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Chapter 29

ECO100 Chapter 29- Monetary Policy in Canada.docx

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Kalina Staub

Chapter 29- Monetary Policy in Canada 29.1 How the Bank of Canada  Implements Monetary Policy Money Supply VS. The Interest Rate • In principle, monetary policy can be implemented either by targeting the money supply or by targeting the interest rate; but for a given MD curve, both cannot be targeted independently • Disadvantages of conducing monetary policy by targeting the money supply are: 1. The Bank of Canada cannot control the process of deposit creation (can influence the money but cannot control it) 2. There is uncertainty regarding the slope of the MD curve 3. There is uncertainty regarding the position of the MD curve • Accommodate the change in the amount of money demanded means Bank must alter the supply of money in order to satisfy the change in desired money holdings by firms/households • Advantage of conducting monetary policy by targeting the interest rate are: 1. The Bank of Canada is able to control a particular interest rate 2. Uncertainty about the slope and position of the MD curve does not prevent the Bank of Canada from establishing its desired interest rate 3. The Bank of Canada can easily communicate its interest rate policy to the public The Bank of Canada and the Overnight Interest Rate • Overall pattern of interest rates corresponding to government securities of different maturities = term structure of interest rates • Overnight Interest Rate- The interest rate that commercial banks charge one another for overnight loans • Commercial banks that need cash because they have run short of reserves can borrow in the overnight market from banks that have excess reserves available • By influencing the overnight interest rate, the Bank of Canada also influences the longer term interest rates that are more relevant for determining aggregate consumption and investment expenditure • Bank establishes target for the overnight rate and announces this target eight times per year at pre-specified dates called fixed announcement dates (FADs) • Bank Rate- The interest rate the Bank of Canada charges commercial banks for loans • The Bank of Canada establishes a target for the overnight interest rate; its instrument for achieving this target is its borrowing and lending activities with commercial banks; by raiding its target rate, the Bank affects the actual overnight interest rates; changes in the overnight rate then lead to changes in other, longer term, interest rates The Money Supply is Endogenous • Open Market Operation- The purchase and sale of government securities on the open market by the central bank • Through its open market operations, the Bank of Canada changes the amount of currency in circulation; these operations however, are not initiated by the Bank; it conducts them to accommodate the changing demand for cash reserves by the commercial banks • Amount of currency in circulation (money supply) is endogenous;; not directly controlled by the Bank of Canada but instead is determined by the economic decisions of households, firms, and commercial banks • Bank of Canada is passive in its decisions regarding the money supply; it conducts its open market operations to accommodate the changing demand for currency coming from the commercial banks Expansionary and Contractionary Monetary Policies  • Reducing the interest rate = expansionary monetary policy because it leads to an expansion of aggregate demand • Increasing the interest rate = contractionary policy because it leads to a contraction (reduction in growth rate) of aggregate demand 29.2 Inflation Targeting Why Target Inflation? • Central banks focus on inflation comes from two observations regarding marco relationships: the costs associated with high inflation and the ultimate cause of sustained inflation • High Inflation is costly  High and uncertain inflation leads to arbitrary income redistributions and also hampers the ability of the price system both to allocate resources efficiently and to produce satisfactory rates of economic growth • Monetary policy is the cause of sustained inflation  Sustained inflation occurs only in those situations in which monetary policy was allowing continual and rapid growth in the money supply; sustained inflation must ultimately be caused by monetary policy  Most economists and central bankers accept that monetary policy is the most important determinant of a country’s long run rate of inflation • The adoption of inflation targeting = Inflation Targeting Inflation Targeting and the Output Gap • Persistent output gaps generally create pressure for the rate of inflation to change; to keep the rate of inflation close to 2%, the Bank of Canada closely monitors real GDP in the short run and designs its policy to keep real GDP close to potential output Inflation Targeting as a Stabilizing Policy • Inflation targets are not as “automatic” a stabilizer as the fiscal stabilizers built into the tax and transfer system; however, as long as the central bank is committed to achieving its inflation target, its policy adjustments will act to stabilize real GDP Complications in Inflation Targeting • Volatile Food and energy prices  Because the volatility of food and energy prices is often unrelated to the level of the output gap in Canada, the Bank of Canada closely monitors the rate of “core” inflation (rate of growth of a special price index, one that is constructed by extracting food, energy, and the effects of indirect taxes) even though its formal target of 2% applies to the rate of CPI
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