Download Chapter 14

Monetary Policy and the
Debate about Macro
Policy
Chapter 14
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14 - 2
Introduction

Monetary policy influences the
economy through changes in the
financial system’s reserves that
influence the money supply and credit
availability in the economy.
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Introduction

Monetary policy is one of the two main
traditional macroeconomic tools to
control the aggregate economy.

While fiscal policy is controlled by the
government directly, monetary policy is
controlled by the central bank in
Canada.
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Effect of Monetary Policy on
the AS/AD Model
Expansionary monetary policy shifts the
AD curve to the right.
 Contractionary monetary policy shifts
the AD curve to the left.

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Effect of Monetary Policy on
the AS/AD Model
The effect of monetary policy on
equilibrium income and the price level
depends on whether inflationary
pressures are set in motion.
 That in turn depends on how close the
economy is to its potential income.

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Effect of Monetary Policy on
the AS/AD Model

The supply conditions of the economy
are central to the effect one believes
monetary policy will have on the
economy.
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Effect of Monetary Policy on
the AS/AD Model

Its effect on real income depends on
how the price level responds.
% Real Income =
% Nominal Income - % Price Level
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Effect of Monetary Policy on
the AS/AD Model
In Keynesian range, real income will
rise with expansionary monetary policy
and decline with contractionary
monetary policy.
 The price level is unaffected.

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Effect of Monetary Policy on
the AS/AD Model

In the Classical range, real income does
not change; the effect is on the price
level and inflation.
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Monetary Policy When Prices
are Fixed, Fig. 14-1a, p 339
Price
level
Expansionary
monetary policy
SAS
P0
Contractionary
monetary policy
Y2
AD2
Y0
AD0
Y1
AD1
Real output
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Expansionary Monetary
Policy in the Classical Range,
Fig. 14-1b, p 339
Price
level
LRAS
SAS1
SAS0
B
P1
P0
A
AD0
Y0
AD1
Real output
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Duties and Structure of the
Bank of Canada
A central bank is a type of bankers’
bank.
 A central bank conducts monetary
policy and acts as financial adviser to
the government.

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Duties and Structure of the
Bank of Canada
In some countries the central bank is a
part of the government.
 In Canada the central bank is not part of
the government – it is a Crown
corporation, not under direct day-to-day
control of the federal government.

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Structure of the Bank
The head of the Bank of Canada is the
Governor of the Bank.
 So far the Bank of Canada has had
seven governors.

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Structure of the Bank
Monetary policy is set by the governor
with the advice of his senior advisers.
 The Bank has a Board of Directors
made up of 12 non-specialists in
monetary policy.

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Structure of the Bank
Price stability has often been the goal of
monetary policy.
 Price stability is interpreted to mean a
low and stable rate of inflation.

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International Considerations
The design and implementation of
monetary policy is affected by
international considerations.
 Exchange rates play a critical role in the
process.

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International Considerations
An exchange rate expresses the value
of one currency in terms of the value of
another.
 Exchange rate can be expressed in two
ways – it tells us how many units of one
currency is needed to buy one unit of
another.

 For
example, it takes Can$1.54 to buy US$1
(or, US$0.65 to buy Can$1)
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International Considerations
Exchange rates matter because
international trade is an important part
of every economy.
 Monetary policy is important because it
will affect international trade through
changes in the money supply.

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International Considerations
The exchange rate as the relative price
of one nation’s currency depends on
how much of that currency is in
circulation.
 Therefore, monetary policy cannot be
set without consideration of international
issues.

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Duties of the Bank

The bank of Canada is responsible for:
 Conducting
monetary policy
 Providing Central banking services
 Issuing bank notes
 Administering public debt.
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The Importance of Monetary
Policy
Monetary policy is the Bank’s most
important function, and the most-used
policy in macroeconomics.
 In practice,the Bank of Canada
conducts monetary policy and controls
it, whereas fiscal policy is conducted
directly by the government.

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The Importance of Monetary
Policy

Actual decisions about monetary policy
are made by the Governor of the Bank
of Canada, with consultation with senior
staff.
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The Conduct of Monetary
Policy

Bank reserves are IOUs of the Bank of
Canada.
 Bank
reserves – either vault cash or
deposits at the Bank.

The monetary base is currency in
circulation plus deposits at the Bank.
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The Conduct of Monetary
Policy

By controlling the monetary base, the
Bank can influence the amount of
money in the economy and the activities
of banks.
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The Conduct of Monetary
Policy
The tools of monetary policy will affect
the amount of reserves in the system.
 The amount of reserves will affect
interest rates.

 Other
things being equal, as reserves
decline, interest rates will rise.
 As reserves increase, interest rates will fall.
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Tools of Monetary Policy

The tools of monetary policy include:
 Changing
the target range for the
overnight financing rate.
 Cash management operations.
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The Overnight Financing
Rate
All chartered banks are members of the
Canadian Payments Association.
 Among other things, this association
runs an electronic funds transfer system
called the Large Value Transfer system
(LVTS), where payments clear and
settle daily.

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The Overnight Financing
Rate
If financial institutions have surplus
balances resulting from the clearing
process at the LVTS, they can loan
them on a very short term basis to those
members who are in deficit position.
 These loans occur in the overnight
market.

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The Overnight Financing
Rate

The overnight financing rate is the
rate of interest associated with these
very short-term loans in the overnight
market.
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The Overnight Financing
Rate

Changes in the overnight financing rate
influence all other rates through the
term structure of interest rates – the
structure of yields on financial
instruments with similar characteristics,
but different terms to maturity.
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The Overnight Financing
Rate

Arbitrage – the buying and selling of
similar goods and services across
different markets – provides the link
between interest rates on dissimilar
assets.
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The Overnight Financing
Rate

The bank rate is the interest rate
charged on advances from the central
bank.
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The Overnight Financing
Rate

The Bank of Canada has a target range
for the overnight financing rate – it falls
between the bank rate (maximum) and
the rate at which the Bank will pay the
LVTS participants who want to leave
their surplus funds with the Bank of
Canada (minimum).
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The Overnight Financing
Rate

The main tool of monetary policy in
Canada is the target range for the
overnight financing rate.
 The
AD will decline if the target range for
the overnight financing rate is increased.
 By decreasing the target range, the AD will
increase.
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Relationship Among Interest
Rates, Fig. 14-2a, p 348
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Relationship Among Interest
Rates, Fig. 14-2b, p 348
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Cash Management
Operations
Cash management is the second major
tool of monetary policy in Canada.
 Cash management operations are the
main techniques for implementing
monetary policy in Canada.

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Cash Management
Operations
Cash management techniques include
various open market operations buying and selling of government bonds
and bills.
 Cash management techniques also
include the transfer of government
deposits between chartered banks (and
others) and the Bank of Canada.

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Open Market Operations

Open market operations involve the
purchase or sale of federal government
securities.
 When
the Bank of Canada buys bonds, the
money supply rises. Thus, an open market
purchase is an example of expansionary
monetary policy.
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Open Market Operations

An open market sale has the opposite
effect:
 When
the Bank of Canada sells bonds, the
money supply declines. Thus, an open
market sale is an example of
contractionary monetary policy.
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Open Market Operations
Open market purchase (expansionary
monetary policy) increases the money
supply, decreasing the interest rates.
 Open market sale (contractionary
monetary policy) reduces the money
supply, increasing interest rates.

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Government Deposits
A transfer of government deposits from
the chartered banks and other financial
institutions to the Bank of Canada
reduces the liquidity in the banking
system.
 This puts an upward pressure on
interest rates.

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Government Deposits
A transfer of government deposits from
the Bank of Canada to the chartered
banks and other financial institutions
increases the liquidity in the banking
system.
 This puts a downward pressure on
interest rates.

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Open Market Operations, Fig. 143a, p 350
Supply
B
A
D1
D0
Quantity of bonds
a) An open market purchase
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Open Market Operations, Fig. 143b, p 350
S0
S1
A
C
Demand
Quantity of bonds
b) An open market sale
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Monetary Policy in the
AS/AD Model

In AS/AD terms, monetary policy works
primarily through its effect on interest
rates.
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Contractionary Monetary
Policy
The Bank decreases the money supply.
 The interest rates go up.
 As interest rates go up, the quantity of
investment goes down, decreasing
income and output.

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Contractionary Monetary
Policy
The AD curve shifts to the left by a
multiple of the shift in investment.
 Income and output decrease.

M i I Y
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Expansionary Monetary
Policy

Expansionary monetary policy works in
the opposite direction.
M i I Y
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Contractionary Monetary
Policy When Prices are Fixed,
Fig. 14-4a, p 351
Price
level
P0
M i I Y
I
SAS
Multiplier
effect
AD1
0
Initial shift
Y1
AD0
Y0
Real income
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Expansionary Monetary
Policy When Prices are Fixed,
Fig. 14-4b, p 351
M i I Y
Price
level
Multiplier effect
Aggregate supply
P0
I
Initial
shift
AD0
0
Y0
AD1
Y1
Real income
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Monetary Policy in the
Circular Flow
If monetary and fiscal policy are
needed, it is because the financial
sector is in some ways clogged and is
not correctly translating savings into
investment.
 Monetary policy works to unclog the
financial sector.

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Keynesian Monetary Policy
in the Circular Flow, Fig. 14-5, p 352
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Emphasis on the Interest
Rate
A rising interest rate indicates a
tightening of monetary policy.
 A falling interest rate indicates a
loosening of monetary policy.

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Emphasis on the Interest
Rate

A natural conclusion is that the Bank
should target interest rates in setting
monetary policy.
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Real and Nominal Interest
Rates
There is a problem in using interest
rates to measure whether monetary
policy is contractionary or expansionary.
 That problem is the real/nominal interest
rate problem.

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Real and Nominal Interest
Rates
Nominal interest rates are those you
actually see and pay.
 Real interest rates are nominal interest
rates adjusted for expected inflation.

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Real and Nominal Interest
Rates

The real interest rate cannot be
observed since it depends on expected
inflation, which cannot be directly
observed.
Nominal interest rate = Real interest rate
+ Expected inflation rate
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Real and Nominal Interest
Rates and Monetary Policy

Making a distinction between nominal
and real interest rates adds uncertainty
to the effect on monetary policy.
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Real and Nominal Interest
Rates and Monetary Policy

If expansionary monetary policy leads to
expectations of increased inflation,
nominal interest rates will go up, leaving
real interest rates unchanged.
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Real and Nominal Interest
Rates and Monetary Policy

The possible effect of monetary policy
on expectations of inflation has led most
economists to conclude that a monetary
regime, not a monetary policy is the
best approach to policy.
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Real and Nominal Interest
Rates and Monetary Policy
A monetary regime is a predetermined
statement of the policy that will be
followed in various situations.
 A monetary policy, in contrast, is a
response to events which is chosen
without a predetermined framework.

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Real and Nominal Interest
Rates and Monetary Policy

The monetary regime the Bank is
currently using involves feedback rules
that center on the overnight financing
rate.
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Real and Nominal Interest
Rates and Monetary Policy
If inflation is above its target the Bank
rises the target range, decreasing the
money supply.
 If inflation is below its target, and if
economy is going into recession, the
Bank lowers the target range,
increasing the money supply.

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Real and Nominal Interest
Rates and Monetary Policy
If inflation is below its target and the
economy is sliding into a recession the
Fed attempts to expand the economy.
 The Fed lowers the Federal funds rate
by buying bonds thereby increasing the
money supply.

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Problems in the Conduct of
Monetary Policy

Five problems of monetary policy are:
 Knowing
what policy to use.
 Understanding the policy you're using.
 Lags in monetary policy.
 Political pressure.
 Conflicting international goals.
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Knowing What Policy to Use
The potential level of income must be
known.
 Otherwise you don’t know whether to
use expansionary or contractionary
monetary policy.

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Understanding the Policy
You’re Using
You must know whether the policy being
used is expansionary or contractionary
in order to use monetary policy
effectively.
 The Bank only indirectly controls the
monetary base.

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Understanding the Policy
You’re Using
The money multiplier is influenced by
both the amount of cash people hold as
well as the lending process at the bank.
 Neither of these are stable numbers.

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Understanding the Policy
You’re Using
Then there are interest rates.
 If interest rates rise, is it because of
expected inflation or is it that the real
interest rate is going up?

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Lags in Monetary Policy
Monetary policy, like fiscal policy, takes
time to work.
 Just because the Bank decreases
interest rates, that does not necessarily
mean that people will borrow money.

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Lags in Monetary Policy

In the face of a contractionary monetary
policy, banks have been creative in
circumventing cuts in the money supply.
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Political Pressure
The Bank is not totally insulated from
political pressure.
 Politicians place great pressure on the
Bank to use expansionary monetary
policy, especially during an election
year.

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Conflicting International
Goals
Monetary policy is conducted in an
international arena.
 It must be coordinated with other
governments’ monetary policies.

© 2003 McGraw-Hill Ryerson Limited.
Monetary Policy and the
Debate about Macro
Policy
End of Chapter 14
© 2003 McGraw-Hill Ryerson Limited.