Chp30 - Monetary Policy

Question 1

Monetary Policy Objective

Answer 1

• control the quantity of money
• control interest rates
• avoid inflation
• prevent excessive swings in RGDP growth and unemployment

Question 2

Inflation Rate Targetting

Answer 2

• the task of Central Bank to pick a certain inflation rate and achieve that rate
• Measured via the CPI
  
  • focuses on core inflation (e.g. excludes oil, food)
• Benefits of targeting
  
  • to make clear goals of Central Bank to traders
  • provides anchor for expectations about future inflation

Question 3

Inflation Rate Targeting Controversy

Answer 3

• not everyone believes targeting is helpful
• in targeting inflation , the Central Bank could unintentionally force a recession
• could permit the value of the dollar to rise in foreign markets hurting exports
• However, it is argued that keeping inflation low makes the max contribution to achieving full employment and sustained growth

Question 4

Monetary Policy Instruments of the Bank of Canada

Answer 4

• The Monetary Base (quantity of money)
• The Exchange Rate
• The Short-Term Interest Rate (the opportunity-cost of holding money)
• The Bank can set any one of these, but not all three
  
  • because changing one effects all the others

Question 5

Overnight Loans Rate

Answer 5

• The interest rate on overnight loans that big banks make to each other
• This is the interest rate that the BofC targets
• BofC will usually only change it by a 1/4 of a percent
• Achieves the target via: Operating Band, and Open Market Operation

Question 6

Operating Band

Answer 6

• The target overnight loans rate +-0.25 percentage points
• Created by the Bank Rate, and the Settlement Balances Rate
• Bank Rate: the interest rate the BofC charges on big banks for loans
  
  • the target overnight rate +0.25 percentage points
• Settlement Balances Rate: amount of interest BofC pays to banks on their reserves in the BofC
  
  • the target overnight rate -0.25 percentage points
• Overnight Rate cannot exceed Operating Band because other banks could turn a profit off BofC

Question 7

Open Market Operation

Answer 7

• determines the actual quantity of reserves in the banking system

Question 8

Controlling Overnight Rate

Answer 8

• Above target
  
  • buy securities to increase reserves
  • increases supply of overnight funds and lowers rate
• Below target
  
  • sells securities to decrease reserves
  • decreases supply of overnight funds and raises rate

Question 9

Ripple Effect of Changing Overnight Loans Rate

Answer 9

• lower Overnight Rate
• short-term interest rate & exchange rate falls
• quantity of money & supply of loanable funds increase
• long-term real interest rate falls
• Consumption Expenditure, Investment, & NX increase
• Aggregate Demand Increases
• RGDP growth and inflation rate increase
• Raise Overnight Rate (vice versa)

Question 10

Interest Rate Changes

Effect of Changing Overnight Rate

Answer 10

• change in the Overnight Rate effects: 3-Month Treasury Bill Rate and the Long-Term Bond Rate
• 3-Month Treasury Rate: moves fairly close to Overnight Rate
• The Long-Term Bond Rate: higher than other two rates due to increase risk; does not fluctuate as much as the above short-term rates

Question 11

Exchange Rate Fluctuation

Effect of Changing Overnight Rate

Answer 11

• responds to changes in the interest rate in Canada relative to the interest rates of other countries
• When overnight rate raises, CDN Dollar appreciates (and vice versa)

Question 12

Monetary and Bank Loan Fluctuation

Effect of Changing Overnight Rate

Answer 12

• rise in overnight rate decreases quantity of money and bank loans (and vice versa)
• change occurs due to: quantity of deposits and loans created by the banking system changes, and the quantity of money demanded changes

Question 13

Long-Term Real Interest Rate Fluctuations

Effect of Changing Overnight Rate

Answer 13

• Demand and Supply in the loanable funds market determine the long-term real interest rate
• fall in overnight rate increases the supply of loanable funds and lowers the equilibrium real interest rate (and vice versa)

Question 14

Expenditure Plan Fluctuations

Effect of Changing Overnight Rate

Answer 14

• overnight rate effects: Consumption Expenditure, Investment. Net Exports
• Consumption Expenditure: lower real interest rate = greater CE and lower saving (and vice versa)
• Investment: lower real interest rate = greater investment (and vice versa)
• Net Exports: lower interest rate = lower exchange rate = greater exports and less imports

Question 15

RGDP and Price Level Fluctuations

Effect of Changing Overnight Rate

Answer 15

• change in aggregate demand results in change in RGDP and price level

Question 16

Bank of Canada Fighting Recession

Answer 16

• The Market for Bank Reserves
  
  • BofC lowers overnight target rate
  • conducts open market operation to increase reserves and hit target rate (shift right in RS curve)
• Money Market
  
  • increase in monetary base increases money supply
  • interest rate falls
  • quantity of money demanded increases (shift left in MS curve
• The Loanable Funds Market
  
  • increase in supply of loanable funds lowers long-term interest rate in increases investment
• RGDP and Price Level
  
  • Increased planned expenditure increases aggregate demand
  • multiplier effect further pushes AD curve

Question 17

BofC Fights Inflation

Answer 17

• Market for Bank Reserves
  
  • raises overnight interest rate target
  • open market sale to decrease reserves and hit target
• Money Market (RS curve shifts left)
  
  • decrease in monetary base decreases supply of money (MS curve shifts left)
  • interest rate rises and money demanded decreases
• The Loanable Funds Market
  
  • decrease in supply of loanable funds raises long-term interest rate and decreases investment (SLF curve shifts left)
• RGDP and the Price Level
  
  • Decrease in investment decreases aggregate demand (AD shifts left, further left after multiplier)

Question 18

Banking Crisis

Answer 18

• Widespread fall in asset prices
  
  • Bank’s equity falls along with this
• Significant Currency Drain
  
  • diminishing reserves result in liquidity crisis
• Run on the Bank
  
  • depositors lose confidence and withdraw deposits
  • loss in reserves; selling assets

Question 19

Policy Action is Response to Banking Crisis

Answer 19

• Open Market Operation
  
  • sale of gov. securities to attack liquidity issue
• Extension of Deposit Insurance
  
  • gives people less incentive to withdraw from bank
• Swap gov. securities for toxic-assets
  
  • attacked liquidity issue
• Gov. buying bank shares
  
  • boosts bank capital and equity; addresses solvency
• Fair Value Accounting
  
  • change in accounting standards; addresses solvency

Question 20

The Taylor Rule

Answer 20

• formula for setting overnight loans rate
  R = 2 + INF + 0.5(INF - 2) + 0.5GAP
  
  • R = overnight loans rate
  • INF = inflation rate
  • GAP = the output gap
• BofC does not use this, believes that they need to take more into account than current inflation