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Chapter 29

Chapter 29 Notes

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ECON 110
Ian James Cromb

Chapter 29 – Monetary Policy in Canada 29.1 – How the Bank of Canada Implements Monetary Policy Money Supply Vs. the Interest Rate  Banks can implement monetary policy by manipulating either the money supply or the interest rate (but not both)  Government could increase the money supply with open-market operations like using money to buy government bonds, and then lending out these new reserves increasing the amount of deposit money in the economy. This would shift the M S curve to the right, and the equilibrium point would move down on a given M curveD  Banks do not manipulate the money supply because… o They can control the amount of cash reserves in the banking system, but they can’t control process of deposit expansion of commercial banks, who may choose not to expand their lending o The slope of the M cDrve is uncertain, and changes in the M curSe may also bring about changes in the M curve D in unpredictable ways o The position of the M curve is also unpredictable, as it is influenced by many factors such as real GDP and price D level, and innovations in the financial sector  Banks normally manipulate the interest rate directly, as this avoids any problems resulting from uncertainty with the slope and position of the M cDrve, and it communicates policy actions more clearly to the public The Bank of Canada and the Overnight Interest Rate  The term structure of interest rates represents interest rates and corresponding maturities  Overnight Interest Rate: the interest rate that commercial banks charge each other for overnight loans  Since rates tend to rise and fall with the overnight interest rate, manipulating this will manipulate all rates in turn  The Bank of Canada manipulates the overnight interest rate with a policy instrument or target that it sets for the rate, a midpoint of a 0.5% range  Bank Rate: the interest rate the Bank of Canada charges commercial banks for loans, the upper rate of the target range o If the banks overnight interest rate target is set for 4%, then it’s willing to lend to commercial banks at the bank rate of 4.25% and willing to pay 3.75% on any deposits it receives from commercial banks The Money Supply is Endogenous  Commercial banks quickly adjust their interest rates to the target overnight interest rate, but borrowers take longer to adjust as they carefully consider how adjustments affect them economically  Open-Market Operation: the purchase and sale of government securities on the open market by the central bank  A rise in the interest rate will decrease demand for borrowing and spending, while a drop in the interest rate will increase the demand  With a growing demand for loans (decreased interest rate) commercial banks may need more cash reserves to make loans, and will sell government bonds to the Bank of Canada. Bank of Canada is purchasing bonds, called and open-market purchase  Open-market sale when the demand for loans is low, and commercial banks want to sell their government bonds to the Bank of Canada  The amount of currency in circulation (resulting from open-market sale) rarely ever falls, as growth of economy increases general demand Expansionary and Contractionary Monetary Policies  Reducing interest rates lead to an expansionary monetary policause because it leads to an expansion of aggregate demand. If the bank wants to reduce growth rate (slowed aggregate demand) it will increase interest rates, resulting in a contractionary monetary policy. Interest Rate Influence Exchange Rate Overnight rate and Catial flows and determines net exports Bank of Canada sets its long-term market exchange rate AD =ASSdetemiines target for overnight interest rates equiibrum P andYY rate determined Interest Rate determine consumption and investment 1 29.2 – Inflation Testing Why Target Inflation?  Inflation is generally harmful to the economy, especially individuals who’s income is not indexed (adjusted for changes in prices level)  Uncertainty in inflation leads to arbitrary income redistributions and also undermines the efficiency of the price system  Long-term effects of monetary policy are very different from short-term effects, and the primary cause for sustained inflation is rapid growth in the money supply  Inflation Targeting is a control of inflation through the money supply by governments (now around 2%) The Role of the Output Gap  The Bank closely monitors GDP in the short-run, looking at output gaps  When a positive shock pushes real GDP about Y*, opening an inflationary output gap excess demand is created in factor markets and wages and other factor prices rise, pushing up firms’ cots and adding to inflationary pressure. The rate of inflation rises above the target, and the Bank will either do nothing, or use a contractionary monetary policy to shift the AD curve to the left and bring the inflation back to its starting point Inflation Targeting as a Stabilizing Policy  Inflation targeting is a stabilizing policy: positive shocks are met with contractionary monetary policy, and negative shocks are met with expansionary monetary policy Complications in Inflation Targeting  When rate of inflation increase for reasons unrelated to the output gap (sudden rise in foreign markets like oil or fruit), the measured rate of inflation of the Canadian CPI rises  To keep track of other changes, Banks monitor the core rate of inflation, which does not take food, energy, and the effects of indirect taxes like the GST into account  Core inflation is much less volatile than the CPI inflation The Exchange Rate and Monetary Policy  Appropriate monetary policy responses for changes in the exchange rate depend on the cause of the change  If trading partners of Canada are booming and demand increases, the Canadian dollar appreciates, and aggregate Canadian demand increases, a shock that eventually causes inflationary pressure. At this point, the Bank can take action by tightening the monetary policy (raising overnight interest rate)  If demand for Canadian assets increases (instead of demand for Canadian goods) because investors liquidate foreign assets and switch to Canadian assets, leading to an increase in demand, which appreciates the Canadian dollar. This makes exports see
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