13.1 How the Bank of Canada Implements Monetary Policy

Question 1

In general, what are the two alternative approaches any central bank has for implementing its monetary policy?

Answer 1

In general, any central bank has two alternative approaches for implementing its monetary policy—it can choose to target the money supply or it can choose to target the interest rate.

Question 2

Can the central bank choose both or only one approch to implementing monetary policy. Why?

Answer 2

Question 3

Graph of the two alternative approaches to implementing monetary policy.

Answer 3

Question 4

How can Central banks implement monetary policy?

Answer 4

Question 5

How could a central bank attempt to shift the Money supply curve directly?

Answer 5

It could do this by buying or selling government securities in the financial markets—transactions called open-market operations.

Question 6

For a given Md curve, what would an increase in money supply eventually lead to?

Answer 6

For a given Md curve, this increase in money supply would lead to a reduction in the equilibrium interest rate and, through the various parts of the transmission mechanism, to an eventual increase in aggregate demand.

Question 7

What are the three reasons why the Bank of Canada does not typically target money supply?

Answer 7

First, while the Bank of Canada can control the amount of cash reserves in the banking system (through open-market operations) it cannot control the process of deposit expansion carried out by the commercial banks.

Uncertainty regarding the slope of the Md curve. Even if the Bank had perfect control over the money supply, it would be unsure about the change in the interest rate that would result from any given change in the supply of money. Since it is the change in the interest rate that ultimately determines the subsequent changes in aggregate demand, this uncertainty would make the conduct of monetary policy very difficult.

Unable to predict accurately the position of the curve at any given time. Changes in both real GDP and the price level cause changes in money demand that the Bank can only approximate.

Question 8

What are the three disadvantages of cunduction monetary policy through targeting hte money supply?

Answer 8

Question 9

What must the bank do to make sure that a new interest rate is consistant with monetary equilibrium?

Answer 9

In order for this new interest rate to be consistent with monetary equilibrium, the Bank must then accommodate the change in the amount of money demanded—that is, it must alter the supply of money in order to satisfy the change in desired money holdings by firms and households.

Question 10

What are the three advantages of a Central bank conducting monetary policy through targeting the interest rate?

Answer 10

Question 11

What do economits call the overall pattern of interest rates corresponding to government securities of different maturities?

Answer 11

Economists refer to the overall pattern of interest rates corresponding to government securities of different maturities as the term structure of interest rates.

Question 12

What is the overnight interest rate?

Answer 12

The interest rate that commercial banks charge one another for overnight loans.

Commercial banks that have run short of reserves can borrow in the overnight market from banks that have excess reserves available. 

The overnight interest rate is a market-determined interest rate that fluctuates daily as the requirements of commercial banks change.

Question 13

What power does The Bank of Canada have with it’s ability to heavily influence the Overnight interest rate?

Answer 13

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.

Question 14

How does the Bank influence the overnight interest rate?

Answer 14

To answer this question, we must make an important distinction between the Bank’s target and the instrument that it uses to achieve that target.

The Bank establishes a target for the overnight interest rate and announces this target eight times per year at pre-specified dates called fixed announcement dates, or FADs.

The Bank’s instrument for achieving its target is its lending and borrowing activities with the commercial banking system.

Question 15

What happens when the Bank announces its target for the overnight rate?

Answer 15

When the Bank announces its target for the overnight rate, it also announces the bank rate, an interest rate 0.25 percentage points above the target rate.

The Bank promises to lend at the bank rate any amount that commercial banks want to borrow.

At the same time, the Bank offers to borrow (accept deposits) in unlimited amounts from commercial banks and pay them an interest rate 0.25 percentage points below the target rate.

With these promises by the Bank, the actual overnight interest rate stays within the 0.5-percentage-point range centred around the target rate, and is usually very close to the target rate itself.

Question 16

By raising or lowering its target rate, what does the central banks achieve?

Answer 16

The Bank of Canada establishes and announces its target for the overnight interest rate; its instrument for achieving this target is its borrowing and lending activities with commercial banks. By raising or lowering its target rate, the Bank affects the actual overnight interest rate. Changes in the overnight interest rate then lead to changes in other, longer-term, interest rates.

Question 17

How quickly do other interest rates change after the overnight rate has been changed?

Answer 17

When the Bank of Canada changes its target for the overnight rate, the change in the actual overnight rate happens almost instantly. Changes in other market interest rates, from home mortgage rates and the prime interest rate to the yields on short- and long-term government securities, also happen very quickly, usually within a day or two.

As these rates adjust, firms and households begin to adjust their borrowing behaviour, but these changes take considerably longer to occur.

Question 18

As the demand for new loans gradually increases in response to the new lower interest rate, commercial banks often find themselves in need of more cash to satisfy their customers’ needs. When this occurs, banks have two options…

Answer 18

First, if they have reserves on deposit at the Bank of Canada, the Bank can convert these reserves into cash and deliver it to the banks.

Second, if the commercial banks have insufficient reserves on deposit at the Bank, they can sell some of their government securities to the Bank in exchange for reserves, and then convert these reserves into cash.

Question 19

What is an open-market operation?

Answer 19

Open-market operation

The purchase or sale of government securities on the open market by the central bank.

Question 20

How does the Bank of Canada change the mount of cash reserves in the banking system?

Answer 20

Through its open-market operations, the Bank of Canada changes the amount of cash reserves in the banking system. These operations, however, are generally not initiated by the Bank; it conducts them to accommodate the changing demand for cash reserves by the commercial banks.

Question 21

What does The Bank of Canada use its target for the overnight interest rate to do?

Answer 21

The Bank of Canada uses its target for the overnight interest rate to influence the money market and implement its monetary policy.

Question 22

What effect does a reduction and an increase in the banks target for the over night rate tend to do?

Answer 22

A reduction in the Bank’s target for the overnight rate will reduce market interest rates and lead to a greater demand for borrowing and hence spending by firms and households.

In contrast, an increase in the Bank’s target for the overnight rate will tend to raise market interest rates and reduce the demand for borrowing and spending by firms and households.

Question 23

Is reducing the target for the overnight interest rate an expansionary on contransionary monitary policy?

Answer 23

We can now clarify the meaning of a contractionary or an expansionary monetary policy. If the Bank of Canada wants to stimulate aggregate demand to increase real GDP, it will reduce its target for the overnight interest rate, and the effect will soon be felt on longer-term market interest rates. Reducing the interest rate is an expansionary monetary policy because it leads to an expansion of real GDP.

Question 24

Is increaseing the target for the overnight rate an expansionary or contractionay monetary policy?

Answer 24

If the Bank instead wants to reduce aggregate demand and real GDP, it will increase its target for the overnight interest rate, and longer-term market interest rates will soon rise as a result. Increasing the interest rate is a contractionary monetary policy because it leads to a contraction of real GDP.

Question 25

Flowchart of monetary transmission

Answer 25

Monetary policy influences aggregate demand through the monetary transmission mechanism. The Bank of Canada sets a target for the overnight interest rate, which influences other market interest rates as well. The change in interest rates leads, via the monetary transmission mechanism, to changes in desired aggregate expenditure. Aggregate demand and aggregate supply then determine the price level and the level of real GDP.