chapter 11 Flashcards
Bank of Canada is responsible for
monetary policy
def
monetary policy
adjusting the supply of money and interest rates to achieve steady growth, full employment, and price stability
def
Price stability
the inflation rate is low enough that it does not significantly affect people’s economic decisions
the Government of Canada and the Bank of Canada have agreed to two specific objectives for monetary policy:
- To contain the annual rate of inflation between 1-3% as measured by increases in the CPI (inflation-control target)
- To use monetary policy to achieve the 2% midpoint of that range
Inflation-control target
range of inflation rates set by a central bank as a monetary policy objective
What provides a good measure of the trend of inflation
core inflation rate
most important monetary policy tool for achieving the objectives of the Bank of Canada
interest rates
Overnight Rate
the interest rate banks charge each other for one-day loans – the main monetary policy tool
What does the overnight rate determine
all other interest rates that banks charge their customer
Open Market Operations
buying or selling government bonds on the bond market by the Bank of Canada
In a recessionary gap (economy slows down) what does the Bank of Canada do?
lowers interest rates to increase aggregate demand and accelerate the economy
Inflation rate rises, real GDP increase, and unemployment decreases
In an inflationary gap (economy speeding to fast) what does the Bank of Canada do?
raises interest rates to decrease aggregate demand to slow down the economy
Inflation rate falls, growth in real GDP decreases, and unemployment increases
How long does the impact on the economy of lower/higher interest rates take
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
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
8
What does the Bank of canada do to lower interest rates and accelerate the economy
buy bonds, which increases the money supply (shifts to the right)
How does the Bank of Canada buy a bond
it pays with cash and the cash deposit increases bank reserves
What does the Bank of Canada do to raise interest rates and slow down the economy
sells bonds, which decreases the money supply (shift to the left)
When the Bank of Canada buys bonds, the increased demand for bonds does what to bond prices and interest rates
raises bond prices and lowers interest rates
When the Bank of Canada sells bonds, the increased supply of bonds does what to bond prices and interest rates
lowers bond prices and raises interest rates
def
Prime rate
the interest rate on loans to lowest-risk corporate borrowers
prime rate =
the overnight rate + 2%
Long-run interest rates for government and corporate bonds of 10-30 years tend to be higher than short-run rates because
long-run bonds are riskier
Hierarchy of what affect business and consumer borrowing
- interest rate
- business investment spending
- consumer spending
International Effects of Interest Rates
- 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
Domestic Monetary transmission Mechanism: Borrowing and Spending
Lower interest rates are a
- 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
Domestic Monetary transmission Mechanism: Borrowing and Spending
Higher interest rates are a
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
What does a fall in interest rates do to the Canadian interest rate differential
decreases the Canadian interest rate differential, causing the Canadian dollar to depreciate on the Forex
- 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
What does a rise in interest rates do to the Canadian interest rate differential
increases the Canadian interest rate differential, causing the Canadian dollar to appreciate on the Forex
Depreciating Canadian Dollar is a ____ AD Shock
positive
- 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
Appreciating Canadian Dollar is a ____ AD shock
negative
- 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
When is this appropriate in monetary policy
Lowering interest rates to increase aggregate demand
appropriate monetary policy for an economy that is predicted to be in a recessionary gap 18 to 24 months in the future
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
When is this appropriate in monetary policy
Raising interest rates to decrease aggregate demand
appropriate monetary policy for an economy that is predicted to be in an inflationary gap 18-24 months in the future
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
Transmission effects of monetary policy: lowering interest rates
- Business investment and consumption increase
- exchange rate depreciates
- net exports increase
- AD = positive demand shock
- unemployment decreases
- inflation increases
Transmission effects of monetary policy: raising interest rates
- business investment decreases
- exchange rate appreciates
- net exports decrease
- AD = negative demand shock
- unemployment increases
- inflation decreases
Individuals and businesses
What happens in a balance sheet recession
individuals and businesses focus on paying down debt and are reluctant to borrow or spend
Recessions are often triggered by
a decrease in business investment spending, falling net exports, or rising interest rates
the Global Financial Crisis was caused by
the collapse of asset prices
What happens when the value of the assets you own falls
you need to cut back on what you spend or owe to restore balance
Real interest rate =
nominal interest rate - inflation rate
What type of interest rate is the most importa for making smart saving and investing decisions
real interest rate
Quantitative easing
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
buying bonds to push up their prices and bring down long-term interest rates
Quantitative Easing Inflation risks using the Quantity theory of money
M x V = P x Q
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)
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
The Coyne Affair
James Coyne was forced to resign as Governor because him and the finance minister were having disagreements about monetary policy objectives
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
The Phillips Curve trade-off between inflation and unemployment works as long as
people’s expectations of inflation do not change
Trade off between inflation and unemployment
Once expectation of inflation begins
- 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
Inflation expectations go up ____, but come down ___
easily, slowly
High inflation is unpredictable, with the speed of price rises becoming also unpredictable. Why is this a problem for businesses
- 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
monetary policy
Yes, Hands Off and No Hands On Agreements
- 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,
Yes Hands Off Rules for Monetary Policy:
- 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
The strongest argument for a hands-off monetary policy is the need to anchor inflationary expectations
No Hands On Discretion for Monetary Policy:
- 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
Monetary policy
Similarities Between Both Camps
- 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
