chapter 11

Question 1

Bank of Canada is responsible for

Answer 1

monetary policy

Question 2

def

monetary policy

Answer 2

adjusting the supply of money and interest rates to achieve steady growth, full employment, and price stability

Question 3

def

Price stability

Answer 3

the inflation rate is low enough that it does not significantly affect people’s economic decisions

Question 4

the Government of Canada and the Bank of Canada have agreed to two specific objectives for monetary policy:

Answer 4

1. To contain the annual rate of inflation between 1-3% as measured by increases in the CPI (inflation-control target)
2. To use monetary policy to achieve the 2% midpoint of that range

Question 5

Inflation-control target

Answer 5

range of inflation rates set by a central bank as a monetary policy objective

Question 6

What provides a good measure of the trend of inflation

Answer 6

core inflation rate

Question 7

most important monetary policy tool for achieving the objectives of the Bank of Canada

Answer 7

interest rates

Question 8

Overnight Rate

Answer 8

the interest rate banks charge each other for one-day loans – the main monetary policy tool

Question 9

What does the overnight rate determine

Answer 9

all other interest rates that banks charge their customer

Question 10

Open Market Operations

Answer 10

buying or selling government bonds on the bond market by the Bank of Canada

Question 11

In a recessionary gap (economy slows down) what does the Bank of Canada do?

Answer 11

lowers interest rates to increase aggregate demand and accelerate the economy

Inflation rate rises, real GDP increase, and unemployment decreases

Question 12

In an inflationary gap (economy speeding to fast) what does the Bank of Canada do?

Answer 12

raises interest rates to decrease aggregate demand to slow down the economy

Inflation rate falls, growth in real GDP decreases, and unemployment increases

Question 13

How long does the impact on the economy of lower/higher interest rates take

Answer 13

up to 24 months, so the Bank of Canada has to predict the impact of a change in interest rates on the economy and inflation rate 2 years in advance

Question 14

How many fixed dates does the Bank of Canada set to announce whether or not it will change the target for the overnight rate and other interest rates

Answer 14

8

Question 15

What does the Bank of canada do to lower interest rates and accelerate the economy

Answer 15

buy bonds, which increases the money supply (shifts to the right)

Question 16

How does the Bank of Canada buy a bond

Answer 16

it pays with cash and the cash deposit increases bank reserves

Question 17

What does the Bank of Canada do to raise interest rates and slow down the economy

Answer 17

sells bonds, which decreases the money supply (shift to the left)

Question 18

When the Bank of Canada buys bonds, the increased demand for bonds does what to bond prices and interest rates

Answer 18

raises bond prices and lowers interest rates

Question 19

When the Bank of Canada sells bonds, the increased supply of bonds does what to bond prices and interest rates

Answer 19

lowers bond prices and raises interest rates

Question 20

def

Prime rate

Answer 20

the interest rate on loans to lowest-risk corporate borrowers

Question 21

prime rate =

Answer 21

the overnight rate + 2%

Question 22

Long-run interest rates for government and corporate bonds of 10-30 years tend to be higher than short-run rates because

Answer 22

long-run bonds are riskier

Question 23

Hierarchy of what affect business and consumer borrowing

Answer 23

1. interest rate
2. business investment spending
3. consumer spending

Question 24

International Effects of Interest Rates

Answer 24

* Interest rates affect the value of the Canadian dollar * The exchange rate changes affect the prices that the rest of the world pays for Canadian exports and the prices that Canadians pay for imports

Question 25

# Domestic Monetary transmission Mechanism: Borrowing and Spending Lower interest rates are a

Answer 25

* positive aggregate demand shock: they reduce the cost of interest-sensitive purchases that require loans, so consumers spend more * Increases in C and I both increase aggregate demand * Increased real GDP, decreased unemployment, and rising inflation

Question 26

# Domestic Monetary transmission Mechanism: Borrowing and Spending Higher interest rates are a

Answer 26

negative aggregate demand shock: they increase the cost of borrowing, decreasing C and I and decreasing aggregate demand * Decreased real GDP, increase unemployment, and decreasing inflation or deflation

Question 27

What does a fall in interest rates do to the Canadian interest rate differential

Answer 27

decreases the Canadian interest rate differential, causing the Canadian dollar to depreciate on the Forex ## Footnote * This makes Canadian exports become less expensive, so non-Canadians buy more of them * Makes imports from the rest of the world more expensive for Canadian customers, buying fewer imports and more Canadian products

Question 28

What does a rise in interest rates do to the Canadian interest rate differential

Answer 28

increases the Canadian interest rate differential, causing the Canadian dollar to appreciate on the Forex

Question 29

Depreciating Canadian Dollar is a ____ AD Shock

Answer 29

positive ## Footnote * The International effect of lower interest rates increases aggregate demand and accelerates the economy * Both increases in exports and the decrease in imports increase aggregate demand * Increase in net exports is a positive aggregate demand shock: increased real GDP, decreased unemployment, rising inflation

Question 30

Appreciating Canadian Dollar is a ____ AD shock

Answer 30

negative ## Footnote * Higher exchange rates makes exports more expensive for the ROW and imports cheaper for Canadians * Net exports decrease, decreasing aggregate demand * Decreased real GDP, increased unemployment, decreasing inflation/deflation

Question 31

# When is this appropriate in monetary policy Lowering interest rates to increase aggregate demand

Answer 31

appropriate monetary policy for an economy that is predicted to be in a recessionary gap 18 to 24 months in the future ## Footnote If the predicted inflation rate is below the Bank of Canada’s target inflation rate of 2%, and real GDP is predicted to be below potential GDp with cyclical unemployment, then lower interest rates help steer the economy toward potential GDP, full employment and stable prices

Question 32

# When is this appropriate in monetary policy Raising interest rates to decrease aggregate demand

Answer 32

appropriate monetary policy for an economy that is predicted to be in an inflationary gap 18-24 months in the future ## Footnote If predicted inflation rate is above the Bank of Canada’s target inflation rate of 2%, and real GDP is predicted to be above potential GDP with an unemployment rate below the natural rate, then higher interest rates help steer the economy toward potential GDP, full employment, and stable prices

Question 33

Transmission effects of monetary policy: lowering interest rates

Answer 33

1. Business investment and consumption increase 2. exchange rate depreciates 3. net exports increase 4. AD = positive demand shock 5. unemployment decreases 6. inflation increases

Question 34

Transmission effects of monetary policy: raising interest rates

Answer 34

1. business investment decreases 2. exchange rate appreciates 3. net exports decrease 4. AD = negative demand shock 5. unemployment increases 6. inflation decreases

Question 35

# Individuals and businesses What happens in a balance sheet recession

Answer 35

individuals and businesses focus on paying down debt and are reluctant to borrow or spend

Question 36

Recessions are often triggered by

Answer 36

a decrease in business investment spending, falling net exports, or rising interest rates

Question 37

the Global Financial Crisis was caused by

Answer 37

the collapse of asset prices

Question 38

What happens when the value of the assets you own falls

Answer 38

you need to cut back on what you spend or owe to restore balance

Question 39

Real interest rate =

Answer 39

nominal interest rate - inflation rate

Question 40

What type of interest rate is the most importa for making smart saving and investing decisions

Answer 40

real interest rate

Question 41

Quantitative easing

Answer 41

a central bank tool of flooding the financial system with money by buying high-risk bonds, mortgages, and assets from banks. These liabilities on bank balance sheets are replaced with cash assets, enabling banks to make new loans ## Footnote buying bonds to push up their prices and bring down long-term interest rates

Question 42

Quantitative Easing Inflation risks using the Quantity theory of money | M x V = P x Q

Answer 42

If velocity (V) is constant and if real GDP (Q) is constant at potential GDP, then any increase in the money supply causes an equal percentage increase in the inflation rate (P) ## Footnote Or if there is an increase in the inflation rate, there must be an accompanying increase in the quantity of money Printing money causes inflation

Question 43

The Coyne Affair

Answer 43

James Coyne was forced to resign as Governor because him and the finance minister were having disagreements about monetary policy objectives ## Footnote The Bank of Canada has considerable independence but ultimately is accountable to Parliament It prevents government influences on monetary policy decisions that are clearly not in the best interest of the country

Question 44

The Phillips Curve trade-off between inflation and unemployment works as long as

Answer 44

people’s expectations of inflation do not change

Question 45

# Trade off between inflation and unemployment Once expectation of inflation begins

Answer 45

* Businesses expect higher prices for inputs and set output prices higher to protect their profits * Banks expect inflation and increase nominal interest rates on loans to protect the real rate of interest they will receive

Question 46

Inflation expectations go up ____, but come down ___

Answer 46

easily, slowly

Question 47

High inflation is unpredictable, with the speed of price rises becoming also unpredictable. Why is this a problem for businesses

Answer 47

* producing for output markets takes time and they have to buy inputs, produce, and transport to output markets to sell * Hard to set output prices and to know what demand will be like if customers are paying more for all other products and services → unpredictable costs and profits | Unpredictable inflation creates risk

Question 48

# monetary policy Yes, Hands Off and No Hands On Agreements

Answer 48

* The need for a government-like player a market economy to function properly * Roles of the Bank of Canada: issuing currency, acting as a banker to banks, and acting as a banker to government, *and also conducting monetary policy (but this is debatable) *One of the lessons of the Global Financial Crisis is the need for more government oversight of the financial system,

Question 49

Yes Hands Off Rules for Monetary Policy:

Answer 49

* Believers in Say’s Law favor a hands-off role for government * Believe that government failure is more likely than market failure * Support an independent central bank to keep monetary policy out of the hands of politicians, including finance ministers * Support fixed rules for monetary policy that leave no discretionary choices for central bankers * Believe that long delays in effects of monetary policy increase the chances that policymakers will get the timing wrong and do more harm than good with discretionary monetary policy ## Footnote The strongest argument for a hands-off monetary policy is the need to anchor inflationary expectations

Question 50

No Hands On Discretion for Monetary Policy:

Answer 50

* Believe that market failure is more likely than government failure * More willing to give government the discretion to set and conduct monetary policy to counter internally generate business cycles * Believes there’s uncertainty of transmission breakdowns in monetary policy * There needs to be someone that makes decisions * There’s a short-run trade-off between inflation and unemployment, sometimes the cost of keeping inflation low may have too high an opportunity cost: high unemployment, lost production, and economic suffering

Question 51

# Monetary policy Similarities Between Both Camps

Answer 51

* Recognize that business cycles happen * See a role for monetary policy adjustments avoiding cycles of boom and bust and keeping the economy on the road to steady growth in living standards, full employment, and stable prices * Inflationary expectations can ruin the short-run trade-off between inflation and unemployment