A Lecture Presentation
in PowerPoint
to accompany
Exploring Economics
by Robert L. Sexton
and Peter Fortura
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
Chapter 18
The Bank of Canada and
Monetary Policy
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.1 The Bank of Canada
In most countries of the world, the
job of controlling the supply of
money belongs to the central bank.
 The Bank of Canada is Canada’s
central bank

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.1 The Bank of Canada
It was established in 1935 as a
result of the economic problems of
the Great Depression
 By having a central bank, the
money supply can be adjusted

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.
18.1 The Bank of Canada

The Bank of Canada
is owned by the federal government
 is controlled by a governor appointed
for a seven year term
 Is controlled by a board of directors
 Has recently adopted and explicit
inflation-control strategy

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.
18.1 The Bank of Canada

has objectives outlined in the Bank of
Canada Act:
 “.
. .to regulate credit and currency in the
best interests of the economic life of the
nation, to control and protect the
external value of the national monetary
unit and to mitigate by its influence
fluctuations in the general level of
production, trade, prices and
employment. . . generally to promote the
economic and financial welfare of
Canada.”
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18.1 The Bank of Canada

5 Functions of the Bank of Canada





First, it issues currency for circulation in
Canada
Second it acts as a bank to the federal
government.
Third it serves as a "banker's bank." to
chartered banks
Fourth it serves as “lender of last resort” to
charter banks to maintain stability.
Fifth, it controls the money supply
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18.1 The Bank of Canada
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18.2 The Equation of Exchange


Perhaps the most important function of
the Bank of Canada is its ability to
regulate the money supply.
In order to fully understand the
significant role that the Bank of Canada
plays in the economy, we will first
examine the role of money in the
national economy.
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18.2 The Equation of Exchange

In the early part of this century,
economists noted a useful relationship
that helps our understanding of the role
of money in the national economy.
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18.2 The Equation of Exchange

The relationship, called the equation of
exchange, can be presented as:
M  V = P  Q,
where
M is the money supply,
V is the income velocity of money,
P is the average prices of final goods and
services, and
Q is the physical quantity of final goods and
services produced in a given period
(usually one year).
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18.2 The Equation of Exchange

V represents the average number of
times that a dollar is used in purchasing
final goods or services in a one-year
period.
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.
18.2 The Equation of Exchange


If individuals are hoarding their money,
velocity will be low.
If individuals are writing lots of cheques
on their chequing accounts and
spending currency as fast as they
receive it, velocity will tend to be high.
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18.2 The Equation of Exchange



The expression P  Q represents the
dollar value of all final goods and
services sold in a country in a given
year.
But that is the definition of nominal
gross domestic product (GDP).
Thus, the average level of prices (P)
times the physical quantity of final
goods and services (Q) equals nominal
GDP.
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18.2 The Equation of Exchange

The quantity equation of money could
also be expressed as: M  V = Nominal
GDP, or V = Nominal GDP/M. That, in
fact, is the definition of velocity

The total output of goods divided by the
amount of money is the same thing as the
average number of times a dollar is used in
final goods transactions in a year.
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18.2 The Equation of Exchange

The magnitude of V will depend on the
definition of money that is used. The
average dollar of money turns over a
few times in the course of a year, with
the precise number depending on the
definition of money.
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18.2 The Equation of Exchange


The equation of exchange is a useful
tool when we try to assess the impact in
a change in the money supply (M) on
the aggregate economy.
If M increases, then one of the following
must happen:



V must decline by the same magnitude, so
that M  V remains constant, leaving P  Q
unchanged;
P must rise
Y must rise
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18.2 The Equation of Exchange
Or P and Q must each rise some, so
that the product of P and Q remains
equal to
M  V.
 If the money supply increases and the
velocity of money does not change,
there will be either higher prices
(inflation), greater real output of
goods and services, or a combination
of both.

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.
18.2 The Equation of Exchange

If one considers a macroeconomic
policy to be successful when real output
is increased but unsuccessful when the
only effect of the policy is inflation, an
increase in M is a good policy if Q
increases but a bad policy if P
increases.
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18.2 The Equation of Exchange


Dampening the rate of increase in M or
even causing it to decline will cause
nominal GDP to fall, unless the change
in M is counteracted by a rising velocity
of money.
Intentionally decreasing M can also
either be good or bad, depending on
whether the declining money GDP is
reflected mainly in falling prices (P) or in
falling real output (Q).
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18.2 The Equation of Exchange

Expanding the money supply, unless
counteracted by increased hoarding of
currency (leading to a decline in V), will
have the same type of impact on
aggregate demand as an expansionary
fiscal policy:



increasing government purchases,
reducing taxes, or
increases in transfer payments.
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.
18.2 The Equation of Exchange


Likewise, policies designed to reduce
the money supply will have a
contractionary impact (unless offset by
a rising velocity of money) on aggregate
demand.
This is similar to the impact obtained
from increasing taxes, decreasing
transfer payments, or decreasing
government purchases.
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18.2 The Equation of Exchange


What the quantity equation of exchange
relationship illustrates is that monetary
policy can be used to obtain the same
objectives as fiscal policy.
Some economists, often called
monetarists, believe that monetary
policy is the most powerful determinant
of macroeconomic results.
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18.2 The Equation of Exchange




Economists once considered the
velocity of money a given.
We now know that it is not constant, but
it often moves in a fairly predictable
pattern over a long period of time.
Thus, the connection between money
supply and GDP is still fairly predictable
However, velocity is less stable when
measured over shorter periods of time
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.
18.2 The Equation of Exchange



For example, an increase in velocity can
occur with anticipated inflation.
When individuals expect inflation, they
will spend their money more quickly.
They don't want to be caught with
money that is going to be worth less in
the future.
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18.2 The Equation of Exchange


Also, an increase in the interest rates
will cause people to hold less money
because people want to hold less
money when the opportunity cost of
holding money increases.
This, in turn, means that the velocity of
money increases.
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18.2 The Equation of Exchange



There is international support for the
fact that the inflation rate tends to rise
more in periods of rapid monetary
expansion.
The relationship is particularly strong
with hyperinflation, as illustrated by the
hyperinflation in Germany in the 1920s.
The cause of hyperinflation is simply
excessive money growth.
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18.3 Implementing Monetary
Policy: Tools of the Bank of Canada

As noted previously, the most important
function of the Bank of Canada is to
regulate the supply of money, called the
Monetary Policy

The Bank of Canada decides whether to
change policies to expand the supply of
money and, hopefully, the real level of
economic activity, or to contract the
money supply, hoping to cool
inflationary pressures.
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18.3 Implementing Monetary
Policy: Tools of the Bank of Canada

The Bank of Canada controls the supply
of money, even though privately owned
Chartered banks actually create and
destroy money by making loans.
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18.3 Implementing Monetary
Policy: Tools of the Bank of Canada

The Bank of Canada has two major
methods to control the supply of money




open market operations
change its bank rate.
Of these tools, the Bank of Canada
uses open market operations the most.
It is by far the most important device
used to influence the money supply.
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18.3 Implementing Monetary
Policy: Tools of the Bank of Canada


Open market operations involve
the purchase and sale of government
securities by the Bank of Canada
For several reasons, open market
operations are the most important
method the Bank of Canada uses to
change the supply of money.
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18.3 Implementing Monetary
Policy: Tools of the Bank of Canada


It can be done quietly, without a lot of
political debate or a public
announcement.
It is also a rather powerful tool, as any
given purchase or sale of securities
usually has an ultimate impact on the
money supply of several times the
amount of the initial transaction.
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.
18.3 Implementing Monetary
Policy: Tools of the Bank of Canada


Suppose Loans R Us Bank has no
excess reserves and one of its
customers, an investment dealer, sells a
bond for $10 000 to the Bank of
Canada.
The customer deposits the cheque from
the Bank of Canada for $10 000 in an
account, and the Bank of Canada
credits the Loans R Us Bank with $10
000 in reserves.
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18.3 Implementing Monetary
Policy: Tools of the Bank of Canada


Suppose the desired reserve is 10
percent.
The Loans R Us Bank only needs new
reserves of $1 000 ($10 000  .10) to
support its $10 000, meaning that it has
acquired $9 000 in new excess reserves
($10 000 new actual reserves minus $1
000 in new desired reserves).
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18.3 Implementing Monetary
Policy: Tools of the Bank of Canada


Loans R Us can, and probably will, lend
out its excess reserves of $9 000,
creating $9 000 in new deposits in the
process.
The recipients of the loans, in turn, will
likely spend the money, leading to still
more new deposits and excess reserves
in other banks.
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18.3 Implementing Monetary
Policy: Tools of the Bank of Canada

The Bank of Canada’s $10 000 bond
purchase directly creates $10 000 in
money in the form of demand deposits,
and indirectly permits up to $90 000 in
additional money to be created through
the multiple expansion in bank deposits.
 The money multiplier is the reciprocal
of the desired reserve ,1/10, or 10.
10  $9 000 = $90 000.
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.
18.3 Implementing Monetary
Policy: Tools of the Bank of Canada

If the desired reserve is 10 percent, a
total of up to $100 000 in new money is
potentially created by the purchase of
one $10 000 bond by the Bank of
Canada.
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18.3 Implementing Monetary
Policy: Tools of the Bank of Canada



The process works in reverse when the
Bank of Canada sells a bond.
The investment dealer purchasing the
bond will pay the Bank of Canada by
cheque, lowering demand deposits in
the banking system.
Reserves of the bank where the
investment dealer has a bank account
will likewise fall.
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.
18.3 Implementing Monetary
Policy: Tools of the Bank of Canada


If the bank had zero excess reserves at
the beginning of the process, it will now
be short of reserves. The bank will
likely reduce its volume of loans which
will lead to a further reduction of
demand
A multiple contraction of deposits and
money will begin.
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.
18.3 Implementing Monetary
Policy: Tools of the Bank of Canada

Generally, in a growing economy where
the real value of goods and services is
increasing over time, an increase in the
supply of money is needed even to
maintain stable prices.
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.
18.3 Implementing Monetary
Policy: Tools of the Bank of Canada

If the velocity of money (V) in the
equation of exchange is fairly constant
and real GDP (denoted by Q in the
equation of exchange) is rising between
3 and 4 percent a year then a 3 or 4
percent increase in M is consistent with
stable prices.
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.
18.3 Implementing Monetary Policy:
Tools of the Bank of Canada

In periods of rising prices (meaning M 
V would be rising considerably), if V is
fairly constant, the growth of M likely will
exceed the 3 to 4 percent annual
growth, seemingly consistent with
long-term price stability.
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.
18.3 Implementing Monetary
Policy: Tools of the Bank of Canada



Chartered banks operate with a very
small portion of their deposits as
reserves.
The main reason they are able to
operate with a low reserve ration is that
they are able to borrow from The Bank
of Canada
The interest rate that the Bank of
Canada charges of these borrowed
reserves is called the bank rate.
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.
18.3 Implementing Monetary
Policy: Tools of the Bank of Canada



If the Bank of Canada raises the bank
rate, it makes it more costly for banks to
borrow funds.
The higher the interest rate banks have
to pay, the lower the potential profit from
any new loans.
Thus fewer loans will be made and less
money created
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.
18.3 Implementing Monetary
Policy: Tools of the Bank of Canada



If the Bank of Canada wants to contract
the money supply, it will raise the rate.
Conversely, if the Bank of Canada
wants to expand the money supply, it
will lower the bank rate, making it
cheaper to borrow funds.
The lower the interest rate, the higher
the potential profit from new loans, so
more new loans will be made and more
money created.
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.
18.3 Implementing Monetary
Policy: Tools of the Bank of Canada

The Bank of Canada sets the bank rate
in relation to the overnight interest
rate.


The overnight interest rate is that rate
chartered banks charge each other for
one day loans.
The Bank of Canada sets a range for
the overnight interest rate by using the
bank rate as the upper limit.
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.
18.3 Implementing Monetary
Policy: Tools of the Bank of Canada



Say the Bank of Canada sets the bank
rate at 3.25 percent.
Chartered banks can borrow funds from
the Bank of Canada for 3.25 percent.
At the same time the Bank of Canada
pays chartered banks interest on their
reserve deposits stored with the Bank of
Canada.
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.
18.3 Implementing Monetary
Policy: Tools of the Bank of Canada



The rate paid to chartered banks on
their reserve deposits is called the
bankers’ deposit rate.
The bankers’ deposit rate is set at the
bank rate minus one-half of one
percentage point.
In this case, the bankers’ deposit rate
would be 2.75 percent.
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.
18.3 Implementing Monetary
Policy: Tools of the Bank of Canada



If a chartered bank needed to borrow
reserve money overnight, it would first
try to borrow from another bank that had
excess reserves.
The overnight rate will fall somewhere
between 2.75 per cent and 3.25
percent.
The first bank will not borrow from the
second bank for more than 3.25 per
cent since it can borrow funds from the
Bank of Canada for that rate.
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.
18.3 Implementing Monetary
Policy: Tools of the Bank of Canada


Likewise the second bank will not lend
reserves to the first bank for less than
2.75 percent, since it can earn that from
the Bank of Canada.
The banks will come to an agreement
as to a rate, of say 3.0 per cent, since
that would benefit the bank borrowing
reserve funds and the bank lending.
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.
18.3 Implementing Monetary
Policy: Tools of the Bank of Canada

The Bank of Canada can do two things
if it wants to reduce the money supply.




sell bonds
raise the bank rate
or a combination of the two
These moves would decrease
aggregate demand, reducing nominal
GDP, hopefully through a decrease in P
rather than Q.
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.
18.3 Implementing Monetary
Policy: Tools of the Bank of Canada

These actions would be the monetary
policy equivalent of a fiscal policy of
raising taxes, lowering transfer
payments, and/or lowering government
purchases.
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.
18.3 Implementing Monetary
Policy: Tools of the Bank of Canada

If the Bank of Canada is concerned
about underutilization of resources (e.g.,
unemployment), it would engage in
precisely the opposite policies



buy bonds
lower the bank rate
These moves would tend to increase
aggregate demand raising nominal
GDP, hopefully through an increase in
Q (in the context of the equation of
exchange) rather than P.
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.
18.3 Implementing Monetary Policy:
Tools of the Bank of Canada


The government could use some
combination of these approaches.
Equivalent expansionary fiscal policy
actions would be to reduce taxes,
increase transfer payments, and/or
increase government purchases.
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.
18.4 Money, Interest Rates, and
Aggregate Demand

The Bank of Canada's policies with
respect to the supply of money has a
direct impact on short-run real interest
rates, and accordingly, on the
components of aggregate demand.

The money market is the market
where money demand and money
supply determine the equilibrium
nominal interest rate.
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.
18.4 Money, Interest Rates, and
Aggregate Demand


When the Bank of Canada acts to
change the money supply, it alters the
money market equilibrium.
People have three basic motives for
holding money instead of other assets:



transactions purposes,
precautionary reasons,
asset purposes.
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18.4 Money, Interest Rates, and
Aggregate Demand


The quantity of money demanded varies
inversely with the rate of interest.
When interest rates are higher, the
opportunity cost in terms of the interest
income on alternative assets forgone of
holding monetary assets is higher, and
persons will want to hold less money for
each of these reasons.
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18.4 Money, Interest Rates, and
Aggregate Demand


At the same time, the demand for
money, particularly for transactions
purposes, is highly dependent on
income levels because the transactions
volume varies directly with income.
And lastly, the demand for money
depends on the price level.
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.
18.4 Money, Interest Rates, and
Aggregate Demand


If the price level increases, buyers will
need more money to purchase their
goods and services.
Or if the price level falls, buyers will
need less money to purchase their
goods and services.
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.
18.4 Money, Interest Rates, and
Aggregate Demand

At lower interest rates, the quantity of
money demanded, but not the demand
for money, is greater. An increase in
income will lead to an increase in the
demand for money, depicted by a
rightward shift in the money demand
curve.
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.
Nominal Interest Rates
Money Demand, Interest Rates, and Income
A  B = Increase in
the quantity of
money demanded
I0
A
C
B
I1
A  C = Increase in
the demand
for money
MD1
MD0
Q0
Q1 Q2
Quantity of Money
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.
18.4 Money, Interest Rates, and
Aggregate Demand

The supply of money is largely
governed by the regulatory policies of
the central bank.
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.
18.4 Money, Interest Rates, and
Aggregate Demand

Whether interest rates are 4 percent or
14 percent, banks seeking to maximize
profits will increase lending as long as
they have reserves above their desired
level because even a 4 percent return
on loans provides more profit than
maintaining those assets in noninterestbearing cash.
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.
18.4 Money, Interest Rates, and
Aggregate Demand


The supply of money is effectively
almost perfectly inelastic with respect to
interest rates over their plausible range,
controlled by Bank of Canada policies,
which determine the level of bank
reserves and the money multiplier.
Therefore, we draw the money supply
curve as vertical, other things equal,
with changes in Bank of Canada
policies acting to shift the money supply
curve.
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.
18.4 Money, Interest Rates, and
Aggregate Demand

Combining the money demand and
money supply curves, money market
equilibrium occurs at that nominal
interest rate where the quantity of
money demanded equals the quantity of
money supplied.
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.
18.4 Money, Interest Rates, and
Aggregate Demand


Rising national income will increase the
amount of money that people want to
hold at any given interest rate; therefore
shifting the demand for money to the
right, leading to a new higher
equilibrium nominal interest rate.
An increase in the money supply lowers
the equilibrium nominal interest rate .
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.
Nominal Interest Rates
Changes in the Money Market Equilibrium
MS0
MS1
B
I1
C
I2
A
I0
MD1
MD0
Q0
Q1
Quantity of Money
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.
18.4 Money, Interest Rates, and
Aggregate Demand

Say the Bank of Canada wants to
pursue an expansionary monetary
policy to increase aggregate demand.


It will buy bonds on the open market,
increasing the the demand for bonds
causing an increase in the price of bonds.
Bond sellers will deposit their cheques
from the Bank of Canada, increasing the
money supply.
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.
18.4 Money, Interest Rates, and
Aggregate Demand


The immediate impact of expansionary
monetary policy is to decrease interest
rates.
The lower interest rate, or the fall in the
cost of borrowing money, then leads to
an increase in aggregate demand for
goods and services at each and every
price level.
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.
18.4 Money, Interest Rates, and
Aggregate Demand


The lower interest rate will increase
home sales, car sales, business
investments, and so on.
That is, an increase in the money
supply will lead to lower interest rates
and an increase in aggregate demand.
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.
The Bank of Canada Buys Bonds, Increases
the Money Supply
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.
18.4 Money, Interest Rates, and
Aggregate Demand


Suppose the Bank of Canada wants to
pursue a contractionary monetary policy
to reduce aggregate demand.
It will sell bonds on the open market,
lowering the price of bonds.
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.
18.4 Money, Interest Rates, and
Aggregate Demand


The purchasers of bonds take the
money out of their chequing account to
pay for the bond, and bank reserves are
reduced by the amount of the cheque.
This reduction in reserves leads to a
reduction in the supply of money, which
leads to an increase in the interest rate
in the money market.
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.
18.4 Money, Interest Rates, and
Aggregate Demand


The higher interest rate then leads to a
reduction in aggregate demand for
goods and services.
In sum, when the The Bank of Canada
sells bonds, it



lowers the price of bonds,
raises interest rates and
reduces aggregate demand, at least in
the short run.
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.
The Bank of Canada Sells Bonds,
Decreases the Money Supply
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.
18.4 Money, Interest Rates, and
Aggregate Demand

There is an inverse correlation between
the interest rate and the price of bonds.


When the price of bonds falls, the interest
rate rises.
When the price of bonds rises, the interest
rate falls.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.4 Money, Interest Rates, and
Aggregate Demand



Some economists believe the Bank of
Canada should try to control the money
supply
Others believe the Bank of Canada
should try to control the interest rate.
The Bank of Canada cannot do both: it
must pick one or the other.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.4 Money, Interest Rates, and
Aggregate Demand

Suppose the demand for money
increases.
 If the Bank of Canada doesn’t allow
the money supply to increase, interest
rates will rise and aggregate demand
will fall.
 If the Bank of Canada wants to keep
the interest rate stable, it will have to
increase the money supply.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
Nominal Interest Rate
Bank of Canada Targeting: Money Supply
Versus the Interest Rate
MS0
MS1
C
i1
A
i0
B
MD1
MD0
Q0
Q1
Quantity of Money
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.4 Money, Interest Rates, and
Aggregate Demand


The problem with targeting the money
supply is that the demand for money
fluctuates considerably in the short run.
Focusing on the growth in the money
supply when the demand for money is
changing unpredictably will lead to large
fluctuations in the interest rate, which
can seriously disrupt the investment
climate.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.4 Money, Interest Rates, and
Aggregate Demand


Keeping interest rates in check would
also create problems.
When the economy grows, the demand
for money also grows, so the Bank of
Canada would have to increase the
money supply to keep interest rates
from rising.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.4 Money, Interest Rates, and
Aggregate Demand


If the economy was in a recession, the
Bank of Canada would have to contract
the money supply.
This would lead to the wrong policy
prescription.


Expanding the money supply during a
boom would eventually lead to inflation.
Contracting the money supply during a
recession would worsen the recession.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.4 Money, Interest Rates, and
Aggregate Demand


The Bank of Canada targets the
overnight interest rate and has been
doing so since 1996.
Announcements regarding the overnight
interest rate are made by the Bank of
Canada on eight pre-specified dates
during the year.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.4 Money, Interest Rates, and
Aggregate Demand

Why is the interest rate used?



Changes in the demand for money can
significantly affect money supply targets
Many economists believe that the primary
effects of monetary policy are felt through
the interest rate
People are more familiar with changes in
the interest rates rather than changes in
the money supply
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.4 Money, Interest Rates, and
Aggregate Demand



Monetary policy actions can be
conveyed through either the money
supply or the interest rate.
A contractionary policy can be thought
of as a decrease in the money supply or
an increase in the interest rate.
An expansionary policy can be thought
of as an increase in the money supply
or a decrease in the interest rate.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.4 Money, Interest Rates, and
Aggregate Demand



The real interest rate is determined by
investment demand and saving supply.
The nominal interest rate is determined
by the demand and supply of money.
Many economist believe that in the
short run, the Bank of Canada can
control the nominal interest rate and the
real interest rate.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.4 Money, Interest Rates, and
Aggregate Demand


The real interest rate is equal to the
nominal interest rate minus the
expected inflation rate.
So a change in the nominal interest rate
tends to change the real interest rate by
the same amount because the expected
inflation rate is slow to change in the
short run.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.4 Money, Interest Rates, and
Aggregate Demand

However, in the long run, after the
inflation rate has adjusted, the real
interest rate is determined by the
intersection of the saving supply and
investment demand curve.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.5 Expansionary and
Contractionary Monetary Policy

An increase in AD through monetary
policy can lead to an increase in real
GDP if the economy is initially operating
at less than full employment.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
Expansionary Monetary Policy at Less Than
Full Employment
LRAS
Price Level
SRAS
PL1
PL0
E0
E1
AD1
AD0
RGDP0 RGDPNR
RGDP
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.5 Expansionary and
Contractionary Monetary Policy

An increase in AD through monetary
policy can lead to only a temporary,
short-run increase in real GDP, if the
economy is initially operating at or
above full employment, with no long-run
effect on output or employment.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
Expansionary Monetary Policy at Full
Employment
Price Level
LRAS
SRAS1
SRAS0
E2
PL2
E1
PL1
PL0
E0
AD1
AD0
RGDPNR RGDP1
RGDP
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.5 Expansionary and
Contractionary Monetary Policy


A contractionary monetary policy would
reduce aggregate demand.
When the economy is temporarily
beyond full employment, an appropriate
countercyclical monetary policy would
shift the aggregate demand curve
leftward, to combat a potential
inflationary boom.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
Contractionary Monetary Policy Beyond Full
Employment
Price Level
LRAS
SRAS
E0
PL0
PL1
E1
AD0
AD1
RGDPNR RGDP0
RGDP
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.5 Expansionary and
Contractionary Monetary Policy

If the Bank of Canada pursues a
contractionary monetary policy when
the economy is at full employment, the
Bank of Canada could cause a
recession by shifting the aggregate
demand curve leftward, resulting in
higher unemployment and a lower price
level.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.5 Expansionary and
Contractionary Monetary Policy

At a lower than expected price level,
owners of inputs will then revise their
expectations downward, causing a
rightward shift in the SRAS curve,
leading to a new long-run equilibrium
back at full employment.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
Contractionary Monetary Policy at Full
Employment
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.5 Expansionary and
Contractionary Monetary Policy



For simplicity, we have assumed that
the global economy does not impact the
Canadian monetary policy.
This is incorrect.
Suppose the Bank of Canada buys
bonds on the open market, leading to
an increase in the money supply and a
fall in interest rates.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.5 Expansionary and
Contractionary Monetary Policy


Some Canadian investors will seek to
invest funds in foreign markets,
exchanging dollars for foreign currency,
leading to a depreciation of the dollar.
This increases exports and decreases
imports, and the increase in net exports
increases RGDP in the short run.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.5 Expansionary and
Contractionary Monetary Policy

Suppose the Bank of Canada sells
bonds on the open market.
 This leads to a decrease in the
money supply and a rise in interest
rates.
 This decreases exports and increases
imports, and the decrease in net
exports decreases RGDP in the short
run.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.5 Expansionary and
Contractionary Monetary Policy

Some foreign investors will seek to
invest funds in the Canadian market,
exchanging foreign currency for
dollars, leading to an appreciation of
the dollar.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.5 Expansionary and
Contractionary Monetary Policy

In an open economy like Canada’s
monetary policy operates on aggregate
demand through two channels:




The interest rate
The exchange rate.
An expansionary monetary policy
causes interest rate of fall and the
exchange rate to depreciate
This causes aggregate demand to
increase
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.5 Expansionary and
Contractionary Monetary Policy



Similarly a contractionary monetary
policy causes interest rates to rise and
the exchange rate to appreciate
Both of which cause aggregate demand
to decrease
The shape of the aggregate supply
curve is a source of debate among
economists, and it has important policy
implications.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.5 Expansionary and
Contractionary Monetary Policy

If the aggregate supply curve is
relatively inelastic, expansionary
monetary and fiscal policy are less
effective at increasing RGDP in the
short run, but have larger effects on the
price level in the short run.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.5 Expansionary and
Contractionary Monetary Policy

If the aggregate supply curve is
relatively elastic, expansionary
monetary and fiscal policy are more
effective at increasing RGDP in the
short run, and have smaller effects on
the price level in the short run.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
Expansionary Policy
B
PL1
PL0
LRAS
SRAS
A
AD1
Price Level
Price Level
LRAS
SRAS
PL1
PL0
B
A
AD1
AD0
AD0
RGDP1
RGDPNR
RGDP
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
RGDP0
RGDPNR
RGDP
18.5 Expansionary and
Contractionary Monetary Policy

If the aggregate supply curve is
relatively inelastic, contractionary
monetary and fiscal policy are less
effective at changing RGDP in the short
run, but have larger effects on the price
level in the short run.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.5 Expansionary and
Contractionary Monetary Policy

If the aggregate supply curve is
relatively elastic, contractionary
monetary and fiscal policy are more
effective at changing RGDP in the short
run, and have smaller effects on the
price level in the short run.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
Contractionary Policy
A
PL0
PL1
LRAS
SRAS
B
AD0
Price Level
Price Level
LRAS
SRAS
PL0
PL1
A
B
AD0
AD1
AD1
RGDP1
RGDPNR
RGDP
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
RGDP1
RGDPNR
RGDP
18.6 Problems in Implementing
Monetary Policy


The lag problem inherent in adopting
fiscal policy changes are much less
acute for monetary policy, largely
because the decisions are not slowed
by the same budgetary process.
The Bank of Canada, because of its
independence, can act very quickly in
undertaking open market operations.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems in Implementing
Monetary Policy

The major effects of a change in policy
on growth in the overall production of
goods and services and on inflation are
usually spread over six to eight quarters
(18 to 24 months).
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems in Implementing
Monetary Policy


One limitation of monetary policy is that
it ultimately must be carried out through
the chartered banking system.
The Central Bank (Bank of Canada) can
change the environment in which banks
act, but the banks themselves must take
the steps necessary to increase or
decrease the supply of money.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems in Implementing
Monetary Policy


Usually, when the Bank of Canada is
trying to constrain monetary expansion,
there is no difficulty in getting chartered
banks to make appropriate responses.
If the Bank of Canada sells bonds,
and/or raises the bank rate, banks will
call in loans that are due for collection to
obtain the necessary reserves, and in
the process of collecting loans, they
lower the supply of money.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems in Implementing
Monetary Policy

When the Bank of Canada wants to
induce monetary expansion, however, it
can provide banks with excess reserves
by buying government bonds but it
cannot force the banks to make loans,
thereby creating new money.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems in Implementing
Monetary Policy


Ordinarily, of course, banks want to
convert their excess reserves to work
earning interest income by making
loans.
But in a deep recession or depression,
banks might be hesitant to make
enough loans to put all those reserves
to work, fearing that they will not be
repaid.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems in Implementing
Monetary Policy

Their pessimism might lead them to
perceive that the risks of making loans
to many normally creditworthy
borrowers outweigh any potential
interest earnings.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems in Implementing
Monetary Policy

Another possible problem that arises
out of existing institutional policy making
arrangements is the coordination of
fiscal and monetary policy.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems in Implementing
Monetary Policy


Decision making with respect to fiscal
policy is made by the Canadian
government, while monetary policy
decision making is in the hands of the
Bank of Canada.
A macroeconomic problem arises if the
federal government's fiscal decision
makers differ on policy objectives or
targets with the Bank of Canada’s
monetary decision makers.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems in Implementing
Monetary Policy


Some people believe that monetary
policy should be more directly controlled
by the federal government, so that all
macroeconomic policy will be
determined more directly by the political
process.
It is argued that such a move would
enhance coordination considerably.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems in Implementing
Monetary Policy

Others argue that it is dangerous to turn
over control of the nation's money
supply to politicians, rather than
allowing decisions to be made by an
independent central back that is
focused more on price stability and
more insulated from political pressures
from the public and from special interest
groups.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems in Implementing
Monetary Policy

Much of macroeconomic policy in
this country is driven by the idea
that the federal government can
counteract economic fluctuations

Stimulating the economy when it is
weak.
 increased
government purchases
 tax
cuts
 transfer payment increases
 easy money

Restraining it when it is overheating.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems In Implementing
Monetary Policy
But policy makers must adopt the
right policies in the right amounts at
the right time for such “stabilization”
to do more good than harm.
 And for government policy makers
to do more good than harm, they
need far more accurate and timely
information than experts can give
them.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems In Implementing
Monetary Policy

First, economists must know not
only which way the economy is
heading, but also how rapidly. And
no one knows exactly what the
economy will do, no matter how
sophisticated the econometric
models used.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems In Implementing
Monetary Policy

Even if economists could provide
completely accurate economic
forecasts of what will happen if
macroeconomic policies are
unchanged, they could not be
certain of how to best promote
stable economic growth.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems In Implementing
Monetary Policy

If economists knew, for example,
that the economy was going to dip
into another recession in six
months, they would then need to
know exactly how much each
possible policy would spur activity
in order to keep the economy
stable.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems In Implementing
Monetary Policy
But such precision is unattainable,
given the complex forecasting
problems faced.
 Further, economists aren’t always
sure what effect a policy will have
on the economy.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems In Implementing
Monetary Policy

It is widely assumed that an
increase in government purchases
quicken economic growth.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems In Implementing
Monetary Policy
Increasing government purchases
increases the budget deficit, which
could send a frightening signal to
the bond markets.
 The result can be to drive up
interest rates and choke off
economic activity.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems In Implementing
Monetary Policy

Even when policy makers know
which direction to nudge the
economy, they can’t be sure which
policy levers to pull, or how hard to
pull them, to fine tune the economy
to stable economic growth.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems In Implementing
Monetary Policy

A third crucial consideration is how
long it will take a policy before it
has its effect on the economy.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems In Implementing
Monetary Policy


Even when increased government
purchases or expansionary monetary
policy does give the economy a boost,
no one knows precisely how long it will
take to do so.
The boost may come very quickly, or
many months (or even years) in the
future, when it may add inflationary
pressures to an economy that is already
overheating, rather than helping the
economy recover from a recession.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems In Implementing
Monetary Policy
Macroeconomic policy making is
like driving down a twisting road in
a car with an unpredictable lag and
degree of response in the steering
mechanism.
 If you turn the wheel to the right,
the car will eventually veer to the
right, but you don’t know exactly
when or how much.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems In Implementing
Monetary Policy
There are severe practical
difficulties in trying to fine-tune the
economy.
 Even the best forecasting models
and methods are far from perfect.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems In Implementing
Monetary Policy
Economists are not exactly sure
where the economy is or where or
how fast it is going, making it very
difficult to prescribe an effective
policy.
 Even if we do know where the
economy is headed, we can not be
sure how large a policy’s effect will
be or when it will take effect.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems In Implementing
Monetary Policy



The Bank of Canada must take into
account the many different factors that
can either offset or reinforce monetary
policy.
This isn’t easy because sometimes
these developments occur
unexpectedly, and because the size and
timing of their effects are difficult to
estimate.
The 1997-98 currency crisis in East Asia
is an example.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems In Implementing
Monetary Policy



Economic activity in that region either
slowed or declined, leading to a
reduction in the aggregate demand.
The foreign exchange value of most of
their currencies depreciated making
Asian produced goods less expensive
and Canadian goods more expensive.
These factors impacted on Canada
reducing aggregate demand and
employment.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems In Implementing
Monetary Policy
Since the 1990’s the Canadian
economy has experience a
productivity increase through hightech and other developments.
 This “new” economy may increase
productivity, allowing for greater
economic growth without creating
inflationary pressures.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.6 Problems In Implementing
Monetary Policy

The Bank of Canada must estimate
how much faster productivity may
be increasing and whether those
increases are temporary or
permanent, which is not an easy
task.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.7 Rational Expectations

Is it possible that people can
anticipate the plans of policy
makers and alter their behaviour
quickly, to neutralize the intended
impact of government action?
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.7 Rational Expectations

For example, if workers see that the
government is allowing the money
supply to expand rapidly, they may
quickly demand higher money wages
in order to offset the anticipated
inflation.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.7 Rational Expectations


In the extreme form, if people could
instantly recognize and respond to
government policy changes, it might be
impossible to alter real output or
unemployment levels through policy
actions unless they can surprise
consumers and businesses.
A number of economists believe that
there is at least some truth to this point
of view.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.7 Rational Expectations

At a minimum, most economists
accept the notion that real output
and the unemployment rate cannot
be altered with the ease that was
earlier believed; some believe that
the unemployment rate can seldom
be influenced by fiscal and
monetary policies.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.7 Rational Expectations

The relatively new extension of
economic theory that leads to this
rather pessimistic conclusion
regarding macroeconomic policy’s
ability to achieve our economic
goals is called the theory of
rational expectations.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.7 Rational Expectations


The notion that expectations or
anticipations of future events are
relevant to economic theory is not new;
for decades economists have
incorporated expectations into models
analyzing many forms of economic
behaviour.
Only in the recent past, however, has a
theory evolved that tries to incorporate
expectations as a central factor in the
analysis of the entire economy.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.7 Rational Expectations

Rational expectation economists believe
that wages and prices are flexible, and
that workers and consumers incorporate
the likely consequences of government
policy changes quickly into their
expectations.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.7 Rational Expectations

In addition, rational expectation
economists believe that the economy is
inherently stable after macroeconomic
shocks, and that tinkering with fiscal
and monetary policy cannot have the
desired effect unless consumers and
workers are caught off-guard (and
catching them off-guard gets harder the
more you try to do it).
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.7 Rational Expectations


Rational expectations theory
suggests that government economic
policies designed to alter aggregate
demand to meet macroeconomic goals
are of very limited effectiveness.
When policy targets become public, it is
argued, people will alter their own
behaviour from what it would otherwise
have been, and, in so doing, they
largely negate the intended impact of
policy changes.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.7 Rational Expectations

If government policy seems tilted
towards permitting more inflation in
order to try to reduce unemployment,
people start spending their money faster
than before, become more adamant in
their wage and other input price
demands, and so on.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.7 Rational Expectations

In the process of quickly altering their
behaviour to reflect the likely
consequences of policy changes, they
make it more difficult (costly) for
government authorities to meet their
macroeconomic objectives.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.7 Rational Expectations


Rather than fooling people into
changing real wages, and therefore
unemployment, with inflation
“surprises,” changes in inflation are
quickly reflected into expectations with
little or no effect on unemployment or
real output even in the short run.
As a consequence, policies intended to
reduce unemployment through
stimulating aggregate demand will often
fail to have the intended effect.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.7 Rational Expectations

Fiscal and monetary policy, according to
this view, will work only if the people are
caught off-guard or fooled by policies so
that they do not modify their behaviour
in a way that reduces policy
effectiveness.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.7 Rational Expectations


In the case of an expansionary
monetary policy, AD will shift to the
right.
As a result of anticipating the
predictable inflationary consequences of
that expansionary policy, the price level
will immediately adjust to a new higher
price level.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.7 Rational Expectations

Consumers, producers, workers, and
lenders who have anticipated the effects
of the expansionary policy simply built
the higher inflation rates into their
product prices, wages, and interest
rates because they realize that
expansionary monetary policy can
cause inflation if the economy is
working close to capacity.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.7 Rational Expectations

Consequently, in an effort to protect
themselves from the higher anticipated
inflation, workers ask for higher wages,
suppliers increase input prices, and
producers raise their product prices.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.7 Rational Expectations


Because wages, prices, and interest
rates are assumed to be flexible, the
adjustments take place immediately.
This increase in input costs for wages,
interest, and raw materials causes the
aggregate supply curve to also shift up
or leftward.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
18.7 Rational Expectations

So the desired policy effect of greater
real output and reduced unemployment
from a shift in the aggregate demand
curve is offset by an upward or leftward
shift in the aggregate supply curve
caused by an increase in input costs.
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.
Rational Expectations and the AD/AS Model
LRAS
SRAS1
SRAS0
PL1
AD1
PL0
AD0
0
RGDPNR
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.
RGDP
18.7 Rational Expectations



An unanticipated increase in AD as a
result of an expansionary monetary
policy stimulates output and
employment in the short run.
The output is beyond the full
employment level, and so is not
sustainable in the long run.
The price level ends up higher than
workers and other input owners
expected.
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.
18.7 Rational Expectations

However, when they eventually realize
that the price level has changed, they
will require higher input prices, shifting
SRAS left to a new long-run equilibrium
at full employment and a higher price
level.
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.
18.7 Rational Expectations

In the short run, the policy expands
output and employment, but only
increases the price level inflation in the
long run.
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.
18.7 Rational Expectations


A correctly anticipated increase in AD
from expansionary monetary or fiscal
policy will not change real output or
unemployment even in the short run.
The only effect is an immediate change
in the price level.
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.
18.7 Rational Expectations

The only way that monetary or fiscal
policy can change output in the rational
expectations model is with a surprise—
an unanticipated change.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
An Expansionary Policy That Is
Unanticipated
Price Level
LRAS
SRAS1
SRAS0
PL2
C
B
PL1
PL0
A
AD1
(Unanticipated)
AD0
RGDPNR RGDP1
RGDP
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.
18.7 Rational Expectations

In the rational expectations model,
when people expect a larger increase in
AD than actually results from a policy
change (say, from a smaller increase in
the money supply than expected), it
leads to a higher price level and a lower
level of RGDP—a recession.
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.
18.7 Rational Expectations

A policy designed to increase output
may actually reduce output if prices and
wages are flexible and the actual
expansionary effect is less than people
anticipated.
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.
An Actual Expansionary Policy That Is Less
Than the Anticipated Policy
Price Level
LRAS
PL2
PL1
PL0
SRAS1
SRAS0
C
B
A
AD2 (Anticipated)
AD1 (Actual)
AD0
RGDP1 RGDPNR
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.
RGDP
18.7 Rational Expectations

Rational expectations theory does
have its critics.

Critics want to know if consumers and
producers are completely informed
about the impact that say, an increase
in money supply will have on the
economy.
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18.7 Rational Expectations
 In
general, not all citizens will be
completely informed, but key
players like corporations, financial
institutions, and labour unions may
well be informed about the impact
of these policy changes.
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.
18.7 Rational Expectations

Are wages and other input prices
really that flexible?
 Even if decision makers could
anticipate the eventual effect of
policy changes on prices, prices
may still be slow to adapt (e.g.,
what if you had just signed a threeyear labour or supply contract when
the new policy is implemented?).
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.
18.7 Rational Expectations


Many economists reject the extreme
rational expectations model of complete
wage and price flexibility.
Most still believe there is a short-run
trade-off between inflation and
unemployment.
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.
18.7 Rational Expectations


The reason is that some input prices are
slow to adjust to changes in the price
level.
In the long run, the expected inflation
rate adjusts to changes in the actual
inflation rate at the natural rate of
output.
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.