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Economics
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ECO105Y1
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Prof.Hare

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Notes for Lecture 17: Macro 1: Monetary Policy and the Role of the Bank of Canada
[with models] [February 9, 2010]
Economic Concepts: macro goals: full employment and price stability, consumer price
index, “core” inflation, central bank, role of central bank, inflation, cost push inflation,
demand pull inflation, printing press inflation, monetary policy, “easy” money policy,
“tight” money policy, inflation targeting by Bank of Canada, discretionary fiscal policy,
expansionary fiscal policy, restrictive fiscal policy, final goods and services again which
forms statement of Gross Domestic Product [Lecture 2], aggregate demand [AD], short run
aggregate supply [SRAS], assumptions behind AD, assumptions behind SRAS, shocks to AD
and SRAS, the Greenspan hypothesis, stagflation, cash reserves of the chartered banks, cash
reserve ratio, M1 money supply, currency in circulation [CIC], Bank of Canada notes,
Canadian currency, multiple expansion [contraction] of deposits in banking system and the
M1 money supply, the banking multiplier, open market operations [OMO].
NOTE: TO BE COVERED IN LECTURE 18: the transmission mechanism, transactions
demand for money, speculative demand for money, liquidity preference curve [LP],
marginal efficiency of investment [MEI], savings/investment equilibrium, conditions for
effective monetary policy [elasticities of LP and MEI; short-term interest rate adjustments
relative to balance-of-payments deficits].
Macro Policy Goals
The macro economic goals for Canada are full employment with price stability. I define full
employment as 95% employment [5% unemployment] and price stability as the condition where
the measurement of price increases does not exceed 5% per year. [ See Lecture 1.] Core inflation
in Canada is falling and in the 2% target range.
In recent years, the unemployment rates have been strongly declining in both Canada and the
United States. The unemployment rate in the United States reached a very unusually low rate of
4%, during 2000 and stands today in the low 5 percentage range. Canada now has reached the
lowest level of unemployment in recent years at 5.8% in January, 2008.
As the global slow-down develops, the unemployment rates in Canada and the United States have
both risen significantly – more so in the United States, where it is currently above 7.5%.
With respect to price stability, the Bank of Canada and the Canadian Government have agreed to
a goal that price increases [inflation] should be contained between 1% and 3%. This is the Bank
of Canada’s definition of price stability.
The Bank of Canada has recently defined modified “core” inflation [CPIX] as the rise in the
Consumer Price Index [CPI] when mostly fruit, vegetable and energy elements have been
extracted from the basket of goods on which the CPI has been measured.. The “core” inflation
elements constitute about 84% of the total basket of goods which are included when the consumer
price index is generated.
The Bank of Canada holds that it is this definition of “core” inflation that should be contained
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within the 1% to 3% range. The rate of “core” inflation has been below the rate of increase in the
Consumer Price Increase by a modest amount through time.
Notice ‘core’ inflation does not include changes in petroleum prices. The former Governor of the
Bank of Canada, David Dodge, has indicated that if the rate of “core” modified inflation exceeded
the median [in the range] of 2%, he would be concerned about inflationary pressures.
Currently, ‘core’ inflation in Canada has been recently falling and has reached 1.4% in January,
2008. Current estimates are that “core” inflation will fall towards 0% during the economic
slowdown. Some economists are predicting a period of deflation i.e., the CPI would decrease.
Japan during the 1990s frequently experienced the problem of deflation.
One of the characteristics of deflation restricts future economic growth. If consumers believe that
key prices e.g., automobiles and other consumer durables, are likely to decrease, they will then
withhold purchases until the future when the threat of deflation ends.
Long-Run Economic Goal: Productivity Growth
Although these short run macro goals determine the policy stance of the Bank of Canada
and the Minister of Finance, Krugman’s position on the long run goal of increased labour
productivity in the manufacturing sector, and throughout the economy, still holds as the
primary economic goal for an industrial country.
It is the principal task of the economic system to utilize resources more efficiently such that higher
levels of real per capita GDP can be achieved over time. As explained in Lectures 5 and 6,
innovation is the leading cause of productivity growth.
Interestingly, the Greenspan thesis is that high productivity growth in the United States has
contained inflation even though the American economy has achieved almost ‘super’ full
employment and some labour costs have increased. This thesis is examined in the AD/SRAS
model explained during the lecture.
Central Bankers and Central Banks
Each industrial country and most developing countries, have established a central bank: the Bank
of Canada, the Federal Reserve System in the United States, the Bank of England, the Bank of
Japan etc..
The primary role of the central bank in an industrial country is to establish monetary policy. In
Canada, this means that the Bank of Canada should undertake policy actions to promote price
stability and to achieve full employment. However, in recent years [i.e., since the mid-1970's], the
Bank of Canada has focused almost exclusively on the goal of price stability.
The Bank of Canada is an independent institution: it is not part of the Canadian Government. All
Central Banks have this status, including the Federal Reserve System which is independent of the
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fiscal policy established by the American Government.
A small part of the operations of a central bank are agency roles on behalf of the federal
government. These central bank operations include: the issuing and canceling of government
bonds; the issuing of domestic coin and bills; the holding of the country’s foreign exchange
reserves and the short-term day-to-day operations in the foreign exchange markets with respect to
the Canadian dollar.
The independent part of the central bank’s operations are more important: the operations
of monetary policy intended to impact upon real output, employment and prices.
Mark Carney has recently replaced David Dodge as Governor of the Bank of Canada. Alan
Greenspan of the Federal Reserve system is probably the most influential economist in the world
recently. Now, he has recently been replaced by Ben Bernanke.
The Costs of High Unemployment and High Inflation
When a country has too high a rate of unemployment [usually associated with a period of price
stability as experienced during the 1930's, the 1950's and the early 1990's], economic costs are
incurred throughout the economy. One opportunity cost would be the loss of disposable income
and the associated hardships incurred by workers who have been laid off. High rates of
unemployment generate what Keynes called “insufficient aggregate demand” i.e., the economy is
not producing the output of which it is capable. In addition, increased excess capacity in a
country’s industrial sector works to reduce growth in labour productivity and growth in real per
capita incomes.
A simple definition of inflation: a persistent and consistent upward movement of prices i.e, the
same basket of consumer goods costs more today than yesterday because of inflationary pressures.
High inflation, usually associated with full employment, also brings significant economic costs to
a country. The costs of inflation [in excess of 5%], as explained in the lecture, include:
a. a worsened balance of trade position [i.e., under a fixed foreign exchange rate regime,
exports would be relatively more expensive for importing countries and imports would be
relatively cheaper in the domestic economy: thus exports would be lower than otherwise
and imports would be higher than otherwise at the expense of domestic production];
b. inflation acts like a regressive tax on workers with weak unions, workers with no
unions and the retired: in each case, nominal increases in income are most often less than
the rate of inflation [i.e., inflation reduces the real disposable income levels of low-income
earners];
c. inflation generates uncertainty about future input costs, product prices and sales levels:
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Description
Notes for Lecture 17: Macro 1: Monetary Policy and the Role of the Bank of Canada [with models] [February 9, 2010] Economic Concepts: macro goals: full employment and price stability, consumer price index, core inflation, central bank, role of central bank, inflation, cost push inflation, demand pull inflation, printing press inflation, monetary policy, easy money policy, tight money policy, inflation targeting by Bank of Canada, discretionary fiscal policy, expansionary fiscal policy, restrictive fiscal policy, final goods and services again which forms statement of Gross Domestic Product [Lecture 2], aggregate demand [AD], short run aggregate supply [SRAS], assumptions behind AD, assumptions behind SRAS, shocks to AD and SRAS, the Greenspan hypothesis, stagflation, cash reserves of the chartered banks, cash reserve ratio, M1 money supply, currency in circulation [CIC], Bank of Canada notes, Canadian currency, multiple expansion [contraction] of deposits in banking system and the M1 money supply, the banking multiplier, open market operations [OMO]. NOTE: TO BE COVERED IN LECTURE 18: the transmission mechanism, transactions demand for money, speculative demand for money, liquidity preference curve [LP], marginal efficiency of investment [MEI], savingsinvestment equilibrium, conditions for effective monetary policy [elasticities of LP and MEI; short-term interest rate adjustments relative to balance-of-payments deficits]. Macro Policy Goals The macro economic goals for Canada are full employment with price stability. I define full employment as 95% employment [5% unemployment] and price stability as the condition where the measurement of price increases does not exceed 5% per year. [ See Lecture 1.] Core inflation in Canada is falling and in the 2% target range. In recent years, the unemployment rates have been strongly declining in both Canada and the United States. The unemployment rate in the United States reached a very unusually low rate of 4%, during 2000 and stands today in the low 5 percentage range. Canada now has reached the lowest level of unemployment in recent years at 5.8% in January, 2008. As the global slow-down develops, the unemployment rates in Canada and the United States have both risen significantly more so in the United States, where it is currently above 7.5%. With respect to price stability, the Bank of Canada and the Canadian Government have agreed to a goal that price increases [inflation] should be contained between 1% and 3%. This is the Bank of Canadas definition of price stability. The Bank of Canada has recently defined modified core inflation [CPIX] as the rise in the Consumer Price Index [CPI] when mostly fruit, vegetable and energy elements have been extracted from the basket of goods on which the CPI has been measured.. The core inflation elements constitute about 84% of the total basket of goods which are included when the consumer price index is generated. The Bank of Canada holds that it is this definition of core inflation that should be contained www.notesolution.com
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