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Chapter 28
Monetary Policy in Canada
Ratna K. Shrestha
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In this chapter you will learn...
1. why the Bank of Canada chooses to directly target
interest rates rather than the money supply.
2. how changes in the Bank of Canada’s target for the
overnight interest rate affect longer-term interest
rates.
3. why many central banks have adopted formal inflation
targets.
4. how the Bank of Canada’s policy of inflation targeting
helps to stabilize the economy.
5. why monetary policy affects real GDP and the price
level only after long time lags.
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28.1 How BOC Implements Monetary Policy
How does the BOC influence the money market and thereby
implement the monetary policy?
Money Supply (MS) Versus the Interest Rate
For any given money demand curve, a central bank has two
alternatives: 1) targeting the money supply or 2) targeting the
interest rate.
However, both cannot be targeted independently. If BOC
targets MS, monetary equilibrium will determine interest
rate. On the other hand if it targets interest rate, MS must
adjust to have the target rate as the equilibrium rate. The
BOC can attempt to shift MS curve by buying or selling
government securities—called open market operation.
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The Bank of Canada (BOC) chooses to implement its monetary
policy by targeting interest rates (rather than the money
supply) because:
1. The Bank can influence the interest rate more easily than it
can affect the money supply. The BOC can control the
amount of cash reserve in the banking system but not the
process of deposit expansion (that depends on commercial
banks).
2. Instability of money demand (slope and its position).
3. Easier to communicate its policy through changes in interest
rates. And also it is easier for the public to see what it means
when interest rate changes.
But which interest rate (of many) does the Bank target?
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The BOC and the Overnight Interest Rate
The BOC controls the overnight interest rate. It is the rate that
one commercial bank charges to the other for overnight loans
(when it falls short of enough cash to start its business the
next day). The BOC controls the rate by:
1. Setting a target for the overnight interest rate.
2. Establishing the bank rate 0.25% above this target. The
bank rate is the rate at which the BOC stands ready to
loan any amount to commercial banks.
3. Establishing a borrowing rate 0.25% below target. This is
the rate BOC pays for the commercial banks reserves.
 keep actual overnight rate within 0.5% band.
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Overnight Interest Rate: Target vs Actual
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Unconventional” Monetary Policy
During the 2007-2008 Financial Crisis
The financial crisis started with the collapse of housing
market in the US. This led to the collapse of the value of
banks’ assets, causing some banks to fail (Examples: Lehman
Brothers, Washington Mutual and AIG). As a result there was
a significant disruptions in the global credit market.
To restore the flow of credit the BOC took an unconventional
measure by significantly reducing the target interest rate
(and also eased terms of lending and broadened the class of
assets for collateral) to increase liquidity in financial sector
and thus interbank lending.
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Unconventional” Monetary Policy
During the 2007-2008 Financial Crisis
In light of declining Canadian export and hence recession,
the BOC reduced its target rate to historic low of 0.25%.
What could the BOC do if the depth of recession suggested a
need for even more expansionary monetary policy?
It could embark on the policy of “quantitative easing” or
“credit easing”. It means the BOC could directly purchase
government securities (in the open market) and supply more
money in the economy.
Between March 2015 and June 2016, European Central Bank
(ECB) bought assets worth 1.1 trillion Euro to infuse more
money in the economy.
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The Money Supply Is Endogenous
As the BOC changes its target for the overnight rate, other
interest rates such as mortgage rates and prime rates and
yields to government bonds change very quickly.
While prime rate (or mortgage rate) can change quickly,
households response to such changes (borrowing behavior)
can take longer time.
Exception: When BOC decreased its overnight rate from 1% to
0.75% in Jan 2015, TD initially refused to decrease its prime
rate but later decreased it by only 0.15%.
In response to interest rate changes, the demand for new loan
adjusts. Commercial banks can sell (or buy) government bonds
to (or from) BOC in exchange for cash to meet this demand.
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The Money Supply Is Endogenous
When the BOC buys securities from commercial banks
(called open market operation) in cash, there will be more
supply of money. As a result commercial banks can loan out
more.
But this open market operation (buying or selling of
government securities) is done passively by the BOC. The
BOC’s decision to how much to sell or buy depends on the
economic decisions of households, firms and commercial
banks. And it is in this sense the money supply is
endogenous.
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Monetary Policies
An expansionary monetary policy occurs when the BOC
reduces its target for the overnight rate. It is expansionary in
the sense that such BOC action would shift the AD curve to
the right.
A contractionary monetary policy occurs when the BOC
increases its target for the overnight interest rate and
eventually decreases MS (or its growth rate)  This action
shifts AD to the left.
Two separate channels in transmission mechanism: Change in
interest rate leads to changes in C and I. At the same time it
changes international capital flows and hence exchange rate
(and thereby X-IM).
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28.2 Inflation Targeting
Why Target Inflation?
Starting 1991, BoC targets to keep inflation rate between 1
and 3% or 2%.
Reasons:
1. High inflation is damaging for economy. For example if prices
double, say, everyday, we want to buy now and make
frequent trips to glocery stores and malls. If all households
do it, then we would be spending too much time shopping
instead of productive activities.
2. Monetary policy can be used to control inflation. If Y > Y*,
BoC can use contractionary policy (increase in r) to control
inflation (that might happen due to shit of AS to the left.
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Inflation Targeting as a Stabilizing Policy
Inflation targeting tends to stabilize output; that is keep Y
close to Y*
a) Use expansionary policy when Y < Y*
b) Use contractionary policy when Y > Y*.
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Complications in Inflation Targeting
1. Volatile Food and Energy Prices
- Prices of many goods included in CPI are determined in
world markets (for example: oil, fruits and vegetables).
- These may change suddenly for reasons unrelated to
Canadian output gaps. For example, On 8 March 2020,
Saudi Arabia initiated a price war with Russia, triggering a
fall in the price of crude oil by 26%.
- Thus the inflation caused by these prices change has little
implication for Canadian monetary policy.
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BoC ignores the price fluctuations of these volatile goods (oil,
vegetables and fruits) and monitors only core inflation (that
ignores these goods). The green line indicats Core Inflation,
which is much stable than CPI inflation.
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2. The Exchange Rate and Monetary Policy.
(1) If Canadian dollar appreciates due to higher exports,
BoC can offset the positive AD shock by tightening the
monetary policy (increase in r). Note increase in r will
shift AD to the left.
(2) On the other hand if Canadian dollar appreciates due
to higher demand for Canadian bonds and assets, it will
lower Canadian exports (due to stronger Canadian $). In
this case BoC can offset this by loosening
(expansionary) monetary policy.
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The Role of Money in the Great Depression:
During the great depression, Federal Reserve did
not supply more money to meet the increased
demand for liquidity (credits).
As a result many banks failed in the US and a severe
recession ensued.
In Canada although the BoC helped the banking
system (and no banks collapsed), Canada had the
same level of depression as in the US.
This led some to raise a question on the
effectiveness of monetary policy.
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Canadian Experience and Lessons:
Keynesians argue that since Canada had the same level
of depression as US despite more money supply,
monetary policy could not be the cause of recession.
Monetarists counter argue that less money supply in
the US caused recession in the US and that spilled over
to Canada.
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Two Views on Great Depression:
a) Monetarists argued that fall in money supply caused
recession in the US.
b) Keynesians, on the other hand, argued that the root
cause of depression was fall in autonomous
expenditure (mainly caused by pessimism).
If MD is completely horizontal, then monetary policy would
be completely ineffective. We call this liquidity trap.
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28.3 Long and Variable Lags
What Are the Lags in Monetary Policy?
Monetary policy operates with a time lag:
(1) changes in expenditure take time. Just because interest is
lower does not mean households starts buying and
businesses start investing right away.
(2) As a result (of slow response), multiplier process takes
time.
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Destabilizing Policy?
 Due to time lag in Monetary policy to take effect,
monetary policy can sometimes be destabilizing.
 For example, in response to Y < Y*, say the BoC
reduces overnight rate. If the effect takes a long time
to kick in and by that time if due to some other
reason(s) the economy starts having Y > Y*, then the
previous policy can do more harm than help in
stabilizing the economy.
 For this reason, monetary policy must be forwardlooking or consider what might happen after one year.
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Quiz 1
1. Suppose the Bank of Canada lowers its target for the
overnight interest rate. In this case, the commercial banks
respond to the resulting ______
A) decrease in the demand for loans by selling government
securities to the Bank of Canada.
B) decrease in the demand for loans by buying
government securities from the Bank of Canada in
exchange for cash.
C) increase in the demand for loans by buying government
securities from the Bank of Canada, against which they
can extend new loans.
D) increase in the demand for loans by selling government
securities to the Bank of Canada in exchange for cash.
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Quiz 2
2. What is the likely policy response by the Bank of
Canada when the economy is experiencing an inflationary
gap?
A) A contractionary monetary policy which leads to a
reduction in investment demand.
B) An expansionary monetary policy which leads to a
decrease in investment demand.
C) A contractionary monetary policy which leads to an
increase in investment demand.
D) An expansionary monetary policy which leads to an
increase in investment demand.
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Quiz 3
3. Given its existing policy regime of "inflation targeting,"
the Bank of Canada would likely react to a large positive
aggregate demand shock by ___________.
A) increasing its target for the overnight interest rate.
B) buying bonds from the open market.
C) decreasing its target for the overnight interest rate.
D) lowering the bank rate.
E) ignoring the shock and allowing the economy to adjust
on its own.
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Quiz 4
4. Suppose output is at its potential level and then there is a
sudden increase in food and energy prices. This increase
_________
A) would be offset by a decline in the Canadian dollar and
so the BOC does not need to take any policy action.
B) makes inflation targeting easier and the BOC responds
by decreasing overnight rate.
C) makes inflation targeting easier and the BOC responds
by increasing overnight rate.
D) would not lead to an immediate policy response because
this change does not affect "core" inflation.
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Quiz 5
5. The BOC changes interest rates directly rather than
changing the money supply because _________________
A) The BOC cannot control the process of deposit
expansion.
B) The BOC may not have information on money demand
and its fluctuations (slope and its position).
C) It is easier to communicate policy through changes in
interest rates.
D) It is easier for the public to see what it means when
interest rate changes.
E) All of the above.
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