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Chapter 29

Economics 102: Chapter 29

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University of British Columbia
ECON 102
Robert Gateman

Economics 102: Principles of Macroeconomics Chapter 29 29.1 How the Bank of Canada Implements Monetary Policy  BOC cannot directly set the money supply or directly set interest rates o BOC instead targets the money supply or interest rates Money Supply Versus the Interest Rate:  Central banks can implement monetary policy through targeting the money supply or interest rate o If money supply is targeting, monetary equilibrium will determine interest rates o  Open-market operations: buying/selling government securities in the market o o Increase in the money supply would lead to a reduction in the equilibrium interest rate  Eventually increase aggregate demand  o Changes in real GDP and P cause changes in money demand that banks cannot approximate o  Central banks can more easily communicate targets of interest rates rather than the money supply The Bank of Canada and the Overnight Interest Rate:  The shorter the bond term, the lower the yield (interest rate)  Overnight interest rate: interest rate that commercial banks charge each other for overnight loans o Tends to be the shortest period of borrowing or lending  Bank's (central) policy instrument: target that it sets for the overnight interest rate o A midpoint of a 0.5% range that the Bank would like to see the overnight interest rate o The Bank announces its target for the overnight rate eight times per year (fixed)  Bank rate: interest rate the BOC charges commercial banks for loans o The upper end of the BOCs target for the overnight interest rate o The lower end target interest rate is the interest the BOC will pay commercial banks for deposits The Money Supply is Endogenous:  When the overnight interest rate is changed, yields change quickly but borrowing behaviour lags  Open market operation: purchase/sale of government securities on the open market by the central bank  The amount of currency in circulation (money supply) is endogenous o Not directly controlled by the BOC but is determined by decisions of households, firms and banks o Economics 102: Principles of Macroeconomics Expansionary and Contractionary Monetary Policies:  Expansionary monetary policy: reducing the interest rate o Leads to an expansion of aggregate demand  Contractionary monetary policy: increasing the overnight interest rate o Reduces aggregate demand (slows the growth rate)  As the longer-term interest rates change desired investment and consumption expenditure change o International capital flows in response to changes in interest rates (affects the exchange rate)  Changes in the exchange rate affect net exports o Changes in aggregate expenditure lead to shift in the AD curve  This changes the level of real GDP and the price level 29.2 Inflation Targeting Why Target Inflation?  Unexpected inflation is associated with high levels of inflation, and is damaging to the economy  High/uncertain inflation leads to arbitrary income redistribution and undermines the efficiency of the price system  Monetary policy in the short-run can have a large influence on real economic variables o Long-run impact appears to be mostly affecting nominal variables (price level and inflation rate)  Demand/supply shocks not related to monetary policy shift AD and AS and change inflation  Sustained inflation occurs only when monetary policy is continual and rapid in the money supply o High inflation is costly for individuals and damaging to the economy o Inflation is the only macroeconomic variable the Bank have systematic and sustained influence The Role of the Output Gap:  As an inflationary gap opens, production increases and inflation rises (above the target midpoint) o The AS curve will shift upward and eventually return real GDP to Y* (close the gap) o Bank could also use contractionary monetary policy to shift AD curve left  Brings the rate of inflation down and closes the output gap Inflation Targeting as a Stabilizing Policy:  Inflation targeting is a stabilizing policy o Positive shocks will be met with contractionary monetary policy o Negative shocks will be met with expansionary monetary policy  Inflation targets are not as automatic a stabilizer as the fiscal stabilizers (tax/transfer system) Economics 102: Principles of Macroeconomics o If the central bank is committed to the target, policy adjustments will act to stabilize the economy Complications in Inflation Targeting:  There are complications in inflation targeting that makes monetary policy harder to set Volatile Food and Energy Prices:  Commodities included in the CPI have the ability to change inflation with market price changes o These price changes have little to do with the size of the output cap (misleading)  Core inflation: rate of growth of special a special price index o Constructed by extracting food, energy and the effects of indirect taxes from the CPI o Much less volatile that is CPI inflation o Better indicator of Canadian excess demand than are changes in CPI inflation Exchange Rate and Monetary Policy:  BOC also pays close attention to the exchange rate o Must take into consideration the cause of the changes to the exchange rate  Appreciation of the CND leads to bank to tighten monetary policy and raise the targeted overnight rate o Increase in demand for Canadian goods pushes up AD and inflation, and monetary policy increase interest rates which lower consumption and investment  Or appreciation leads bank to loosen monetary policy and lower the targeted overnight rate o Increase in demand for Canadian assets pushes bond up, CND increases and may push investors out, but if not the BOC could lower interest rates thus lowering bond prices o Both work towards to objective of keeping the targeted interest rate 29.3 Long and Variable Lags What are the Lags in Monetary Policy?  Lags in operation of policy can sometimes cause stabilization policy to be destabilizing Changes in Expenditure Take Time:  When the BOC changes its overnight target, the overnight interest rate changes very quickly o Longer-term interest rates also change relatively quickly o Large borrowing (cars, mortgages, etc.) take more time (sometimes more than a year) The Multiplier Process Takes Time:  Changes in consumption, investments, and
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