Chapter 14 Flashcards
Monetary Policy Objective
- The objective of monetary policy is ultimately political
- the Bank’s job is to control the quantity of money and interest rates in order to avoid inflation
- when possible, prevent excessive swings in real GDP growth and unemployment.
Inflation rate targeting agreement of 2016
- The target is defined in terms of the 12-month rate of
change in the total CPI. - The inflation target is the 2 percent midpoint of the
1 to 3 percent inflation-control range. - The agreement will run until December 31, 2021
Rationale for an Inflation-Control Target
Two main benefits flow from adopting an inflation-control
target:
1. Fewer surprises and mistakes on the part of savers and
investors.
2. Anchors expectations about future inflation.
Controversy About the Inflation-Control Target
Critics of inflation targeting fear that
1. By focusing on inflation, the Bank might permit the
unemployment rate to rise or real GDP growth to slow.
2. The Bank might permit the value of the dollar rise on the
foreign exchange market and make exports suffer.
Who is responsible for monetary policy
The Bank of Canada’s Governing Council is responsible for the conduct of monetary policy.
What is the Bank of Canada’s monetary policy
instrument?
The monetary policy instrument is a variable that the
Bank of Canada can directly control or closely target.
The Bank of Canada has three possible instruments (3)
- The quantity of money (the monetary base)
- The price of Canadian money on the foreign exchange
market (the exchange rate) - The opportunity cost of holding money (the short-term
interest rate)
The bank of Canada can set any of these variables but not all 3 as they are interconnected
How do the 3 possible instruments effect each other
- If the Bank decreased the quantity of money, both the
interest rate and the exchange rate would rise. - If the Bank raised the interest rate, the quantity of
money would decrease and the exchange rate would
rise. - If the Bank lowered the exchange rate, the quantity of
money would increase and the interest rate would fall.
Short term interest rate/overnight loans rate
- the BOCs choice of policy instrument (also same choice as most other major central banks)
- Given this choice, the exchange rate and the quantity of
money to find their own equilibrium values - BOC targets the overnight loans rate
overnight loans rate
the interest rate on overnight loans that chartered banks make to each other
How does BOC make its interest rate decision
- Bank of Canada
gathers data about the economy, the way it responds to
shocks, and the way it responds to policy - The Bank must then process the data and come to a
judgement about the best level for the policy instrument - After announcing an interest rate decision, the Bank
engages in a public communication to explain the reasons
for its decision
How the BOC hits the overnight loans rate target
Once an interest rate decision is made, the Bank of
Canada achieves its target by using two tools:
- Operating band
- Open market operations
The operating band
the target overnight loans rate plus or minus 0.25 percentage points. So the operating band is 0.5 percentage points wide
The operating band
the target overnight loans rate plus or minus 0.25 percentage points. So the operating band is 0.5 percentage points wide
The operating band
the target overnight loans rate plus or minus 0.25 percentage points. So the operating band is 0.5 percentage points wide
The Bank creates the operating band by setting
- Bank rate, the interest rate that the Bank charges big banks on loans, is set at the target overnight loans rate plus 0.25 percentage points.
- Settlement balances rate, the interest rate the Bank pays on reserves, is set at the target overnight loans rate minus 0.25 percentage point.
When the Bank of Canada lowers the overnight loans rate
1.The Bank buys securities in an open market operation. (open market purchase)
2. Other short-term interest rates and the exchange rate fall.
3. The quantity of money and the supply of loanable funds increase.
4. The long-term real interest rate falls.
5. Consumption expenditure, investment, and net exports increase.
6. Aggregate demand increases.
7. Real GDP growth and the inflation rate increase.
The ripple effects that follow a change in the overnight rate
change three components of aggregate expenditure
▪ Consumption expenditure
▪ Investment
▪ Net exports
How the BOC fights recession
- If inflation is low and the
output gap is negative, the
Bank lowers the overnight
loans rate target. - The Bank conducts an
open market purchase to
increase reserves …
and hit the new overnight
loans rate target. - An increase in reserves
increases the supply of
money - The short-term interest
rate falls, and the quantity
of money demanded
increases - The increase in the
supply of money
increases the supply
of loanable funds. - The long-term real
interest rate falls and
investment increases. - The fall in the real
interest rate increases
aggregate planned
expenditure. - The multiplier increases
aggregate demand.
How the BOC fights inflation
- If inflation is too high and
the output gap is positive,
the Bank of Canada
raises the overnight
loans rate target. - The Bank conducts an
open market sale to
decrease reserves … - and hit the new overnight
loans rate target. - A decrease in reserves
decreases the supply of
money. - The short-term interest
rate increases, and the
quantity of money
demanded decreases. - The decrease in the
supply of money
decreases the supply of
loanable funds. - The long-term real
interest rate rises and
investment decreases - The rise in real interest
rate decreases aggregate
planned expenditure - The multiplier decreases
aggregate demand.
