Lecture Nine: Monetary Policy
March 20, 2012
Background to the Bank of Canada
On eight preset dates a year, the Bank of Canada announced whether the interest rate
will rise, fall or remain constant until the next decision date.
-How does the Bank make its interest rate decision?
-What does the Bank do to keep interest rates where it wants them?
-Does the Bank’s interest rate change influence the economy in the way the Bank
-Can the Bank speed up economic growth by lowering interest rates and keep inflation
in check by raising them?
Monetary Policy Objective and Framework
Canada’s monetary policy objectives and framework for setting and achieving that ob-
jective stems from the relationship between the Bank of Canada and the government of
Monetary Policy Objectives
The objective of monetary policy is ultimately political.
It stems from the mandate to the Bank of Canada, which is set out in the Bank of Cana-
da Act 1935
-Basically, the Bank’s job is to control the quantity of money and interest rates in order
to avoid inflation and when possible, prevent excessive swings in real GDP growth and
Joint Statement of the Government of Canada and the Bank of Canada
The agreement is
1. The inflation-control target: 1-3 percent per year
2. Keep trend inflation at the 2% midpoint
3. The agreement will run for five years, and will be renewed sometime during 2011
Such a monetary policy strategy is called inflation rate targeting.
Interpretation of the Agreement
The inflation-control target uses the CPI as the measure of inflation.
-So, the Bank has agreed to keep the CPI at a target of 2% a year
But the Bank also plays close attention to core inflation, which it calls its operational
-The Bank believes that core inflation is a better measure of the underlying inflation
trend and better predicts future CPI inflation
Historically, the actual CPI inflation rate has only rarely gone outside the target range.
-The Bank has held CPI inflation to its target, with only small and temporary deviations
Rationale for Inflation-Control Target
Two main benefits flow from adopting an inflation-control target
1. Fewer surprises and mistakes on the part of savers and investors
2. Anchors expectations about future inflation
Controversy About the Inflation-Control Target
Critics of inflation targeting fear that
1. By focusing on inflation, the Bank might permit the unemployment rate to rise or real
GDP growth to slow
2. The Bank might permit the value of the dollar rise on the foreign exchange market
and make exports suffer
Supporters of inflation targeting respond
1. Keeping inflation low and stable is the best way to achieve full employment and sus-
tained economic growth
2. The Bank’s record is good. The last time the Bank created a recession was at the be-
ginning of the 1990s when it was faced with double-digit inflation
Responsibility for Monetary Policy
The Bank of Canada’s Governing Council is responsible for the conduct of monetary
-The Governor and the Minister 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
The Conduct of Monetary Policy
Choosing a Policy Instrument
As the sole issuer of Canadian money, the Bank of Canada can decide to control
1. The quantity of money (the monetary base), or
2. The price of Canadian money on the foreign exchange market (the exchange rate), or
3. The best opportunity cost of holding money (the short-term interest rate)
The Bank can set only one of these instruments.
The Overnight Rate
The Bank of Canada’s choice of policy instrument (which is the same choice as made
by most other major central banks) is a short term interest rate.
Given this choice, the exchange rate and the quantity of money to find their own equilib-