Chapter 13 Flashcards
What are the 2 alternative approaches that any central bank can choose for implementing its monetary policy?
Target the money supply
Target the interest rate
However, both cannot be targeted independently for a given MD curve
How does the Bank of Canada choose to conduct monetary policy?
By targeting the interest rate (rather than the money supply)
Why does the Bank of Canada choose to target the interest rate when conducting monetary policy?
- The Bank of Canada can control the interest rate
- Uncertainty about the slope and position of the MD curve does not prevent the Bank of Canada from establishing its desired interest rate
- The Bank of Canada can easily communicate its interest-rate policy to the public
What is the overnight interest rate?
It is the interest rate that commercial banks charge one another for overnight loans
What can the Bank of Canada do by influencing the overnight interest rate?
It influences the long-term interest rates that are more relevant for determining aggregate consumption and investment expenditure
What is the bank rate?
It is an interest rate that is 0.25 percentage points above the target rate
What does the Bank promise to do for commercial banks?
It promises to lend at the bank rate any amount that it wishes to borrow
What does the Bank offer to borrow from commercial banks?
It offers to accept deposits from commercial banks and pay them an interest rate 0.25 percentage points below the target
Where does the actual overnight interest rate stay?
It stays within the 0.5-percentage-point range centred around the target rate
What is the Bank rate lending equation?
Bank rate lending = overnight rate + 0.25% points
What is the Bank rate borrowing equation?
Bank rate borrowing = overnight rate - 0.25% points
What is the Bank rate equation?
Bank rate = overnight target rate +/- 0.25% points
When the Bank of Canada changes its target for the overnight rate what change in what occurs instantly?
The actual overnight rate. Changes in other market interest rates also happen very quickly
As the rates adjust what do firms and households begin to do?
They begin to adjust their borrowing behaviour
As the demand for new loans gradually adjusts to the new lower interest rates, what do commercial banks often find themselves in need of?
They find themselves in need of more cash reserves with which to make loans
Why do banks sell some of their government securities to the Bank of Canada?
In exchange for cash (or electronic reserves) that they can then use to extend new loans
What is an open-market operation?
It is the purchase or sale of government securities on the open market by the central bank
What does the Bank of Canada do through its open-market operations?
It changes the amount of currency in circulation
What is money supply?
It is the sum of bank deposits and currency in circulation
Is money supply endogenous or exogenous?
It is endogenous
Is the Bank of Canada passive or active in its decisions that change the amount of currency in circulation
Passive
Why does the Bank of Canada conduct its open-market operations?
To accommodate the changing demand for currency coming from the commercial banks
What will happen if the Bank wants to stimulate AD?
It will reduce its target for the overnight interest rate, and this affects longer-term market interest rates
What kind of monetary policy is reducing the interest rate and why?
An expansionary monetary policy because it leads to an expansion of AD
What kind of monetary policy is reducing the AD and why?
It is a contractionary monetary policy because it leads to a contraction of AD since this will raise its target for overnight interest rate
Why do we target inflation?
High inflation is costly
Monetary policy is the cause of sustained inflation
The adoption of inflation targeting
What are the two observations that explain why central bank’s focus on inflation?
- High uncertain inflation
Arbitrary income redistributions and hampers the ability to the price system to i) allocate resources efficiently and ii) produce satisfactory rates of economic growth - Most economists and central banks accept that monetary policy is the most important determinant of a country’s long-run rate of inflation
What is the formal percent target of the inflation rate?
It is 2%
What does the Bank of Canada have to do in order to keep inflation at 2%?
It needs to monitor the output gap and the associated pressures that may be pushing inflation above or below the target
What do persistent output gaps generate?
They generally create pressure for the rate of inflation to change
What does the Bank of Canada do to keep GDP close to potential output?
It designs its policy to do this
What do negative shocks in the economy lead to? What policy is used to deal with these changes?
They lead to a recessionary gap which means that there is high unemployment and low inflation. Expansionary monetary policy is used to address these issues
What do positive shocks in the economy lead to? How are these changes addressed?
They create an inflationary gap and threaten to increase the rate of inflation. They are addressed with contractionary monetary policy
Why does the Bank of Canada closely monitor the “core” rate of inflation?
Because food and energy prices are volatile so they are often unrelated to the level of the output gap in Canada
What can changes in the exchange rate signal?
They can signal the need for changes in the stance of monetary policy
What are the lags in monetary policy?
- Changes in expenditure take time
- The multiplier process takes time
What are the types of lag? (3)
Recognition Lag
Implementation Lag
Impact Lag
What should the Bank of Canada design it’s policy for?
For what is expected to occur in the future rather than for what has already been observed
What increases the difficulty of stabilizing the economy?
The extensive time lags in the effectiveness of monetary policy increase the difficulty of stabilizing the economy
What kind of effect may monetary policy have?
It may have a destabilizing effect
What do time lags in monetary policy require?
They require that decisions regarding a loosening or tightening of monetary policy be forward-looking
