EDITragan_12ce_ch29

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Chapter 29
Monetary Policy
in Canada
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In this chapter you will learn
1. why the Bank of Canada chooses to set interest rates
rather than directly influence 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.
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In this chapter you will learn
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.
6. about the main economic challenges that the Bank of
Canada has faced over the past three decades.
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29.1 HOW THE BANK OF CANADA
IMPLEMENTS MONETARY POLICY
Money Supply Versus the Interest Rate
For any given money demand curve, any central bank must
choose between:
- setting the money supply
- setting the interest rate
Both cannot be set independently.
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How could the Bank of Canada actually try to increase the MS?
1. Simply lend reserves to commercial banks
2. Open Market Operations
1. B of C buys G of C bonds in the open market
2. B of C pays for the bonds by writing a cheque cashable at the B of C
3. Seller of G of C bonds deposits the cheque in her commercial bank
account
4. Her commercial bank deposits the cheque at the B of C –
commercial bank reserves have just increased
How to decrease the MS? Do the reverse
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Actually, the Bank of Canada chooses to implement its
monetary policy by setting interest rates because:
1. the Bank can influence an interest rate more
easily than it can affect the money supply.
2. the instability of money demand.
3. it is easier to communicate its policy through
changes in interest rates.
Trying to control the money supply turns out to be too
imprecise in practice.
But which interest rate (of many) does the Bank influence?
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The Bank of Canada and
the Overnight Interest Rate
The Overnight Interest Rate
Commercial banks borrow and lend reserves to each other
overnight.
The Overnight Interest Rate is the interest rate in this
overnight market.
You can think of this rate as the cost of reserves to
commercial banks.
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The Bank of Canada can more-or-less control the overnight
interest rate. It does this by:
1. Setting a target for the overnight interest rate
2. Establishing the Bank Rate 0.25% above this target
B of C will lend any amount of reserves at this rate
3. Establishing a borrowing rate 0.25% below target
B of C will borrow any amount of reserves at this rate
 keep actual overnight rate within 0.5% band
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Setting the Overnight Rate
B of C will lend any amount of reserves at the Bank Rate,
so the Overnight Rate should never go above the Bank Rate
RS
B of C will borrow any amount of
reserves at the Target Rate less
0.25%,
so the Overnight Rate should
never go below the Bank Rate
RD
B of C covers any excess supply
of or excess demand for
reserves.
excess supply
Bank
Rate
•
Target
rate
TR-0.25%
excess demand
Quantity of Reserves
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Can it really do this? Yes.
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The Money Supply Is Endogenous
As the Bank of Canada changes its target for the overnight
rate:
- other interest rates change (very quickly)
- bank lending changes (more slowly)
- banks’ demand for currency changes (as lending
changes)
 the Bank of Canada responds by supplying
currency or buying currency from commercial banks
 the need for open-market operations
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But these transactions are done passively by the Bank of
Canada:
 the money supply is endogenous
APPLYING ECONOMIC CONCEPTS 29-1
What Determines the Amount of
Currency in Circulation?
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Expansionary and Contractionary Monetary
Policies
An expansionary monetary policy occurs when the Bank of
Canada reduces its target for the overnight interest rate
 eventually increases MS (or its growth rate)
A contractionary monetary policy occurs when the Bank of
Canada increases its target for the overnight interest rate
 eventually decreases MS (or its growth rate)
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29.2 INFLATION TARGETING
Why Target Inflation?
Over the past few decades, central banks have come to
realize two things:
1. High inflation is costly for individuals and
damaging for economies.
- affects those on incomes fixed in nominal terms
- high inflation is associated with volatility in inflation
(unexpected inflation) results in real income reallocation –
borrowers/lenders, workers/firms, etc.
- distorts our ability to perceive relative price changes
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Why Target Inflation?
Over the past few decades, central banks have come to
realize two things:
2. Inflation is the one variable on which monetary
policy can have a systematic and sustained
influence.
exogenous AD and AS shocks can cause isolated
periods of inflation but only accommodating monetary policy
can cause sustained inflations.
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Price Level
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P1
P0
AS0
•
•
E1
E0
AD1
Monetary policy can have
short-run real effects and
is useful in helping end
recessions.
AD0
Y0 Y*
Real GDP
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Price Level
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AS0
• E0
P0
•
P1
Monetary policy can have
short-run real effects and
is useful in helping end
inflationary booms
but it cannot directly affect Y*
E1
AD1
Y* Y0
Real GDP
How does the B of C know that a positive or negative output gap exists?
It monitors the rate of inflation
Why not output or employment/unemployment?
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Recognition of these points has led many central banks to
adopt formal inflation targets:
- New Zealand (1990)
- Canada (1991)
- Israel, U.K., Australia
- Finland, Spain, Sweden
- plus many others
Canada has renewed its inflation targets several times since
1991:
- the current target of 1% lasts until December 2011
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The Role of the Output Gap
In the short run, when an output gap opens, the Bank has two
choices:
- allow the adjustment process to operate
- intervene with monetary policy
Since output gaps put pressure on inflation, the Bank monitors
the output gap and may intervene in order to keep output near
potential
- thereby keeping inflation within the target band
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Bank’s policy
closes gap
Output Gap
Positive shock
opens gap
Time
0
Bank’s policy
closes gap
Inflation Rate
Negative shock
opens gap
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3%
Inflation target
band
2%
1%
t0
t1
t2
t3
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Time
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Inflation Targeting as a Stabilizing Policy
As the previous diagram suggests, inflation targeting tends to
stabilize output:
- in response to a positive output shock, the Bank
tightens policy
- in response to a negative output shock, the Bank
loosens policy
 policy tends to keep output close to Y*
But this is not automatic stabilization — the Bank must
actively change policy.
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Complications in Inflation Targeting
Inflation targeting is complicated by two factors:
1. Volatile Food and Energy Prices
- prices of many goods included in CPI are determined
in world markets
- these may change suddenly for reasons unrelated to
Canadian output gaps
 the Bank also monitors core inflation
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2. The Exchange Rate and Monetary Policy
- the Bank must identify the cause of any exchange
rate change before determining the appropriate
policy response
- consider an appreciation of the Canadian dollar
caused by an increase in demand for exports
(contractionary monetary policy)
- or an appreciation of the Canadian dollar caused by
an increase in demand for Canadian bonds
(expansionary monetary policy)
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The appropriate response by the Bank would be different in
these two cases.
For a more detailed discussion of how movements in the
exchange rate complicate the implementation of monetary
policy, look for “Monetary Policy and the Exchange Rate
in Canada” in the Additional Topics section of this book’s
MyEconLab.
www.myeconlab.com
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Not in Text
3. Asset price bubbles
What if the money supply is increased and interest rates fall but
the lower interest rates and increased credit do not lead to an increase in
the demand for current output?
What if the lower interest rates and increased credit lead for an
increase in the demand for existing assets (houses, real estate, ‘dot com’
stocks, equities, gold, etc).
If the central bank is targeting inflation it will largely miss this
asset price inflation – it could easily start a price bubble for a class of
assets. People buying the asset whose price is rising with borrowed
money (speculating) – the price bubble burst, the asset price falls and
they default on their borrowings. (money is credit) The banking system
is in now trouble. Sound familiar?
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29.3 LONG AND VARIABLE LAGS
What Are the Lags in Monetary Policy?
Monetary policy operates with a time lag that is long and
variable for two main reasons:
• changes in expenditure take time
• the multiplier process takes time
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LESSONS FROM HISTORY 29-1
Two Views on the Role of Money in
the Great Depression
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Destabilizing Policy?
Long and variable lags  some monetarists argued that
central banks should not try to stabilize national income.
They argued that attempts to stabilize will more likely be
destabilizing
- they advocate the use of a monetary rule
- increase bank reserves at a constant rate
Most economists now agree that monetary policy can lead
to more economic stability. ????
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Rate of Inflation
Political Difficulties
3%
Actual Inflation
1%
Bank of
Canada’s
target inflation
band
A
•
Inflation Forecast
Current
Period
Time
Monetary policy must be forward-looking.
 often creates difficulties when policy is tightened
now because of expected future inflation
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29.4 30 YEARS OF CANADIAN
OPTIONAL
MONETARY POLICY
Early 1980s:
- inflation reached 12 percent as a result of OPEC oil
shocks in the mid and late 1970s
- the Bank embarked on a strict policy of monetary
restraint
- but unanticipated surge in money demand led to a
much tighter monetary policy than intended
 the most serious recession since the 1930s
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OPTIONAL
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Economic Recovery: 1983-1987
OPTIONAL
The main challenge was creating sufficient liquidity to
accommodate the recovery without triggering a return to the
high inflation rates.
Rising Inflation: 1987-1990
Inflation crept upwards throughout the late 1980s.
Many economists argued the need for tightening monetary
policy.
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Disinflation: 1990-1992
OPTIONAL
The Bank of Canada embarked on its stated policy of “price
stability.”
When the tight monetary policy took effect:
- interest rates increased
- the Canadian dollar appreciated
- inflation fell suddenly
The economy entered a significant recession in the early
1990s.
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Inflation Targeting I: 1991-2000
OPTIONAL
The ensuing economic recovery was quite gradual:
- excessive stimulation could have led to a return of
inflation
- insufficient stimulation could have caused the
economy to stall
Beginning in 1996, the recovery was more robust and
inflation remained well within the 1 to 3 percent target band.
By 2000, Canadian GDP was near its potential level and
inflation was just below 2 percent and quite stable.
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Two issues complicated monetary policy in the late 1990s:
OPTIONAL
1. The Asian Crisis
This presented a (confusing) combination of aggregate
demand and aggregate supply shocks.
2. The Stock Market
The “bull market” of the late 1990s presented some
challenges — how should monetary policy respond?
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Inflation Targeting II: 2001-Present
OPTIONAL
The terrorist attacks of 9/11 presented substantial
challenges for monetary policy:
- the U.S. economy was already slowing down
- policy interest rates were dramatically reduced
The 2002-2006 period presented other challenges:
- commodity prices were rising sharply
- U.S. dollar was weakening against most currencies
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OPTIONAL
With the success of many central banks in maintaining
low and stable inflation, some economists have raised
the concern that inflation may now be “too low,” and that
the economy may actually function more smoothly with
slightly higher inflation. For more details about this
contentious debate, look for “Can Inflation Be Too Low?”
in the Additional Topics section of this book’s MyEconLab.
www.myeconlab.com
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