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EC250 > Chapter 10 - Monetary Policy > Flashcards

Chapter 10 - Monetary Policy Flashcards

1
Q

Does the Bank of Canada manage the exchange rate?

A

No

The Bank sets targets for inflation but cannot manage the exchange

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2
Q

What are the 4 main responsibilities of the Bank of Canada?

A
  1. Conduct monetary policy
  2. Design/produce bank notes
  3. Oversee payment system
  4. Manage federal government funds
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3
Q

What are the two elements of the monetary policy framework?

A
  1. A flexible exchange rate
  2. An inflation target
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4
Q

What is the inflation target in Canada?

A

Range of 1-3%, maintain close to 2% midpoint over medium term

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5
Q

How does the Bank try to achieve the inflation target? And in what amount of time does it need to do so?

Time = amount of quarters

A

Raising or lowering policy interest rates within a horizon of 6-8 quarters

6-8 quarters is the usual time it takes for policy actions to work

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6
Q

What is included in core CPI?

A

Fruit, vegetables, gasoline, fuel oil, natural gas, mortage interest, intercity transportation, and tobacco + effect of changes in indirect taxes on everything else

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7
Q

Does the bank want to rapidly bring inflation back to target or slowly?

A

Slowly, because rapid changes would cause bigger variations in output

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8
Q

What is core inflation?

A

Inflation rate for narrower indices

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9
Q

How are core inflation and core CPI different?

A

Core inflation is calculated with volatile/extreme price changes, while core CPI does not include volatile/extreme price changes

I think… his explanation in the textbook doesn’t make much sense lol

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10
Q

Why does Canada not switch to core inflation instead of using CPI inflation, if CPI inflation is usually around the target 2%?

A

Because CPI inflation is easier for people to understand; avoid suspicion that they are manipulated the reported rate of inflation

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11
Q

What is the overnight rate?

Also called Policy Interest Rate

A

The rate at which banks lend money to each other at the end of each day

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12
Q

What is multilateral netting?

A

2+ institutions cancelling offsetting obligations
Example: CIBC owes $5 mil to TD and $4 mil to Royal Bank, TD owes CIBC $4 mil and owes Royal Bank $6 mil, and Royal Bank owes CIBC $4 mil and owes TD $2 mil

CIBC owes: 5 + 4 = $9
CIBC is owed: $4 + 4 = $8
Net CIBC owes 9-8 = $1

Royal Bank owes: 4 + 2 = $6
Royal Bank is owed: 4 + 6 = $10
Net royal bank owes 6-10 = -$4

TD owes: 4 + 6 = $10
TD is owed: 5 + 2 = $7
Net TD owes: 10 - 7 = $3

Therefore CIBC transfers $1 mil and TD transfers $3 mil to Royal Bank, because Royal Bank is owed more than they owe to others

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13
Q

Explain what netting is

A

When institutions transfer money to each other in ways that cancel out obligations
Example: If CIBC owes TD $5 mil, and TD owes CIBC $4 mil, CIBC will just send $1 mil and TD won’t send anything to offset the two debts

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14
Q

What is the operating band?

A

The operating band is a range of rates above and below the target rate in order to control the overnight rate

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15
Q

How wide is the operating band?

Percentage

A

.5%

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16
Q

What is the upper end of the operating band?

A

The bank rate = target rate + .25%

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17
Q

What is the lower end of the operating band?

A

The deposit rate = the target rate - .25%

Usually .25%, lately is the target

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18
Q

How does the Bank stay within the operating band?

A

Providing backstops - always ready to lend funds overnight at the bank rate and will always pay the rate equal to the bottom of the band on deposits

Because no bank will lend to another at a rate below the bottom of the band or borrow from another above the bank rate; if a bank tried to offer rates above or below, other banks will just go to Bank of Canada instead; preventative measures

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19
Q

Why does the Bank use the overnight interest rate?

A

When interest rates go down, people/business borrow and spend more, boosting economy
If there is inflation, bank will raise interest to slow down borrowing and spending

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20
Q

How is the target for overnight interest rate set?

A

Meetings with Governing Council 8 times a year

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21
Q

Who is in the Governing Council?

A

Governer, Senior Deputy Governer, and 4 deputy governers

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22
Q

Of these three, what does the Bank of Canada control and why only one of them?
1. The money supply
2. Inflation
3. Interest

Why - as opposed to other options it could control

A

Control inflation. The Bank can only control one of the three because money supply cannot be controlled when inflation is controlled, and if controlling the interest rate would have to adjust the money supply.

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23
Q

What did the Bank of Canada originally control in the 60’s and why did they change this?

A

Controlled the exchange rate to maintain a fixed rate of CADUSD = $.925. Ended this in the 70s because of significant upward pressure of the dollar, wanted to avoid revaluation.

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24
Q

What was the Bank control from 1970-75 and why did they change this?

A

Bank controlled the interest rate because the switch the floated dollar over fixed made the dollar appreciate, making it difficult to export. Tried to reduce value by limiting interest rates. Changed this because money supply grew very quickly leading to high inflation.

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25
Q

What was the Bank controlling in 1975 - 1980 and why?

A

Controlled the money supply, because of high inflation from fast growth of money supply after controlled interest rates. Used monetarism theory from Milton Friedman that inflation is caused by fast rate of money supply.

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26
Q

How did the Bank decide to control the money supply?

i.e. what exactly did they target?

A

They targeted the growth of M1: cash and chequing deposits, because M1 measured liquidity - strong link between M1 and inflation.

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27
Q

Why did the approach to targeting M1 not succeed for the Bank in controlling inflation?

A

Needed a stable link between M1 and inflation, but due to financial innovations (chequable saving deposits) that were not part of M1, link was broken. Everyone switched from M1 to chequable saving depoits, so M1 was growing as desired by liquidity grew faster.
Expansionary policy was too high, and inflation grew.

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28
Q

What did the Bank decide to control from 1980-83?

A

Interest rates, raised significantly to reduce inflation - but caused severe recession

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29
Q

What did the Bank decide to do in the 90s to target inflation?

A

Target the inflation rate at 2-4% (now 1-3%)

30
Q

Why did the Bank decide to target inflation of CPI?

3 important advantages

A
  1. Easily understood by public
  2. Announced with little delay
  3. Not revised
31
Q

What are the costs of constant, expected inflation, with no taxes?

A
  1. Higher costs of changing prices (prices need to change their prices more frequently, which is costly)
  2. Difficult to buy housing
  3. Money illusion
  4. Changing unit of account
32
Q

Why is it more difficult to buy housing in constant expected inflation scenario?

A

Because higher inflation = higher nominal interest rate on mortgages = bigger payments on houses

33
Q

What is money illusion?

A

Attaching importance to nominal values instead of real values leading to bad decisions

34
Q

What is changing unit of account and how does it relate to constant expected inflation scenario?

A

Money is a unit of account which changes constantly but by small manageable amounts over long periods of time (unlike other units of account like kg, which have defined values). With inflation, the value of money changes a lot very quickly, which would be very disruptive and would make money a very bad unit of account (like crypto).

35
Q

What is the Fisher equation and what is it used for?

A

Long-term nominal interest rate = real interest rate + expected inflation/deflation
Used to express relationship between nominal and real interest rates under inflation - in this case used to calculate mortgage with interest rates

36
Q

What are the costs of constant expected inflation with taxes?

A
  1. Real return on savings
  2. Capital gains
  3. Non-indexed tax system
37
Q

What is real return on savings and how does it become a cost of constant expected inflation with taxes?

A

Real return on savings = extra amount of goods and services obtained by delaying consumption by saving instead and gaining interest on savings
Person who saves receives:
Real after tax return = real return net of tax - (the tax rate x inflation)
Higher inflation rate = lower return = lower savings

38
Q

What is capital gain and how is this an effect of constant expected inflation with taxes?

A

Capital gain should be the increase in real value of an asset. Inflation will impose high costs on people who receive capital gain, because nominal increase in the value will be taxed. Inflation accumulated over time will distort the value more and more, even if real value hasn’t changed at all. If someone sold an asset in these conditions for high value, will be taxed very high amount.

Hard to explain this one cause the textbook description was meh

39
Q

What is the non-indexed tax system and how is this a cost of constant expected inflation with taxes?

A

Non-indexed tax systems are when tax brackets are not adjusted for inflation, raising the tax burden which gives more to the government = government tax grab
If tax system is not indexed, anyone paying taxes pay higher real taxes with higher inflation, thus making less even though in the same tax bracket (because the real value of tax free amount fell)

Doesn’t explain how this related to the constant expected inflation lol

40
Q

What are the costs of unexpected inflation?

A

Debtors gain (young people and house owners gain), creditors lose (old people and banks lose)

41
Q

Why does unexpected inflation cause debtors to gain and creditors to lose?

A

Amount borrowers repay is worth less than in real terms than expected before the inflation - ex-post return/real interest rate is 0

42
Q

Do the losses and gains cancel out in unexpected inflation? Explain

A

No, because of revealed preference - if two solutions of equal cost are available, the solution chosen is preferred to the other
The loaner would not have agreed to real interest of zero - they agreed to an amount before the inflation changed it to zero, so their preference was the amount before. Thus, they are worse off.

43
Q

Who gains the most and least from unexpected inflation?

A

Government gains the most (biggest debtor) as well as home owners and young people, and older people with pensions/banks lose the most.

44
Q

What is the problem with variability of inflation and when is inflation more variable?

regarding investment

A

Investment becomes more risky because of raised uncertainty. Higher inflation = more variability

45
Q

What are the costs of deflation?

A
  1. Consumer purchases go down
  2. Debt deflation
46
Q

How does deflation affect consumer purchases?

A

Consumers delay big purchases because they expect lower future prices, decreasing demand and income

47
Q

How does deflation affect debt deflation?

A

Real value of debts increase, making it harder to pay debts and default/bankruptcies become more common - banks lend less and investment goes down as well as purchases

48
Q

What are the benefits of moderate inflation?

A

Easier to reduce real wages

49
Q

Why is the reduction of real wages beneficial?

A

If inflation is 0 (price level is constant), reduction in real wage requires cut in nominal wage.

Moderate inflation allows reductions in real wages without reducing nominal wages - reducing nominal wages is hard to do because workers resist nominal cuts, even though the actual (nominal) amount doesn’t matter - what matters is the purchasing (real) power - but they don’t understand this (due to money illusion).

If nominal wages increase 2%, and inflation is 4%, real wages can fall by 2%

Thus, moderate inflation is good because you can lower real wages when demand for labour falls and cost of labour needs to be reduced.

50
Q

What is the 0 bound and how does this limit monetary policy?

A

Zero bound was established so policy rates could not go below zero. Recently this has changed and countries have been going below zero.
Limits policy because the banks don’t like to go any lower than -1% even if they want to when inflation is close to zero. Bank has less control of real interest rate when inflation is lower because the nominal interest will also be lower, leaving no room to lower real interest.
Can reduce the real interest when inflation is higher, because nominal interest will provide more wiggle room to do so.

51
Q

How did Zimbabwe’s central bank make price level go up so much?

A

They were under control of the government and printed very large quantities of money, which in turn increased the price level because the value of money fell.

52
Q

Why have central banks been moving towards independance?

A

Because government interference can lead to decisions which are not beneficial for the country i.e. like what happened in Zimbabwe. Also because plans are time-inconsistent.

53
Q

What is time consistency vs inconsistency?

A

Consistency = when a plan is unchanged
Inconsistency = when a plan changes after a certain amount of time

Ex. Making a policy plan for the future. First year is unchanged, nothing unexpected. After first year policymaker reevaluates, and if they change the policy for a new plan, this means the original plan was time inconsistent.

54
Q

What is discretionary policy? How is this different to rules?

A

Policymaker chooses the best course of action at every moment of time. Rules have policymakers specify what they will do in a situation and stick to the promise.

55
Q

What are three examples of when time inconsistency occurs? Explain a situation for each. What type of policy is this?

A
  1. Exams - professor announces an exam at start of term to ensure you study, and once you have studied she cancels the exam
  2. Building restrictions in hurricane areas - require homeowners to carry insurance and announce if they don’t, they won’t get help. Hurricane hits and lots of people don’t have insurance - government ends up helping.
  3. Taxation of fixed assets - to encourage investment, government promises not to increase taxes on fixed assets. This is not preferable for the government, so once people invest, government breaks the policy and raises taxes.

This is discretionary policy

56
Q

What is the problem with discretionary policy in time inconsistent scenarios?

A

The policymaker can break their promises at any moment depending on what the best course of action is for them at that moment in time. This is bad because eventually people figure out that they will not live up to their promises and won’t do what they are expected to do.

57
Q

How is the problem with time inconsistent policy improved? How does this relate to central bank independancy?

A

Replacing discretion with rules - no incentives to break promises, so promise leads to better outcomes.

Central banks being independent from governments will allow them to end discretionary policy making, leading to better outcomes vs letting the government change a policy due to time-inconsistent plan to benefit themselves (government can do this because they can change things whenever they want, regardless of what the Bank says is better)

58
Q

When is monetary policy time inconsistent?

A

The central bank has incentive to raise inflation above expected because unexpected inflation leads to lower real interest, leading to higher demand and lower unemployment
If central bank follows discretionary policy, people will not believe the promises of low inflation

59
Q

Why would rules be better for the central bank?

A

The only goal is low inflation, if independant, policymakers will only be evaluated on inflation

60
Q

Why would only have rules not be good for the central bank?

A

Too inflexible, must be able to react to other variables

61
Q

What are the two situations that cause debate as to whether the Bank is independent or not?

A

The directive - if conflict between prime minister’s choise and the governer of the Bank, Prime Minister can issue a directive and the governer must either follow or resign

This hasn’t happened for 50 years, and the consensus is:
* If the reason it hasn’t happened is because the governer didn’t want to risk their job or disagree with the Prime Minister, they are not independent
* If the reason it hasn’t happened is because the government doesn’t want politcal backlash, so don’t issue directives, the Bank is independent

62
Q

How is monetary policy different in the US? What is the EFFR?

A

The US uses a range for the overnight rate that is .25% wide. The EFFR is the effective federal funds rate = the rate overnight loans were actually made at

63
Q

What was the average decrease in Canada vs the US for policy rates?

A

Canada = -4.41
US = -5.33

64
Q

What was the average decrease in policy rates in Canada vs the US during the pandemic?

A

US = -1.5%
Canada = -1.75%

65
Q

Does Canadian monetary policy follow the US?

A

Not directly, but the Canadian economy is indirectly affected US policy changes, so Canada has to adjust sometimes because of these affects

66
Q

True or false: the policy rates after the Great Recession went back up after the recession to the highest they were at any time during the last 60 years

A

False, they stayed low for about 8 years at the lowest they were at any time during the last 60 years

67
Q

What new policy approaches were introduced after the great recession?

A

Quantitative easing: large scale purchases of long-term assets in the market

68
Q

What is the goal of quantitative easing?

A

To increase the prices of long-term assets and flatten the term structure, as well as increase bank reserves and induce them to increase lending

69
Q

What is the following equation for?
π = π^℮ + β (u^n - u)

A

It is a model of inflation and the natural rate of unemployment
Where π^℮ = expected inflation, u^n = natural rate of employment
Shows how expectations and slack in the market are to major factors in inflation and policy making

70
Q

What is the main danger of keeping interest rates low for too long? Why?

A

Inflation remains high, so expected inflation increases
1. Expectations - prices increase to keep up with price of supplies/workers or by what they expect other firms to raise by
2. Slack in the market

EC250 (6 decks)

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