Quiz 2

Question 1

Government of Canada Bond Purchase Program

Answer 1

Quantitative Easing

Question 2

Purpose of QE?

Answer 2

To support the 2% inflation target

To do that, we strive to keep the economy’s production as close to capacity as possible.

Question 3

How does QE affect interest rates?

Answer 3

• when BoC buys up bonds at a given maturity, it drives up prices which lowers the interest rate that the bonds pay holders.
  -When the interest rate on government bonds is lower, this transmits itself to other interest rates.
• Stimulates more borrowing and spending which helps inflation move closer to the 2% inflation target

Question 4

Main policy tool in normal times

Answer 4

Overnight Rate

Question 5

Features of the overnight rate.

Answer 5

• has a direct impact on the cost of borrowing over very short terms
  -increases or decreases the policy rate
• Shapes the market’s expectations for future overnight rates.
• in turn, affects the longer- term borrowing and lending rates.

Question 6

Mechanics of QE

Answer 6

• every week, the Government of Canada sells bonds to financial institutions
• The bank then buys bonds from auction participants
• This is a reverse auction (the bank holds an auction to buy, not sell)
• BoC announces how many bonds they will buy, and institutions make offers through a competitive bidding process. The bank purchases the lowest-priced bonds.
• increases BoC’s balance sheet

Question 7

How does the BoC pay for bonds?

Answer 7

• They don’t print money
• Pays using a particular form of liability (settlement balances)

Question 8

Settlement Balance

Answer 8

-Settlement balances can be defined as interest-bearing deposits that belong to participants of Canada’s payment system and that are an integral part of the high-value payment system (HVPS)
- how banks pay for the bonds the BoC purchases.
- BOC ->The bonds purchased are assets. The settlement balance is a liability.
- BOC pays interest on this liability at a rate of one to one of the policy rate
- Commercial Banks -> doesn’t change balance sheet
- settlement balances can only be issued by central banks

Question 9

Four main responsibilities of BoC

Answer 9

1. Government’s bank (funds management/ fiscal agent/manages foreign exchange transactions)
2. Issue banknotes
3. Stability of the Financial System (lender of last resort)
4. Monetary Policy (adjusting policy rate)

Question 10

Conventional monetary policy

Answer 10

Overnight rates

Question 11

Unconventional monetary policy

Answer 11

• QE/ QT
• useful when policy interest rate is at effective lower bound
• adds or subtracts liquidity in bond markets or other financial markets

Question 12

Who is responsible for implementing MP?

Answer 12

Governing Council

Question 13

Two important parts to the framework for MP

Answer 13

1. Inflation Control Target
2. A flexible exchange rate system

Question 14

Inflation Control Target

Answer 14

• Targets inflation at 2% a band of 1-3% over the medium term.
• The target is symmetric
• The target is forward-looking
• The inflation target is flexible.
• MP is endogenous

Question 15

Monetary policy framework inception

Answer 15

-1991
-Renewed every 5 years

Question 16

MP transmission mechanism (The interest rate part)

Answer 16

1. BoC examines the current economy and forecasts
2. If inflation is expansionary/recessionary tighten/ loosen MP
   - forward guidance can strengthen the effects
   - MP operated with a lag

Question 17

Objective of MP

Answer 17

• Keep inflation at 2% within the target band of 1-3%
• Economy at full capacity
• same for overnight rates and QE

Question 18

Flexible Exchange Rate System

Answer 18

: neither the government nor the BoC targets or sets a particular value for the Canadian Dollar
- the value of the CAD against other currencies determined in the foreign exchange markets

Question 19

With a flexible Exchange rate:

Answer 19

-The exchange rate is a source of possible 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 20

If the CAD depreciates significantly

Answer 20

-Can make household prices higher
- imported goods are more expensive
- the shock passes through to inflation
∆e −→ ∆π −→ monetary policy decisions

Question 21

The exchange rate as an insulator for the domestic economy

Answer 21

If Canada experiences a sharp decline in demand for exports, then the Canadian dollar may depreciate; this depreciation may make our exports less costly, may offset some of the decline in exports.
∆NX(−)−→∆e−→∆NX(+butsmaller) −→∆Y

Question 22

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

Answer 22

……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 23

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

Answer 23

…….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 24

the exchange rate influences inflation ______ and inflation and output _______

Answer 24

directly
∆e −→ ∆π −→ MP decisions

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

Question 25

Circular system (monetary policy)

Answer 25

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