PowerPoint Presentation by
Mehdi Arzandeh, University of Manitoba
Interest Rates and
Monetary Policy
15
LEARNING OBJECTIVES
LO15.1
LO15.2
LO15.3
LO15.4
LO15.5
LO15.6
LO15.7
Discuss how the equilibrium interest rate is determined in the market for money.
List and explain the main functions of the Bank of Canada.
List and explain the goals and tools of monetary policy.
Describe the overnight lending rate and how the Bank of Canada directly
influences it.
Identify the mechanisms by which monetary policy affects GDP and the price level.
Explain the effectiveness of monetary policy and its shortcomings.
Describe the effects of the international economy on the operation of monetary
policy.
© 2016 McGraw‐Hill Education Limited
15-2
15.1
The Market for Money and
the Determination of Interest Rates
The Demand for Money
• Transactions Demand, 𝑫𝒕
• Demand for money as a medium of exchange
• Varies directly with GDP
• Asset Demand, 𝑫𝒂
• Demand for money as a store of value
• Varies inversely with the interest rate
• Asset Demand, 𝑫𝒎
• The horizontal summation of the asset demand and the transaction demand
LO1
© 2016 McGraw‐Hill Education Limited
15-3
KEY GRAPH - The Demand for Money, the Supply of
Money, and the Equilibrium Interest Rate
FIGURE 15-1
Rate of interest, i percent
(a)
Transactions
demand for
money, Dt
(b)
Asset
demand for
money, Da
10
Sm
7.5
=5
+
5
2.5
Dt
0
50
100
150
Da
200
Amount of money
demanded
(billions of dollars)
LO1
(c)
Total
demand for
money, Dm
and supply
50
100
150
200
Amount of money
demanded
(billions of dollars)
© 2016 McGraw‐Hill Education Limited
Dm
50
100
150
200
250
300
Amount of money
demanded and supplied
(billions of dollars)
15-4
15.1
The Market for Money and
the Determination of Interest Rates
• The Equilibrium Interest Rate
• Interest rate
• The price paid for the use of money
• Equilibrium interest rate
• Demand for money combined with supply of money
determine the equilibrium rate of interest
LO1
© 2016 McGraw‐Hill Education Limited
15-5
15.1
The Market for Money and
the Determination of Interest Rates
• Interest Rates and Bond Prices
• When the interest rate increases, bond prices fall; and vice
versa.
• Example
• A $1,000 bond pays $50 annual interest. Interest yield on this bond is
___
$50/$1000 = 5%
• Interest rate rises to 7.5%, bond price will fall to ____
$50/7.5% = $667
• Interest rate falls to 2.5%, bond price will rise to ____
$50/2.5% = $2000
LO1
© 2016 McGraw‐Hill Education Limited
15-6
15.2
1.
2.
3.
4.
5.
LO2
Functions of the Bank of Canada
Acting as the “Bankers’ Bank”
Issuing Currency
Acting As Fiscal Agent
Supervising the Chartered Banks
Regulating the Supply of Money
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15-7
15.2
Functions of the Bank of Canada
Bank of Canada Independence
• Voters hold Parliament responsible
• Bank must be protected from political pressures
LO2
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15-8
15.2
Functions of the Bank of Canada
Consolidated Balance Sheet of the Bank of Canada
• Assets
1. Securities
2. Advances to Chartered Banks
• Liabilities
1. Chartered Banks Deposits
2. Government of Canada Deposits
3. Notes in Circulation
LO2
© 2016 McGraw‐Hill Education Limited
15-9
TABLE 15-1
Bank of Canada Statement of Assets and
Liabilities, December 31, 2014 (in millions)
Assets
Advances to chartered
banks
Treasury bills of Canada
Other securities issued or
guaranteed by Canada
Securities purchased under
resale agreement
Other assets
Total
Liabilities
$ 26
Notes in circulation
19,998
Government of Canada
deposits
71,022
Chartered bank deposits
1,397
Other liabilities
$69,980
21,874
176
2,263
850
$93,293
Total
$93,293
Source: Adapted from Bank of Canada, Weekly Financial Statements, February 20, 2015.
http://www.bankofcanada.ca/publications-research/periodicals/wfs/; accessed July 23, 2015.
LO2
© 2016 McGraw‐Hill Education Limited
15-10
15.3
Goals and Tools of Monetary
Policy
• Goals of Monetary Policy
• To keep inflation low, stable and predictable, to moderate
the business cycle, and help the economy achieve full
employment and sustained growth.
• By altering the money supply to influence interest rates
• Inflation target range of 1-3% annually
LO3
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15-11
15.1 GLOBAL PERSPECTIVE
Central Banks, Selected Nations
LO3
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15-12
15.3
Goals and Tools of Monetary
Policy
• Tools of Monetary Policy
• Open-Market Operations
• Bank Rate
LO3
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15-13
15.3
Goals and Tools of Monetary
Policy
• Open-Market Operations
• Bank of Canada BUYS bonds from the chartered
banks
• Chartered bank gives up bonds
• Bank of Canada pays chartered bank by increasing
chartered bank’s reserves
LO3
© 2016 McGraw‐Hill Education Limited
15-14
15.3
Goals and Tools of Monetary
Policy
Bank of Canada Buys Bonds from Chartered Banks
Bank of Canada
Assets
Liabilities
+ Securities
+ Deposits of Chartered Banks
(a) Securities
Assets
(b) Reserves
Chartered Banks
Liabilities and Net Worth
-Securities (a)
+Reserves (b)
LO3
© 2016 McGraw‐Hill Education Limited
15-15
15.3
Goals and Tools of Monetary
Policy
• Open-Market Operations
• Bank of Canada BUYS bonds from the public
• Public gives up bonds for cheque
• Cheque is deposited in chartered bank
• Chartered bank’s reserves increase
LO3
© 2016 McGraw‐Hill Education Limited
15-16
FIGURE 15-2
The Bank of Canada’s Purchase of Bonds and the
Expansion of the Money Supply
Bank of Canada buys $1,000 bond from a chartered bank.
New Reserves
$1000
Excess
Reserves
$5000
Bank System Lending
Total Increase in the Money Supply, ($5,000)
LO3
© 2016 McGraw‐Hill Education Limited
15-17
FIGURE 15-2
The Bank of Canada’s Purchase of Bonds and the
Expansion of the Money Supply
Bank of Canada buys $1,000 bond from the public.
New Reserves
$1000
$200
Desired
Reserves
$800
Excess
Reserves
$4000
Bank System Lending
$1000
Initial
Chequable
Deposit
Total Increase in the Money Supply, ($5000)
LO3
© 2016 McGraw‐Hill Education Limited
15-18
15.3
Goals and Tools of Monetary
Policy
• Open-Market Operations
• Bank of Canada BUYS bonds
• Chartered bank’s reserves increase
• Banks increase lending
• Money supply increases
• Bank of Canada SELLS bonds
• Chartered bank’s reserves decrease
• Banks decrease lending
• Money supply decreases
LO3
© 2016 McGraw‐Hill Education Limited
15-19
15.3
Goals and Tools of Monetary
Policy
Bank of Canada Sells Bonds to Chartered Banks
Bank of Canada
Assets
Liabilities and Net Worth
- Securities
- Reserves of Chartered Banks
(a) Securities
Assets
(b) Reserves
Chartered Banks
Liabilities and Net Worth
+ Securities (a)
- Reserves (b)
LO3
© 2016 McGraw‐Hill Education Limited
15-20
15.3
Goals and Tools of Monetary
Policy
• Open-Market Operations
• Bank of Canada SELLS bonds to the public
• Public pays bonds with cheque
• Cheque is cleared in chartered bank
• Chartered bank’s reserves decrease
• The Bank of Canada bond sales of $1000 to the chartered banking
system reduce the system’s actual and excess reserves by $1000.
• But a $1000 bond sale to the public reduces excess reserves by $800
LO3
© 2016 McGraw‐Hill Education Limited
15-21
15.3
Goals and Tools of Monetary
Policy
• The Bank Rate and the Overnight Lending Rate
• The bank rate is the interest rate the Bank of Canada charges
on the loans to the chartered banks
• Bank rate is set at the upper end of the Bank of Canada’s
operating band for the overnight lending rate
• Bank has a publicized target for the overnight lending rate
LO3
© 2016 McGraw‐Hill Education Limited
15-22
15.4
Targeting the
Overnight Lending Rate
• The Bank of Canada sets a target level for the
overnight rate, often referred to as the key policy
rate or key interest rate
• Overnight lending Rate
• The interest rate charged by banks on overnight loans
• Bank of Canada conducts open market operations
to achieve the target
LO4
© 2016 McGraw‐Hill Education Limited
15-23
Federal Funds Rate, Percent
FIGURE 15-3
Targeting the Overnight Lending Rate
Sf 3
4.5
Decrease
in Supply
Sf 1
4.0
Increase
in Supply
Sf 2
3.5
Df
Qf3
Qf1
Qf2
Quantity of Reserves
LO4
© 2016 McGraw‐Hill Education Limited
15-24
15.4 Goals of Monetary Policy
•Monetary Policy
• Expansionary monetary policy
• Economy faces a recession
• Lower target for overnight lending rate
• Bank of Canada buys securities
• Expanded money supply
• Downward pressure on other interest rates
LO4
© 2016 McGraw‐Hill Education Limited
15-25
15.4 Goals of Monetary Policy
•Monetary Policy
• Restrictive monetary policy
• Periods of rising inflation
• Increases target for overnight lending rate
• Bank of Canada sells securities
• Increases money supply
• Increases other interest rates
LO4
© 2016 McGraw‐Hill Education Limited
15-26
FIGURE 15-4
LO4
The Prime Interest Rate, the Bank Rate, the Overnight
Target Rate, and the Overnight Lending Rate in Canada,
1998–2014
© 2016 McGraw‐Hill Education Limited
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15.4 Goals of Monetary Policy
The Taylor Rule
• If real GDP rises by 1% above potential GDP, the Bank should raise the
overnight rate by 0.5 percentage point
• If inflation rises by 1% above its target of 2 percent, the bank should
raise the overnight lending rate by 0.5%
• When real GDP is equal to potential GDP and inflation is equal to its
target, the overnight rate should remain about 4%, implying a real
interest rate of 2%.
LO4
© 2016 McGraw‐Hill Education Limited
15-28
15.5
Monetary Policy, Real GDP
and Price Level
Cause-Effect Chain: The Transmission Mechanism
• Money supply impacts interest rates
• Interest rates affect investment
• Investment is a component of AD
• Equilibrium GDP is changed
LO5
© 2016 McGraw‐Hill Education Limited
15-29
FIGURE 15-5
KEY GRAPH - Monetary Policy and Equilibrium GDP
Sm1
Sm2
Sm3
AS
10
P3
8
Dm
6
0
AD3
I=$25
AD2
I=$20
AD1
I=$15
P2
$125
$150
$175
Amount of money
demanded and
supplied
(billions of dollars)
LO5
(c)
Equilibrium real
GDP and the
Price level
(b)
Investment
demand
Price Level
Rate of Interest, i (Percent)
(a)
The market
for money
ID
$15
$20
$25
Amount of investment
(billions of dollars)
© 2016 McGraw‐Hill Education Limited
Q1
Qf Q3
Real GDP
(billions of dollars)
15-30
FIGURE 15-5
KEY GRAPH - Monetary Policy and Equilibrium GDP
(d)
Equilibrium real
GDP and the
Price level
(c)
Equilibrium real
GDP and the
Price level
AS
AS
P3
AD3
I=$25
AD2
I=$20
AD1
I=$15
P2
Q1
Qf Q3
Real GDP
(billions of dollars)
Price Level
Price Level
P3
LO5
c
b
a
AD3
I=$25
AD4
I=$22.5
AD2
I=$20
AD1
I=$15
P2
Q1
Qf Q3
Real GDP
(billions of dollars)
© 2016 McGraw‐Hill Education Limited
15-31
TABLE 15-2
Monetary Policy: The Transmission
Mechanism (1) Expansionary Monetary Policy
Problem: unemployment and recession

Bank of Canada buys bonds and lowers the bank rate

Excess cash reserves increase

Overnight rate falls

Money supply rises

Interest rate falls

Investment spending increases

Aggregate demand increases

Real GDP rises
LO5
© 2016 McGraw‐Hill Education Limited
15-32
TABLE 15-2
Monetary Policy: The Transmission
Mechanism (2) Restrictive Monetary Policy
Problem: Inflation

Bank of Canada sells bonds and raises the bank rate

Excess cash reserves decrease

Overnight rate rises

Money supply falls

Interest rate rises

Investment spending decreases

Aggregate demand decreases

Inflation declines
LO5
© 2016 McGraw‐Hill Education Limited
15-33
15.6
Monetary Policy: Evaluation
and Issues
•Dominant component of Canadian national
stabilization policy
•Two key advantages over fiscal policy:
• Speed and flexibility
• Isolation from political pressure
LO6
© 2016 McGraw‐Hill Education Limited
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15.6
Monetary Policy: Evaluation
and Issues
Recent Monetary Policy in Canada
• Economy slowed at the end of 2000, so Bank cut interest rates in 2001.
• Expansion in 2002 led to increased rates.
• Reduced rate to stimulate the economy in 2004
• Interest rate hikes from 2005 – 2007.
• Started dropping again in 2008 to an all time low of 0.25% in 2009.
• Began to increase the overnight lending rates in the autumn of 2010, but
rates stayed at historic lows throughout 2014.
LO6
© 2016 McGraw‐Hill Education Limited
15-35
15.6
Monetary Policy: Evaluation
and Issues
Problems and Complications
• Monetary policy has certain limitations and faces
real-world complications:
• Lags
• Cyclical asymmetry and liquidity trap
• Inflation Targeting
Increased transparency of monetary policy and
accountability
LO6
© 2016 McGraw‐Hill Education Limited
15-36
TABLE 15-3
Monetary Policy and the Net Export Effect
Net exports effects reinforce monetary policy
LO7
(1) Expansionary monetary policy
(2) Restrictive monetary policy
Problem: recession, slow growth
Problem: inflation


Expansionary monetary policy (lower
interest rate)
Restrictive monetary policy (higher interest
rate)


Decreased foreign demand for dollars
Increased foreign demand for dollars


Dollar depreciates
Dollar appreciates


Net exports increase (aggregate demand
increases, strengthening the expansionary
monetary policy)
Net exports decrease (aggregate demand
decreases, strengthening the restrictive
monetary policy)
© 2016 McGraw‐Hill Education Limited
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15.7
Monetary Policy and
the International Economy
 Macroeconomic Stability and the Trade Balance
• The easy money policy that is appropriate for the alleviation
of unemployment and sluggish growth is compatible with
the goal of correcting a balance-of-trade deficit.
• The tight money policy used to alleviate inflation conflicts
with the goal of correcting a balance-of-trade deficit.
LO7
© 2016 McGraw‐Hill Education Limited
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The LAST
WORD
Worries about ZIRP, QE, and Twist
ZIRP, QE, and Operation Twist provided massive economic stimulus during and after the
Great Recession. But there remain many worries about unintended consequences.
• The Fed lowered the short-term interest rates to nearly zero (a.k.a. zero
interest rate policy, ZIRP)
• The Fed also engaged in bond purchasing (Quantitative Easing, QE)
• The policy known as Operation Twist lowered longer-term interest rates.
• The U.S. federal government was running a large annual budget deficits.
 Concern about huge interest costs after ZIRP ended
 ZIRP punishes savers
© 2016 McGraw‐Hill Education Limited
15-39
Chapter Summary
LO15.1
LO15.2
LO15.3
LO15.4
LO15.5
LO15.6
LO15.7
Discuss how the equilibrium interest rate is determined
in the market for money.
List and explain the main functions of the Bank of
Canada.
List and explain the goals and tools of monetary policy.
Describe the overnight lending rate and how the Bank of
Canada directly influences it.
Identify the mechanisms by which monetary policy
affects GDP and the price level.
Explain the effectiveness of monetary policy and its
shortcomings.
Describe the effects of the international economy on the
operation of monetary policy.
© 2016 McGraw‐Hill Education Limited
15-40