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Chapter 29

ECON 102 Chapter Notes - Chapter 29: Quantitative Easing, Core Inflation, High Tech


Department
Economics
Course Code
ECON 102
Professor
Robert Gateman
Chapter
29

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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

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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)
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