Chapter 14

Question 1

Monetary Policy Objective

Answer 1

• 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.

Question 2

Inflation rate targeting agreement of 2016

Answer 2

1. The target is defined in terms of the 12-month rate of
   change in the total CPI.
2. The inflation target is the 2 percent midpoint of the
   1 to 3 percent inflation-control range.
3. The agreement will run until December 31, 2021

Question 3

Rationale for an Inflation-Control Target

Answer 3

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.

Question 4

Controversy About the Inflation-Control Target

Answer 4

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.

Question 5

Who is responsible for monetary policy

Answer 5

The Bank of Canada’s Governing Council is responsible for the conduct of monetary policy.

Question 6

What is the Bank of Canada’s monetary policy
instrument?

Answer 6

The monetary policy instrument is a variable that the
Bank of Canada can directly control or closely target.

Question 7

The Bank of Canada has three possible instruments (3)

Answer 7

1. The quantity of money (the monetary base)
2. The price of Canadian money on the foreign exchange
   market (the exchange rate)
3. 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

Question 8

How do the 3 possible instruments effect each other

Answer 8

1. If the Bank decreased the quantity of money, both the
   interest rate and the exchange rate would rise.
2. If the Bank raised the interest rate, the quantity of
   money would decrease and the exchange rate would
   rise.
3. If the Bank lowered the exchange rate, the quantity of
   money would increase and the interest rate would fall.

Question 9

Short term interest rate/overnight loans rate

Answer 9

• 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

Question 10

overnight loans rate

Answer 10

the interest rate on overnight loans that chartered banks make to each other

Question 11

How does BOC make its interest rate decision

Answer 11

• 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

Question 12

How the BOC hits the overnight loans rate target

Answer 12

Once an interest rate decision is made, the Bank of
Canada achieves its target by using two tools:
- Operating band
- Open market operations

Question 13

The operating band

Answer 13

the target overnight loans rate plus or minus 0.25 percentage points. So the operating band is 0.5 percentage points wide

Question 14

The operating band

Answer 14

the target overnight loans rate plus or minus 0.25 percentage points. So the operating band is 0.5 percentage points wide

Question 14

The operating band

Answer 14

the target overnight loans rate plus or minus 0.25 percentage points. So the operating band is 0.5 percentage points wide

Question 15

The Bank creates the operating band by setting

Answer 15

1. 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.
2. Settlement balances rate, the interest rate the Bank pays on reserves, is set at the target overnight loans rate minus 0.25 percentage point.

Question 16

When the Bank of Canada lowers the overnight loans rate

Answer 16

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.

Question 17

The ripple effects that follow a change in the overnight rate
change three components of aggregate expenditure

Answer 17

▪ Consumption expenditure
▪ Investment
▪ Net exports

Question 18

How the BOC fights recession

Answer 18

• 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.

Question 19

How the BOC fights inflation

Answer 19

• 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.