Monetary Policy

Chapter 14 Monetary Policy

The Bank of Canada Making Monetary Policy When the BOC announces a policy change, its press release talks about the overnight rate or bank rate. The Board meets eight times a year and formally approves interest rate decisions.

Monetary Policy Indicators Monetary policy indicators are the current features of the economy that the Bank looks at to determine whether it needs to apply the brake or the accelerator to influence future inflation, real GDP, and unemployment. Currently, the overnight loans rate is the main monetary policy indicator.

Monetary Policy Tools Four Monetary Policy Tools 1. Required reserve ratio (no loner used in Canada). 2. Bank rate and bankers’ deposit rate. 3. Open market operations. 4. Government deposit shifting

Controlling the Quantity of Money

Ripple Effects of Monetary Policy

Ripple Effects of Monetary Policy

MP to Lower Unemployment If BOC buys securities in Open Market, AD shifts to the right to restore full employment.

Ripple Effects of Monetary Policy MP to Lower Inflation Monetary policy decreases AD to restore full employment and avoid inflation.

Ripple Effects of Monetary Policy Time Lags in the Adjustment Process The BOC needs a combination of good judgment and good luck to achieve its monetary policy goal of low and stable inflation and full employment. The Bank is handicapped by the fact that the ripple effect of its actions are not entirely predictable.

Ripple Effects of Monetary Policy Money Target Versus Interest Rate Target The BOC prefers to target the interest rate and change the quantity of money automatically if the demand for money fluctuates.

Ripple Effects of Monetary Policy Bank targets the interest rate. Fluctuations in the demand for monetary base now bring fluctuations in the quantity of money and hold the interest rate steady.

How BOC Raises Interest Rates? The BOC sells securities in the open market. This action mops up bank reserves. Some banks are short of reserves and seek to borrow reserves from other banks. The overnight rate rises. With fewer reserves, the banks make a smaller quantity of new loans each day and the quantity of money decreases.

1. The current interest rate is 5 % a year. 2. The Bank’s target interest rate is 6 % a year. 3. To raise the interest rate to the target, the BOC must sell securities in the open market and decrease the quantity of money to $98 billion.

How BOC Lowers Interest Rate? If the BOC fears recession, it acts to increase AD. The BOC announces that it will lower the short-term interest rates. To achieve this goal, the BOC buys securities in the open market. This action increases bank reserves. Flush with reserves, banks now seek to lend reserves to other banks. The overnight rate falls. With more reserves, the banks increase their lending and the quantity of money increases.

1. The current interest rate is 5 % a year. 2. The Bank’s target is 4 % a year. 3. To lower the interest rate to the target, the BOC buys securities in the open market and increase the quantity of money to $102 billion.

Ripple Effects of Monetary Policy Suppose that the BOC increases the interest rate. Then  Investment and consumption expenditure decrease.  The dollar rises, and net exports decrease.  A multiplier process induces a further decrease in consumption expenditure and AD.

Ripple Effects of Monetary Policy Bank targets the quantity of money. Fluctuations in the demand for monetary base bring unwanted fluctuations in the interest rate.

Money Multiplier The Multiplier Process Taking these effects together, investment, consumption expenditure, and net exports are all interest-sensitive components of expenditure. So a rise in the interest rate brings a decrease in AE. Real GDP and disposable income decrease further, and so does consumption expenditure. Real GDP growth slows, and the inflation rate slows.

BOC’s Fight against Inflation Investment demand curve. The interest rate is 5 % a year and investment is $200 billion. 1. The BOC raises the interest rate and the quantity of investment decreases.

2. Expenditure decreases by ∆I. 3. The multiplier induces additional expenditure cuts. The AD curve shifts to AD1, real GDP decreases to potential GDP, and inflation is avoided.

BOC’s Fight Against Recession

The interest rate is 5 % a year and investment is $200 billion. 1. The BOC lowers the interest rate and the quantity of investment increases.

BANK OF CANADA AND MONETARY POLICY

2. Expenditure increases by ∆I. 3. The multiplier induces additional expenditure. The AD curve shifts to AD1, real GDP increases to potential GDP, and recession is avoided.

Size of Multiplier The Size of the Multiplier effect of monetary policy depends on the sensitivity of expenditure plans to the interest rate. The larger the effect of a change in the interest rate on AE, the greater is the money multiplier and the smaller is the change in the interest rate that achieves the BOC’s objective.

Limitations of Monetary Policy Monetary policy has an advantage over fiscal policy because it cuts out the law-making time lags. But monetary policy shares the other two limitations of fiscal policy: • Estimating potential GDP is hard • Economic forecasting is error-prone.

Macroeconomic Policy Debates How should fiscal policy and monetary policy be used? Two historical schools of thoughts on Macroeconomic policy: Keynesians and monetarists. The debate concerns three issues: • Fiscal policy versus monetary policy • Interest rate versus quantity of money • Real GDP versus inflation

Macroeconomic Policy Debates Fiscal Policy Versus Monetary Policy Either tool can be used to influence AD, so the choice between them turns on their side effects: • Fiscal policy influences the allocation of resources and the distribution of income and wealth. • Monetary policy influences the allocation of resources between consumption and investment and exports and imports. Stabilization policy relies on both tools.

Macroeconomic Policy Debates Interest Rate Versus Quantity of Money Set the interest rate and let the quantity of money be determined by the demand for money, or Set the growth rate of the quantity of money and let the interest rate fluctuate with the demand for money. • Monetarists favor a target for the money growth rate • Keynesians favor a target for the interest rate The BOC is Keynesian on this issue. It sets the overnight rate and has no target for money growth.

Macroeconomic Policy Debates Real GDP Versus Inflation Keynesians place more weight on real GDP. • They want policy to restore real GDP to potential GDP quickly. They pay little attention to inflation. Monetarists place more weight on inflation. • They want the inflation rate slowed if it rises and no action if the inflation rate is low. BOC monetarist on this issue.

The Bank of Canada in Action Gerald Bouey’s Fight Against Inflation In the early 1980s, when Gerald Bouey was governor of the BOC, the Bank slowed the growth rate of money and interest rates rose dramatically. Real GDP decreased in a deep recession. The unemployment rate increased and remained high through the 1980s. The inflation rate slowed.

The Bank of Canada in Action John Crow’s Push for Price Stability John Crow became governor of the BOC in 1987. Crow was a fierce inflation fighter. He brought the inflation rate down to less than 3%, but at the cost of another recession during 1990-1991.

The Bank of Canada in Action Gordon Thiessen’s and David Dodge’s Balancing Acts Gordon Thiessen succeeded John Crow as governor of the BOC in 1994. Thiessen held the inflation rate inside its target range and helped set the scene for the strong expansion of the late 1990s and early 2000s. David Dodge succeeded Thiessen in 2001. Dodge attempted to keep the economy expanding through a U.S. recession and permitted inflation to exceed its target for the first time since inflation targeting began.