Quiz 2 Flashcards
Government of Canada Bond Purchase Program
Quantitative Easing
Purpose of QE?
To support the 2% inflation target
To do that, we strive to keep the economy’s production as close to capacity as possible.
How does QE affect interest rates?
- 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
Main policy tool in normal times
Overnight Rate
Features of the overnight rate.
- 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.
Mechanics of QE
- 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
How does the BoC pay for bonds?
- They don’t print money
- Pays using a particular form of liability (settlement balances)
Settlement Balance
-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
Four main responsibilities of BoC
- Government’s bank (funds management/ fiscal agent/manages foreign exchange transactions)
- Issue banknotes
- Stability of the Financial System (lender of last resort)
- Monetary Policy (adjusting policy rate)
Conventional monetary policy
Overnight rates
Unconventional monetary policy
- QE/ QT
- useful when policy interest rate is at effective lower bound
- adds or subtracts liquidity in bond markets or other financial markets
Who is responsible for implementing MP?
Governing Council
Two important parts to the framework for MP
- Inflation Control Target
- A flexible exchange rate system
Inflation Control Target
- 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
Monetary policy framework inception
-1991
-Renewed every 5 years
MP transmission mechanism (The interest rate part)
- BoC examines the current economy and forecasts
- If inflation is expansionary/recessionary tighten/ loosen MP
- forward guidance can strengthen the effects
- MP operated with a lag
Objective of MP
- Keep inflation at 2% within the target band of 1-3%
- Economy at full capacity
- same for overnight rates and QE
Flexible Exchange Rate System
: 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
With a flexible Exchange rate:
-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
If the CAD depreciates significantly
-Can make household prices higher
- imported goods are more expensive
- the shock passes through to inflation
∆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, 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
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.
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.
