bank lowers the overnight rate, other short-term interest rates and the exchange rate also fall  Q money and SLF increase, LR real interest rate falls  increases consumption expenditure and investment  Canadian exports are cheaper and imports costly, net exports rise  Easier bank loans reinforce effect of lower interest rates on aggregate expenditure  AD rises  real GDP rises, P rises relative to what they would’ve been  real GDP growth& inflation speed up  When the Bank raises the overnight rate, it is the opposite  Monetary transmission mechanism: changes in the supply and demand for money affect AD 1. Change in money demand/supply changes equilibrium interest rate 2. Change in desired investment expenditure (transmission from the money market to the real goods market, how changes in monetary variables lead to changes in real output) 3. Change in aggregate demand  Interest rate changes: happen quickly and relatively predictable 1. Overnight rate: as soon as the Bank announces a new setting for the overnight rate, it undertakes the necessary open market operations to hit the target 2. Short-term bill rate: the interest rate paid by the government on 3-month Treasury bills. Closely follows the overnight rate because the 2 rates are almost identical  substitution effect o Banks have a choice about how to hold their short-term liquid assets, and an overnight loan to another bank is a substitute for short-term securities like Treasury bills. o If the interest on Treasury bills > overnight rate, the QS overnight loans decreases and demand for Treasury bills rises  price of Treasury bills rises and interest rate falls o if interest rate on Treasury bills < overnight rate, QS of overnight loans rises and D for Treasury bills decreases  price of Treasury bills falls and interest rate rises o when interest on Treasury bills = overnight rate, there’s no incentive for bank to switch between making an overnight loan and buying Treasury bills  both the Treasury bill market and the overnight loans market are in equilibrium 3. Long term corporate bond rate: interest rate paid on bonds issued by large corporations o on loans that finance their purchases of
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