29.1 How the Bank of Canada Implements Monetary Policy
In principle, monetary policy can be implemented either by targeting the
money supply of by targeting the interest rate. But for a given D curve, both
cannot be targeted independently.
Open-market operations: transactions that involve the Bank buying/selling
government securities in the financial markets.
o If the Bank buys $100,000 of government bonds from a willing seller,
the Bank increases the amount of cash reserves by that amount and
would increase the amount of deposit money through the concept of
the multiple expansion of deposits.
The Bank does not implement its monetary policy in this way for 3 reasons:
o It cannot control the multiple expansion of deposits (banks may not
be willing to lend anymore money then they currently are).
o The Bank cannot be certain about the slope of the M cDrve (cannot
fully be sure what the result would be from any given change in the
supply of money).
o The Bank cannot be certain as well of the position of the M Durve.
Most central banks (including the Bank of Canada) choose to target the
interest rate than the money supply itself.
o This means that they must accommodate the change in the amount of
money demanded (must alter the supply of money in order to satisfy
the change in desired money holdings by firms/households.
Advantages of targeting the interest rate:
o The Bank of Canada is able to control a particular market interest rate.
o Uncertainty about the slop and position of the M curve does not
prevent the Bank of Canada from establishing its desired interest rate.
o The Bank of Canada can easily communicate an interest-rate change
to the public.
A change in the interest rate is more meaningful to the public
then a change in reserves.
Term structure of interest rates: the overall pattern of interest rates
corresponding to government securities of different maturities (used by
Yields on government securities generally increase as the term to maturity
o Since the various government securities are viewed as close
substitutes by bondholders, the different rates tend to rise and fall
Overnight interest rate: the interest rate that commercial banks charge one
another for overnight loans (shortest term).
o Banks can borrow in the overnight market from banks that have
excess reserves available. o This rate is market-determined and fluctuates daily as the cash
requirements of commercial banks change.
o As the overnight rate fluctuates, the rest of the interest rates fluctuate
in the same direction.
Since the Bank has considerable influence on the overnight
rate, it can affect all interest rates by changing it.
Economists refer to the tool by which the Bank sets a target for the overnight
interest rate as the policy instrument.
o It is the midpoint of a 0.5% range within which it would like to see the
actual overnight interest rate.
Fixed announcement dates (FADs): 8 pre-specified dates on which the Bank
announces its target for the overnight rate.
When the Bank announces the target for the overnight rate, it simultaneously
sets two other rates.
o Upper rate of the 0.5% range (bank rate)
The interest the Bank of Canada charges commercial banks for
o Lower rate of the 0.5% range
The interest the Bank of Canada pays commercial banks for
The 0.5% range is often referred to as the Bank’s target range for the
overnight interest rate.
The Bank can be sure that the actual overnight interest rste will be within the
set range because:
o No lender would accept a lower return than the lower rate set by the
o No borrower would accept a higher rate of interest than the bank rate
set by the Bank.
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. But the Bank does not initiate these transactions; it
conducts them to accommodate the changing demand for currency by the
The amount of currency in circulation is said to be endogenous because it is
not directly controlled by the Bank, but instead is determined by the
economic decisions of households, firms, and commercial banks.
Two types of monetary policy:
When the interest rate is reduced therefore leading to an
expansion of aggregate demand.
When the interest rate is increased therefore leading to a
contraction of aggregate demand.
The monetary transmission mechanism: Bank of Canada sets its target for overnight
Overnight rate and longer-term market
interest rates determined
Interest rates influence capital Interest rates determine
flows and exchange rate consumption and investment
Exchange rate Targeting
determines net exports AD = AS High
Determines equilibrium P and Y inflation:
damaging to the economy
and is costly for firms and individuals.
It reduces the purchasing power of money.
Incomes that are fixed in nominal terms will suffer.
o Undermines the ability of the price system to signal changes in
relative scarcity through changes in relative prices.
Consumers/producers won’t be able to discern if the price is
rising relative to other goods and services or whether it is
rising only because of widespread inflation.
Central banks have come to accept to propositions about inflation:
o High inflation is costly for individuals and damaging to the economy.
o Inflation is the only macroeconomic variable over which central banks
have a systematic and sustained influence.
In light of these two propositions, many central banks have adopted formal
systems of inflation targeting.
o First adopted by New Zealand in 1990, than by Canada in 1991 (U.S.
Federal Reserve is yet to adopt a formal inflationary target).
After short-run effects on real GDP are experienced, the economy’s
adjustment process tends to return real GDP to the level of potential output
(short-run effects cause by the Bank’s policies).
When there is an inflationary gap, labour and other factors of production are
used intensively in order to increase output (generates excess demand in
o Wages and other factor prices begin to rise, pushing up firms’ costs
and adding to the inflationary pressure.
Output gaps create pressure for the rate of inflation to change. To change the
rate of inflation close to the 2% target, the Bank closely monitors real GDP in the short run and designs its policy to keep real GDP close to potential
o The Bank can implement an expansionary monetary policy in the
situation where there is a recessionary gap.
o The Bank can implement a contractionary monetary policy in the
situation where there is an inflationary gap.
Inflation targeting is a stabilizing policy. Positive shocks will be met with a
contractionary monetary policy; negative shocks will be met with an
expansionary monetary policy.
Inflation targets are not as “automatic” a stabilizer as the fiscal stabilizers
built into the tax-and-transfer system. But if the central bank is committed to
maintaining the credib