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Justin Smith

EC140 March 12 2013 Monetary Policy - The objective of monetary policy is to o Control the quantity of money and interest rates in order to avoid inflation o Prevent excessive swings in real GDP growth and unemployment. - The Bank of Canada (BoC) conducts monetary policy o It is an “arms-length” organization o It is not a government department, but is owned by them o Minister of Finance can still order BoC to change policy o Policy is implemented with less political influence  Makes them better able to manage the economy Official Monetary Policy of Canada - The BoC operates an inflation rate targeting policy o Alters interest rates and the money supply to keep inflation in a given range - Specifically, the policy is o Inflation is kept in a band between 1 to 3 percent a year. o Inflation is targeted at the 2 percent midpoint. o Recently, BoC has signalled it will depart from this policy if needed - Inflation target uses the CPI as the measure of inflation. o Bank also pays close attention to core inflation, which it calls its operational guide. o Bank believes core inflation is a better measure of the underlying inflation trend and better predicts future CPI inflation. - (a) Figure on the left shows: - Bank’s inflation target, actual inflation rate - Actual rate sometimes falls out of acceptable range - In times of very fast recessions of expansions - Occurs due to timing and administrative lags - (b) The Bank has held CPI inflation to its target, with only small and temporary deviations 1 EC140 March 12 2013 Why Control Inflation Specifically? - Mark Carney and Ben Bernanke favour this policy - Two main benefits: - Fewer surprises and mistakes on the part of savers and investors. o Called “transparency” o Businesses are better able to anticipate future rates and inflation, and therefore make better investments - Anchors expectations about future inflation o Promotes stable, consistent economic growth Downsides to Inflation Targeting - Alan Greenspan does not favour inflation targeting - Critics of inflation targeting fear that by keeping inflation low, - The unemployment rate might rise - Real GDP growth might be slow. - The value of the dollar might rise on the foreign exchange market o Making exports suffer The Conduct of Monetary Policy - The Bank of Canada achieves its objectives mainly by altering the money supply - It has the option to set any of the following by altering money supply o The quantity of money (the monetary base) o The exchange rate o The short-term interest rate - The BoC cannot set more than one of these constant at one time o It must let the other two vary - Dutch disease: high oil prices hurt the manufacturing industry - The BoC sets short-term interest rates (because everyone knows what that implies for economic outcomes; people can use this information to make decisions) o The exchange rate and the quantity of money to find their own equilibrium values. - The rate that BoC targets is the overnight loans rate o Overnight loans rate: the interest rate on overnight loans that big banks make to each other. (ex. CIBC will lend RBC money to meet their loan requirements, and RBC will pay it back the next day) o The BoC will announce their targets 8 times yearly - Recall o Banks lend to each other to maintain cash reserves  If they have too much, they lend  If they have too little, they borrow 2 EC140 March 12 2013 - Figure shows the overnight loans rate - Rate is high in good times to combat inflation - Low in bad times to boost the economy - Since late 2000, - BoC sets eight fixed dates on which it announces its overnight rate target for the coming six weeks. - Before 2000, - BoC announced changes in the overnight loans rate whenever it was required. - As GDP rises quickly, so does the interest rate (b/c the BoC tries to slow the economy down by increasing the interest rate) - In 2010, they couldn’t lower the interest rate any further because it was already at 0 How does the BoC determine what the interest rate should be? - Judgements based on sophisticated models based on economic data o Regional, national, international macro data o Financial market data o Inflation expectations - Governor and Governing council ultimately decide To meet their targets, the BoC uses two tools: 1. Operating band: the target overnight rate plus or minus 0.25 percentage points. o The operating band is therefore 0.5 percentage points wide. o The Bank creates the operating band by setting:  Bank rate: the interest rate that the BoC charges big banks on loans.  Acts as cap on overnight loans rate  Settlement balances rate: the interest rate the BoC pays on reserves.  Acts as lower bound on interest paid on overnight loans 2. Open market operations: the purchase or sale of government securities by the Bank of Canada from or to a chartered bank or the public. o When the Bank buys securities, it pays for them with newly created reserves held by the banks. o When the Bank sells securities, they are paid for with reserves held by banks. o Open market operations influence banks’ reserves.  Changes in the amount of reserves affect the overnight loans rate 3 EC140 March 12 2013 - Demand for Reserves (held at the BoC for everyday transactions) - Less reserves when overnight rate is higher - Opportunity cost of holding the funds in reserve is larger when overnight loans rate is higher - Better to lend out reserves - Reserves <= 0 when the overnight rate equals the bank rate. - Can just get a loan from BoC to meet all reserve needs - No loss since it is also earning the same rate lending on the market - If the overnight rate equals the settlement balances rate - Banks are indifferent between holding reserves and lending reserves. - Banks will hold any amount of reserves at that rate - The overnight rate cannot exceed bank rate - A bank could earn a profit by borrowing from the Bank of Canada and lending to another bank. - The overnight rate cannot fall below the settlement balances rate. - A bank could profit by borrowing from another bank and increasing its reserves at the Bank of Canada. - Supply of Reserves - The BoC’s open market operations determine the supply of reserves in banking system. - It is thus a vertical line at the level set by the BoC - In this case, the vertical line at 50 million - Equilibrium in the market for reserves determines the overnight rate. How monetary policy works: - When the BoC lowers the overnight rate: o Other short-term interest rates and the exchange rate fall. o The quantity of money and the supply of loanable funds increase. o The long-term real interest rate falls. o Consumption expenditure, investment, and net exports increase. o Aggregate demand increases. o Real GDP growth and the inflation rate increase - When the BoC raises th
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