Inflation Targeting Framework Part 1 and Part 2 Flashcards
When was the great inflation?
- 1970s was a period of high and variable inflation for many countries, including Canada
- Followed by stagflation
Stagflation
-inflation rate is high or increasing
-the economic growth rate slows
- unemployment remains steadily high.
Advantage and disadvantage of stating inflation-control targets
Advantage — a very transparent policy objective that, if successful, should anchor inflation expectations.
Disadvantage — central banks do not directly control inflation. Failing to meet targets might lead to lost credibility.
The great moderation
a period of stable inflation and relatively stable economic activity
When was the Bank of Canada established?
Established by the Bank of Canada Act in 1935
What were the mandates in the Bank of Canada Act of 1935
- economic growth
- exchange rate stability
- low unemployment
- and low inflation
Four main responsibilities of the BoC (core functions)
- The Government of Canada’s bank (funds management or fiscal agent)
- Also, the Government of Canada’s agent for foreign
exchange transactions.
- Also, the Government of Canada’s agent for foreign
- Issuance of bank notes (currency)
- Stability of the financial system (financial system)
- centre of the Canadian financial system
- lender of last resort
- macro-prudential policy
- Monetary policy
- Adjusting the policy interest rate
- Quantitative easing/ tightening
Policy Rate
The interest rate on overnight lending between large financial institutions. These are institutions that are direct participants in the Lynx payments system that have settlement accounts at the Bank of Canada
Conventional Monetary Policy
Interest Rates
unconventional Monetary Policy
Quantitative Easing and Tightening
When is the unconventional monetary policy most useful?
- when the policy interest rate is at its effective (zero) lower bound
- also useful when more than conventional monetary policy is needed
The objective of quantitative monetary policies (quantitative easing/ tightening)
- Change monetary conditions across all lending markets.
- Rather than relying on having changes in the overnight rate (target) feed through to other interest rates, quantitative policy measures has the Bank adding or subtracting liquidity (buying or selling assets) in bond markets or even in other financial markets
The objective of monetary policy
Keep inflation low, stable, and predictable
- Allows Canadians to make spending and investment decisions with more confidence
- encourages longer-term investment in Canada’s economy
- contributes to sustained job creation and greater productivity
-In turn, leads to improvements in our standard of living
Who is responsible for implementing monetary policy?
The Governing Council
- Small and all from the Bank of Canada except (recently) one external member
Two important parts to the framework for monetary policy:
- The Inflation Control Target
- A Flexible Exchange Rate System
- A framework for managing the business cycle, ‘short run’ fluctuations in economic activity and inflation — in a small open economy.
When was the inflation control target implemented in Canada?
adopted in 1991
- an agreement between the Bank of Canada and the Government of Canada
How often is the monetary policy framework renewed?
every 5 years
Characteristics of the inflation target
The inflation target is symmetric
The inflation target is forward-looking; policy-making faces a lot of uncertainty.
The inflation target is flexible.
Monetary policy is endogenous:
The Bank adjusts interest rates to keep inflation on target. And the economy running at ‘full capacity’.
monetary policy transmission mechanism
- Central bank examines the current economy and forecasts
- If inflation and economic activity are expansionary: tighten monetary policy (raise policy interest rate)/ recessionary: loosen monetary policy (lower policy interest rate)
- Forward guidance can strengthen the effects
- Monetary policy operates with a lag
Flexible Exchange Rate System
Neither the government nor the Bank of Canada targets or sets a particular value for the Canadian dollar.
With a flexible exchange rate:
The exchange rate is a possible source of shocks to the Canadian economy.
The exchange rate acts as an insulator for the Canadian economy.
The exchange rate is part of the monetary policy transmission mechanism.
A significant depreciation of the exchange rate (fall in value of the Canadian dollar) can…..
….give rise to higher prices for households — imported goods are more expensive.
If the exchange rate change (‘the shock’) passes through to Canadian inflation, then this may require a monetary policy response
∆e −→ ∆π −→ monetary policy decisions
The exchange rate as an insulator for the domestic economy
If Canada experiences a sharp decline in demand for exports (e.g. 2008), then as part of the adjustment process, the Canadian dollar may depreciate; this depreciation, by making our exports less costly, may offset some of the decline in exports.
∆NX(−)−→∆e−→∆NX(+butsmaller) −→∆Y
A tightening of monetary policy (rise in interest rates) makes domestic assets……
……relatively more attractive — increases demand for domestic currency, appreciating the nominal exchange rate.
The appreciation of the nominal exchange rate reduces economic activity through lower demand for our exports.
A loosening of monetary policy (fall in interest rates) makes domestic assets……
…….relatively less attractive — decreases demand for domestic currency, depreciating the nominal exchange rate.
The depreciation of the nominal exchange rate further expands economic activity through higher demand for exports.
Of course, the exchange rate influences inflation ______ and inflation and output _______
directly
∆e −→ ∆π −→ MP decisions
indirectly
∆NX(−)−→∆e−→∆NX(+butsmaller) −→∆Y–>MP decisions
Circular system (monetary policy)
monetary policy has to be forward looking and responding to the state of the economy.
framework for monetary policy in Canada
inflation targeting and a flexible exchange rate.
Within this framework, monetary policy actions include
Interest rate policy, quantitative policies, and emergency lending facilities.
