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ECO102H1 (54)
Chapter 29

ECO100Y1 Chapter 29 Notes

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Robert Gazzale

ECO100Y1 Textbook Notes Chapter 29 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 D 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 economists).  Yields on government securities generally increase as the term to maturity increases. o Since the various government securities are viewed as close substitutes by bondholders, the different rates tend to rise and fall together.  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 loans. o Lower rate of the 0.5% range  The interest the Bank of Canada pays commercial banks for their deposits  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 Bank. 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 commercial banks.  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: o Expansionary  When the interest rate is reduced therefore leading to an expansion of aggregate demand. o Contractionary  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 rate Overnight rate and longer-term market interest rates determined Interest rates influence capital Interest rates determine flows and exchange rate consumption and investment 29.2 Inflation Exchange rate Targeting determines net exports AD = AS  High Determines equilibrium P and Y inflation: o Is 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 factor markets). 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 output. 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
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