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Chapter 29

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ECON 110
Ian James Cromb

Chapter 29: Monetary Policy in Canada How the B. of C. Implements Monetary Policy Money Supply vs. Interest Rate  In principle, a central banks can implement monetary policy either by targeting the money supply or by targeting the interest rate o But for a given M cDrve, both cannot be targeted independently – if you target money supply, interest rate will move to equilibrium; if you target interest rate, the money supply will adjust to accommodate the movement along the M curDe  Open-market operations are an attempt of shifting the M Surve (to change the amount of currency in circulation) by buying/selling gov’t securities in the financial markets o Commercial banks could get more money and start money creation process o This method is not used to change the money supply Disadvantages of Conducting Monetary Policy by Targeting the Money Supply 1. The B. of C. cannot control the process of deposit creation by commercial banks 2. There’s uncertainty regarding the slope of MDcurve – can’t tell what change would be 3. There is uncertainty regarding the position of the D curve – can only be approximated Advantages of Conducting Monetary Policy by Targeting the Interest Rate 1. The B. of C. is able to control a particular market interest rate 2. Uncertainty about the slope and position of the MDcurve does not prevent the B. of C. from establishing its desired interest rate – interest rate is most imp. for affecting AD 3. The B. of C. can easily communicate an interest-rate change to the public as they are more meaningful to firms/households rather than the level of reserves The Bank of Canada and the Overnight Interest Rate  There are many different interest rates in the Canadian economy corresponding to different types of loans that last (mature) different amounts of time (90 days vs. 30 yrs.)  An overnight interest rate is the shortest period of borrowing/lending – it is the interest rate that commercial banks charge one another for overnight loans o Might need money of reserves are low  OIR and other interest rates tend to rise and fall together so B. of C. can control longer term interest rates by influencing the overnight rate  which have more influence on AD  To control OIR, the B. of C. sets a target for the rate, announcing it 8 times per year and a target range in which it the overnight range should fall o At upper point (Bank rate), BoC willing to lend commercial banks desired money o At lower point, B. of C. is willing to accept any deposits from them  By raising or lowing the target rate, the B. of C. affects the actual overnight interest rate The Money Supply is Endogenous  When the BoC changes its target for the overnight rate, the change in the actual overnight rate happens almost instantly – other interest rates change quickly too (1 or 2 days) o As rates adjust, firms & households adjust their borrowing behaviour but these changes take a lot longer  As the demand for loans adjust, commercial banks often find themselves in need of more cash reserves with which to make new loans – sell gov’t securities to BoC  Might say that the MS is endogenous and not directly controlled by the BoC but by households and firms  conduct open-market operations to accommodate the changing demand for currency coming from the commercial banks Expansionary and Contractionary Monetary Policies  Economists label a monetary-policy action as being expansionary or contractionary depending on how the policy affects interest rates, not the overall amount of money  If they want to stimulate the level of AD, it will reduce its target for the overnight rate which will then effect the longer-term market interest rates  leads to expansion of AD  If they want to reduce AD, it will increase its target for the overnight rate which will then effect the longer-term market interest rates  leads to contraction (slowing) of AD Inflation Targeting Why Target Inflation?  High inflation is damaging to the economy and is costly to firms and households o Inflation reduces the real purchasing power of those people whose incomes are stated in dollar terms and insufficiently indexed to adjust to changes in price level  The uncertainty generated by inflation is also damaging for the economy o When inflation is high, it tends to be very volatile making it difficult to predict o Periods of high inflation are characterized by having much unexpected inflation  High inflation undermines the ability of the price system to signal changes in relative scarcity through changes in relative prices
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