chapter 28

Question 1

what are the two approaches for implementing its monetary policy

Answer 1

1. Target the money supply
2. Target the interest rate

But for a given MD curve, both cannot be targeted independently

Question 2

The Bank of Canada chooses to conduct monetary policy by targeting the interest rate (rather than the money supply) because :

(three reasons)

Answer 2

1. The Bank of Canada is able to control a particular interest rate.
2. Uncertainty about the slope and position of the MD curve does not prevent the Bank of Canada from establishing its desired interest rate.
3. The Bank of Canada can easily communicate its interest-rate policy to the public

Question 3

def. overnight interest rate

Answer 3

the interest rate at which major financial institutions borrow and lend one-day (or “overnight”) funds among themselves

Question 4

describe the reasoning/mechanics of the overnight interest rate

Answer 4

• Banks that need cash because they have run short of reserves can
borrow in the overnight market from other banks that have excess reserves.
• The Bank of Canada sets a target level for that rate.
• The Bank of Canada exercises considerable influence over the overnight interest rate.

Question 5

when the bank announces its target for the overnight rate, it also announces ______

Answer 5

1. rate that charges for loans (bank rate):

2. rate that pays for deposits

Question 6

rate that charges for loans (bank rate)

Answer 6

the interest rate the Bank of Canada charges commercial banks for loans—0.25 percentage points above the target rate. The Bank promises to lend at this bank rate any amount that commercial banks want to borrow

Question 7

rate that pays for deposits:

Answer 7

the Bank offers to borrow (accept deposits) in unlimited amounts from commercial banks and pay them an interest rate 0.25 percentage points below the target.

Question 8

The actual overnight interest rate stays within the ______________ range centred around the target rate

Answer 8

0.5-percentagepoint

Question 9

The Bank can more or less control the overnight interest rate.
It does this by:

Answer 9

1. Setting a target for the overnight interest rate
2. Establishing the bank rate 0.25% above this target
3. Establishing a borrowing rate 0.25% below target

=> keep actual overnight rate within 0.5% band

Question 10

how does the bank of canada change the amount of currency in circulation?

Answer 10

through its open-market operations

Banks can sell some of their government securities to the Bank of Canada in exchange for cash (or electronic reserves) and then use this cash to extend new loans.

The purchase or sale of government securities on the open market by the central bank is an open-market operation

Question 11

what happens as the Bank changes its target for the overnight rate?

Answer 11

• other interest rates change
• bank lending changes
• banks’ demand for currency changes

=> the Bank responds by supplying currency or buying currency from
commercial banks
=>the need for open-market operations

Question 12

The amount of currency in circulation (and also the money supply) is __________

It is not directly controlled by the Bank of Canada, but instead is
determined by ____________

Answer 12

endogenous

the economic decisions of households, firms, and commercial banks

Question 13

The Bank of Canada is ________ in its decisions regarding the money
supply.

It conducts its __________ to accommodate the
changing demand for currency coming from the commercial bank

Answer 13

passive

conducts its open-market operations

Question 14

if banks need more cash what happens on open market?

Answer 14

open-market purchase

Question 15

if banks have excess cash, what happens on open market?

Answer 15

open-market sale

Question 16

An expansionary monetary policy occurs when the Bank of Canada
_______ its target for the overnight interest rate

Answer 16

reduces

Question 17

what happens when the target for the overnight interest rate is reduced

Answer 17

eventually increases MS (or its growth rate)

Question 18

A contractionary monetary policy occurs when the Bank of Canada
________ its target for the overnight interest rate.

Answer 18

increases

Question 19

what happens when the target for the overnight interest rate is increased?

Answer 19

eventually decreases MS (or its growth rate)

Question 20

what about inflation have central banks come to realize?

Answer 20

1. High inflation is costly for individuals and damaging for economies.
   => High and uncertain inflation leads to arbitrary income redistributions and also undermines the efficiency of the price system.
2. Inflation is the one variable on which monetary policy can have a systematic and sustained influence.

Question 21

what does keeping inflation to its formal 2-percent target require?

Answer 21

Keeping inflation close to its formal 2-percent target, requires the
Bank of Canada to monitor the output gap and the associated
pressures that may be pushing inflation above or below the target.

Persistent output gaps generally create pressure for the rate of inflation to change.

So the Bank of Canada designs its policy to keep real GDP close to potential output

Question 22

in the short run, when an output gap opens, what two choices does the Bank have?

Answer 22

• allow the adjustment process to operate

* intervene with monetary policy

Question 23

describe inflation targeting to stabilize output

Answer 23

• in response to a positive output shock, the Bank tightens policy
• in response to a negative output shock, the Bank loosens policy
=> policy tends to keep output close to Y*

**this is not automatic stabilization, the Bank must actively change policy

Question 24

what two factors is inflation targeting complicated by?

Answer 24

1. volatile food and energy prices

2. the exchange rate and monetary policy

Question 25

describe how Volatile Food and Energy Prices complicates inflation targeting

Answer 25

• prices of many goods included in CPI are determined in world markets
• these may change suddenly for reasons unrelated to Canadian
output gaps

==> the Bank also monitors core inflation (excludes food, energy and the effects of indirect taxes).

Question 26

describe how the exchange rate and monetary policy complicate inflation targeting

Answer 26

• the Bank must identify the cause of any exchange rate change before determining the appropriate policy response
• consider an appreciation of the Canadian dollar caused by an increase in demand for exports
=> Bank rises its target for overnight interest rate
• or an appreciation of the Canadian dollar caused by an increase in demand for Canadian bonds
=> Bank reduces its target for overnight interest rate

Question 27

describe the timelines for the overnight interest rate

Answer 27

• Almost immediate effects on the exchange rate and interest rates.
• Between 9 and 12 months for the full effect on output.
• Between 18 and 24 months for the full effect on inflation.

Question 28

what two main reasons make it so that monetary policy operates with a time lag that is long and variable?

Answer 28

• changes in expenditure take time

* the multiplier process takes time

Question 29

The fact that monetary-policy actions taken today will not affect
output and inflation until one to two years in the future means that
the Bank of Canada must design its policy for __________ rather than what has already been observed.

Answer 29

what is expected to occur in the future

Question 30

the long time lags in the effectiveness of monetary policy _______ the difficulty of stabilizing the economy

monetary policy may have a _________ effect

Answer 30

increase

destabilizing