Inflation Targeting Framework Part 1 and Part 2

Question 1

When was the great inflation?

Answer 1

• 1970s was a period of high and variable inflation for many countries, including Canada
• Followed by stagflation

Question 2

Stagflation

Answer 2

-inflation rate is high or increasing
-the economic growth rate slows
- unemployment remains steadily high.

Question 3

Advantage and disadvantage of stating inflation-control targets

Answer 3

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.

Question 4

The great moderation

Answer 4

a period of stable inflation and relatively stable economic activity

Question 5

When was the Bank of Canada established?

Answer 5

Established by the Bank of Canada Act in 1935

Question 6

What were the mandates in the Bank of Canada Act of 1935

Answer 6

• economic growth
• exchange rate stability
• low unemployment
• and low inflation

Question 7

Four main responsibilities of the BoC (core functions)

Answer 7

1. The Government of Canada’s bank (funds management or fiscal agent)
   
   • Also, the Government of Canada’s agent for foreign
     exchange transactions.
2. Issuance of bank notes (currency)
3. Stability of the financial system (financial system)
   
   • centre of the Canadian financial system
   • lender of last resort
   • macro-prudential policy
4. Monetary policy
   
   • Adjusting the policy interest rate
   • Quantitative easing/ tightening

Question 8

Policy Rate

Answer 8

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

Question 9

Conventional Monetary Policy

Answer 9

Interest Rates

Question 10

unconventional Monetary Policy

Answer 10

Quantitative Easing and Tightening

Question 11

When is the unconventional monetary policy most useful?

Answer 11

• when the policy interest rate is at its effective (zero) lower bound
• also useful when more than conventional monetary policy is needed

Question 12

The objective of quantitative monetary policies (quantitative easing/ tightening)

Answer 12

• 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

Question 13

The objective of monetary policy

Answer 13

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

Question 14

Who is responsible for implementing monetary policy?

Answer 14

The Governing Council
- Small and all from the Bank of Canada except (recently) one external member

Question 15

Two important parts to the framework for monetary policy:

Answer 15

1. The Inflation Control Target
2. 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.

Question 16

When was the inflation control target implemented in Canada?

Answer 16

adopted in 1991
- an agreement between the Bank of Canada and the Government of Canada

Question 17

How often is the monetary policy framework renewed?

Answer 17

every 5 years

Question 18

Characteristics of the inflation target

Answer 18

The inflation target is symmetric

The inflation target is forward-looking; policy-making faces a lot of uncertainty.

The inflation target is flexible.

Question 19

Monetary policy is endogenous:

Answer 19

The Bank adjusts interest rates to keep inflation on target. And the economy running at ‘full capacity’.

Question 20

monetary policy transmission mechanism

Answer 20

• 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

Question 21

Flexible Exchange Rate System

Answer 21

Neither the government nor the Bank of Canada targets or sets a particular value for the Canadian dollar.

Question 22

With a flexible exchange rate:

Answer 22

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.

Question 23

A significant depreciation of the exchange rate (fall in value of the Canadian dollar) can…..

Answer 23

….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

Question 24

The exchange rate as an insulator for the domestic economy

Answer 24

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

Question 25

A tightening of monetary policy (rise in interest rates) makes domestic assets……

Answer 25

……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.

Question 26

A loosening of monetary policy (fall in interest rates) makes domestic assets……

Answer 26

…….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.

Question 27

Of course, the exchange rate influences inflation ______ and inflation and output _______

Answer 27

directly
∆e −→ ∆π −→ MP decisions

indirectly
∆NX(−)−→∆e−→∆NX(+butsmaller) −→∆Y–>MP decisions

Question 28

Circular system (monetary policy)

Answer 28

monetary policy has to be forward looking and responding to the state of the economy.

Question 29

framework for monetary policy in Canada

Answer 29

inflation targeting and a flexible exchange rate.

Question 30

Within this framework, monetary policy actions include

Answer 30

Interest rate policy, quantitative policies, and emergency lending facilities.