Download MONETARY POLICY

MONETARY
POLICY
26
CHAPTER
Objectives
After studying this chapter, you will able to
ƒ Describe the structure of the Bank of Canada
ƒ Describe the tools used by the Bank of Canada to conduct
monetary policy
ƒ Explain what an open market operation is and how it works
ƒ Explain how the Bank of Canada changes the quantity of
money
ƒ Explain how the Bank of Canada influences interest rates
ƒ Explain how the Bank of Canada influences the economy
© Pearson Education Canada, 2003
Fiddling with the Knobs
Almost every month, the financial news reports on the
Bank of Canada’s views about interest rates.
What is the Bank of Canada?
Why might the Bank of Canada want to change interest
rates?
How does it change interest rates?
© Pearson Education Canada, 2003
The Bank of Canada
The Bank of Canada is Canada’s central bank.
A central bank is the public authority that supervises
financial institutions and markets and conducts monetary
policy.
Monetary policy is the attempt to control inflation and
moderate the business cycle by changing the quantity of
money and adjusting interest rates and the exchange rate.
How do interest rates influence the economy?
© Pearson Education Canada, 2003
The Bank of Canada
The Bank of Canada was established in 1935.
The governor of the Bank is appointed by the federal
government.
The current governor, who was appointed in 2001, is
David Dodge.
There are two possible models for the relationship
between a central bank and government:
ƒ Independent central bank
ƒ Subordinate central bank
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
The Bank of Canada
An independent central bank sets its own goals and
makes its own decisions about how to pursue those goals
and might listen to the views of government but is not
obliged to pay any attention to those views.
A subordinate central bank pursues goals set by the
government and sometimes takes directions from the
government on how best to achieve those goals.
The Bank of Canada pursues inflation targets laid down by
the government but makes its own decisions on how best
to achieve those goals.
© Pearson Education Canada, 2003
1
The Bank of Canada
The Bank of Canada
The Bank of Canada’s Balance Sheet
The Bank of Canada’s assets are government securities
and loans to banks (plus some other small items).
The Bank of Canada’s liabilities are its notes (the $5, $10,
$20, $50, and $100 notes), banks deposits, and
government deposits.
The monetary base is the sum of Bank of Canada notes
outside the Bank, chartered bank deposits at the Bank of
Canada, and coins held by households, firms, and banks.
Making Monetary Policy
Monetary policy making involves three elements:
ƒ Monetary policy objectives
ƒ Monetary policy indicators
ƒ Monetary policy tools
(Coins are issued by the government, not the Bank of
Canada.)
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
The Bank of Canada
The Bank of Canada
Monetary Policy Objectives
The objectives of monetary policy, as stated in the Bank of
Canada Act, are to
Monetary Policy Indicators
…regulate credit and currency in the best interests of the
economic life of the nation…and to mitigate by its
influence fluctuations in the general level of production,
trade, prices and employment, so far as may be possible
within the scope of monetary action…
Current objective: keep the inflation rate between 1
percent and 3 percent a year and smooth fluctuations as
much as possible.
© Pearson Education Canada, 2003
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.
The indicators change as the Bank learns more about how
the economy works.
Currently, the overnight loans rate, the interest rate on
large-scale loans that chartered banks make to each
other, is the main monetary policy indicator.
© Pearson Education Canada, 2003
The Bank of Canada
Figure 26.1 shows the
overnight loans rate since
the mid 1970s.
The Bank’s actions raise
this interest rate to slow
future inflation and lower
this interest rate to boost
real GDP.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
2
The Bank of Canada
Monetary Policy Tools
The four monetary policy tools are:
ƒ Required reserve ratio
ƒ Bank rate and bankers’ deposit rate
ƒ Open market operations
ƒ Government deposit shifting
© Pearson Education Canada, 2003
The Bank of Canada
The Bank of Canada
The Bank of Canada no longer requires chartered banks
to hold a minimum level of reserves.
The required reserve ratio in Canada is zero.
Bank rate is the interest rate that the Bank of Canada
charges the chartered banks on the reserves it lends
them.
The bankers’ deposit rate is the interest rate that the Bank
of Canada pays to chartered banks on their deposits at the
Bank.
The Bank of Canada sets the bankers’ deposit rate at
bank rate minus half
a percent.
© Pearson Education Canada, 2003
Controlling the Quantity of Money
How an Open Market Operation Works
An open market operation is the purchase or sale of
government of Canada securities by the Bank of Canada
in the open market.
When the Bank of Canada conducts an open market
operation by buying a government security, it increases
banks’ reserves.
Government deposit shifting is the transfer of government
funds by the Bank of Canada from the government’s
account at the Bank to a government account at a
chartered bank.
Banks loan the excess reserves.
© Pearson Education Canada, 2003
Controlling the Quantity of Money
Although the details differ, the ultimate process of how an
open market operation changes the money supply is the
same regardless of whether the Bank of Canada conducts
its transactions with a commercial bank or a member of
the public.
By making loans, they create money.
The reverse occurs when the Bank of Canada sells a
government security.
© Pearson Education Canada, 2003
Controlling the
Quantity of Money
Figure 26.2(a) illustrates
an open market operation
in which the Bank of
Canada buys securities
from a chartered bank.
An open market operation that increases banks’ reserves
also increases the monetary base.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
3
Controlling the
Quantity of Money
Figure 26.2(b) illustrates
an open market
operation in which the
Bank of Canada buys
securities from the
public.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
Controlling the Quantity of Money
Monetary Base and Bank Reserves
The money multiplier is the amount by which a change in
the monetary base is multiplied to calculate the final
change in the money supply.
An increase in currency held outside the banks is called a
currency drain.
Such a drain reduces the amount of banks’ reserves,
thereby decreasing the amount that banks can loan and
reducing the money multiplier.
© Pearson Education Canada, 2003
Controlling the Quantity of Money
The money multiplier differs from the deposit multiplier.
The deposit multiplier shows how much a change in
reserves affects deposits.
© Pearson Education Canada, 2003
Controlling the Quantity of Money
The Money Multiplier
When the Bank of Canada increases the monetary base, a
sequence of nine events follows. They are:
1.Banks have excess reserves
2.Banks lend excess reserves
3.Bank deposits increase
The money multiplier shows how much a change in the
monetary base affects the money supply.
4.The quantity of money increases
5.New money is used to make payments
6.Some of the new money remains on deposit
7.Some of the new money is a currency drain
8.Desired reserves increase because deposits have increased
© Pearson Education Canada, 2003
9.Excess reserves decrease,
remain
positive
© Pearsonbut
Education
Canada,
2003
4
Controlling the Quantity of Money
Figure 26.3 illustrates a round in the multiplier process
following an open market operation.
© Pearson Education Canada, 2003
Controlling the Quantity of Money
The Canadian Money Multiplier
The Canadian money multiplier is the change in the
quantity of money divided by the change in the monetary
base.
Because there are two definitions of money, M1 and M2+,
there are two money multipliers.
The M1 multiplier is about 2.2.
Controlling the Quantity of Money
Figure 26.4 keeps track of the magnitude of the multiplier
effect of an open market operation.
© Pearson Education Canada, 2003
Ripple Effects of Monetary Policy
Figure 26.5 summarizes
the ripple effects of the
Bank of Canada’s
monetary policy actions.
The AS-AD model helps to
see how monetary policy
influences real GDP and
the price level.
The M2+ multiplier is about 10.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
Ripple Effects of Monetary Policy
Monetary Policy to Lower
Unemployment
Figure 26.6 shows an
economy that is
experiencing
unemployment.
Monetary policy increases
aggregate demand to
restore full employment.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
5
Ripple Effects of Monetary Policy
Monetary Policy to Lower
Inflation
Figure 26.7 shows an
economy that is
experiencing inflation.
Monetary policy decreases
aggregate demand to
restore full employment
and avoid inflation.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
Ripple Effects of Monetary Policy
Time Lags in the Adjustment Process
The Bank of Canada 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 long drawn out and not entirely
predictable.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
Ripple Effects of Monetary Policy
Interest Rate Fluctuations
Figure 26.8 shows how
interest rates respond to
the Bank’s actions.
Short-term interest rates
move closely with the
overnight loans rate.
Long-term interest rates
move in the same direction
but fluctuate less.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
6
Ripple Effects of Monetary Policy
Figure 26.9 shows how
interest rates respond to
changes in the monetary
base.
During the 1970s, a
decreasing monetary base
increased interest rates.
But the demand for
monetary base fluctuates.
© Pearson Education Canada, 2003
Ripple Effects of Monetary Policy
Money Target Versus Interest Rate Target
Because the demand for monetary base fluctuates, the
Bank of Canada prefers to target the interest rate and
change the quantity of money automatically if the
demand for money changes.
Figure 26.10 on the next slides illustrates the distinction
between targeting the quantity of money and targeting
the interest rate.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
Ripple Effects of Monetary Policy
In Figure 26.10(a), the
Bank targets the quantity
of money.
Fluctuations in the
demand for monetary
base bring unwanted
fluctuations in the interest
rate.
© Pearson Education Canada, 2003
Ripple Effects of Monetary Policy
In Figure 26.10(b), the
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.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
7
Ripple Effects of Monetary Policy
The Exchange Rate
The exchange rate
responds to changes in
the interest rate.
But other factors also
influence the exchange
rate, as Figure 26.11
shows.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
Ripple Effects of Monetary Policy
Interest Rates, Aggregate
Demand, and Real GDP
Fluctuations
The AS-AD model show
how real GDP responds to
changes in the interest rate.
Figure 26.12 shows that
these effects take about a
year, on the average, to
occur.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
The Bank of Canada in Action
Gerald Bouey’s Fight Against Inflation
In the early 1980s, when Gerald Bouey was governor of
the Bank of Canada, 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.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
8
The Bank of Canada in Action
The Bank of Canada in Action
Gordon Thiessen’s and David Dodge’s Balancing Acts
John Crow’s Push for Price Stability
John Crow became governor of the Bank of Canada in
1987.
Crow was a fierce inflation fighter.
He brought the inflation rate down to less than three
percent, but at the cost of another recession during 19901991.
© Pearson Education Canada, 2003
MONETARY
POLICY
Gordon Thiessen succeeded John Crow as governor of the
Bank of Canada 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.
© Pearson Education Canada, 2003
26
CHAPTER
THE
END
© Pearson Education Canada, 2003
9