Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
Exchange rate wikipedia , lookup
Business cycle wikipedia , lookup
Nominal rigidity wikipedia , lookup
Real bills doctrine wikipedia , lookup
Ragnar Nurkse's balanced growth theory wikipedia , lookup
Okishio's theorem wikipedia , lookup
Modern Monetary Theory wikipedia , lookup
Fiscal multiplier wikipedia , lookup
Helicopter money wikipedia , lookup
Monetary policy wikipedia , lookup
Quantitative easing wikipedia , lookup
1 of 80 Chapter 19 What Macroeconomics Is All About Copyright © 2011 Pearson Canada Inc. 2 of 80 Output and Income National output of goods and services during a given period is measured as gross domestic product - GDP A nation’s income during a given period is exactly equal to the total of all goods and services it creates during a given period Therefore Y = GDP MFC 41-111 MFC 41-111 MFC 41-111 MFC41-111MFC2007 3 of 80 Potential output is what the economy could produce if all resources were employed at their normal levels of utilization - often called full-employment output Output Gap = Y-Y* When Y < Y* , there is a recessionary gap. When Y > Y*, there is an inflationary gap. Copyright © 2011 Pearson Canada Inc. 4 of 80 Real GDP Recessionary Gap Peak Actual GDP Potential GDP Peak Trough Inflationary Gap Time Copyright © 2011 Pearson Canada Inc. 5 of 80 Employment, Unemployment, and the Labour Force Productivity Inflation and the Price Level Interest Rates The International Economy Copyright © 2011 Pearson Canada Inc. 6 of 80 Chapter 20 The Measurement of National Income Copyright © 2011 Pearson Canada Inc. 7 of 80 IMa Ca Ia Ga Xa Ca + Ia + Ga + (Xa - IMa) = GDP mfc2007mfc2007mfc2007mfc2007mfc2007mfc2007 8 of 80 Does the accounting identity GDP = Ca + Ia + Ga + (Xa - IMa) imply that everything that firms produce each year is automatically sold to customers? NO! INVENTORIES! INVENTORIES! INVENTORIES! mfc2007mfc2007mfc2007mfc2007mfc2007mfc2007 9 of 80 Chapter 21 The Simplest Short-Run Macro Model Copyright © 2011 Pearson Canada Inc. 10 of 80 We use the same conceptual set up to do macroeconomic theory as the national income accountants IM But we are doing something quite different C I G X C + I + G + (X - IM) = Desired Aggregate Expenditure mfc2007mfc2007mfc2007mfc2007mfc2007mfc2007 11 of 80 Two general types of expenditures: - autonomous expenditures do not depend on the level of national income - induced expenditures do depend on the level of national income MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007 12 of 80 The Aggregate Expenditure Function The AE function: - relates desired aggregate expenditure to actual national income In the absence of government and international trade, desired aggregate expenditure is: AE = C + I This is called a ‘closed economy with no government’ no Government, no Trade AE = C + I + G + NX A Lou Dobbs economy (or perhaps the Fox Network economy). mfc2007mfc2007mfc2007mfc2007 Copyright © 2011 Pearson Canada Inc. 13 of 80 The simple consumption function is written as: C = a + bYD where a represents autonomous consumption expenditure and bYd represents induced consumption expenditure. C a 45º line C Slope = b Note: the slope of this simple consumption function (b) is less than one. YD mfc2007mfc2007mfc2007mfc2007 Copyright © 2011 Pearson Canada Inc. 14 of 80 Shifts in the Consumption Function What might cause a shift in the consumption function (the amount of consumption desired by all households at all levels of income)? - change in wealth - change in interest rates - change in expectations - change in population size or age distribution - change in taste - ? MFC2007MFC2007MFC2007MFC2007MFC2007MFC2007 15 of 80 Desired Investment Expenditure Recall: Investment refers to purchases of - capital stock (plant & equipment) - residential building - business inventories Investment expenditure is the most volatile component of GDP: changes in investment expenditure are strongly associated with short-run fluctuations Three important determinants of aggregate investment expenditure are: • the real interest rate • changes in the level of sales • business confidence mfc2007mfc2007mfc2007mfc2007 Copyright © 2011 Pearson Canada Inc. 16 of 80 The equilibrium condition is: Y = AE(Y) Desired A.E. In this model, output is said to be demand determined. 45º line AE 900 600 • 300 105 300 600 900 Actual National Income In words: Equilibrium national income is that level of national income where desired aggregate expenditure equals actual national income. Copyright © 2011 Pearson Canada Inc. 17 of 80 21.2 Equilibrium National Income Recall: desired aggregate expenditure is what buyers want to buy during the period (C + I in our simple model) actual output is what firms actually produce during the period (Y or GDP) If desired aggregate expenditure exceeds actual output: - what is happening to inventories? falling - there is pressure for output to rise If desired aggregate expenditure is less than actual output: - what is happening to inventories? rising - there is pressure for output to fall mfc2007mfc2007mfc2007mfc2007 Copyright © 2011 Pearson Canada Inc. 18 of 80 Simple multiplier = Y 1 = A 1-z AE AE =Y E1 • e1 • e´1 where z is the marginal propensity to spend out of national income and A is the change in autonomous expenditure. AE0 A e0 • E0 Y0 AE1 Y Y1 Y Copyright © 2011 Pearson Canada Inc. 19 of 80 Chapter 22 Adding Government and Trade to the Simple Macro Model Copyright © 2011 Pearson Canada Inc. 20 of 80 In this chapter we consider all of the economic agents who might buy final goods and services from Canadian firms C IM I X G C + I + G + (X - IM) = Desired Aggregate Expenditure mfc2007mfc2007mfc2007mfc2007mfc2007mfc2007 21 of 80 22.1 Introducing Government Government Purchases Net Tax Revenues Copyright © 2011 Pearson Canada Inc. 007,MFC2007MFC2007MFC2007 22 of 80 22.2 Introducing Foreign Trade Net Exports For imports, we assume: IM = mY where m is the marginal propensity to import. Thus, net exports are given by: NX = X - mY Copyright © 2011 Pearson Canada Inc. 23 of 80 Shifts in the Net Export Function - Summary * Foreign Income - An increase in foreign income results in an increase in Canadian exports - NX function shifts up. (and the reverse) Relative International Prices - A rise in Canadian prices relative to foreign prices reduces Canadian exports (X shifts down). The IM function also rotates up since Canadians now spend a higher fraction of income on foreign goods. The NX (=X-IM) function shifts down and also gets steeper. (and the reverse) Appreciation of the Canadian dollar - A rise in the value of the Canadian dollar reduces Canadian exports (X shifts down). The IM function also rotates up since Canadians now spend a higher fraction of income on foreign goods. The NX (=X-IM) function shifts down and also gets steeper. (and the reverse) Other considerations: Barriers to trade – tariffs, quotas, regulations, etc. Mad cow disease, lead paint on toys, etc. Taste – trade promotion, ‘buy Canadian’ MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 24 of 80 The Multiplier with Taxes and Imports Imports and taxes make z smaller the simple multiplier is also smaller z = b(1 - t) - m Copyright © 2011 Pearson Canada Inc. 25 of 80 What might cause the AE line to shift upwards or downwards? * AE AE =Y - interest rate E0 • e0 - exchange rate - expectations (confidence) - wealth e´1 - Canadian prices relative to foreign prices e1 • AE0 AE AE1 •E 1 - foreign incomes -G Y1 - etc. Y What might cause the slope of the AE line to change? MPC (or b), t, m MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 Y0 Y 26 of 80 Chapter 23 Output and Prices in the Short Run Copyright © 2011 Pearson Canada Inc. 27 of 80 The Aggregate Demand Curve The aggregate demand (AD) curve relates equilibrium real GDP to the price level. For any given P, the AD curve shows the level of real GDP for which desired aggregate expenditure equals actual GDP. Changes in the price level cause movements along the AD curve. Copyright © 2011 Pearson Canada Inc. 28 of 80 AE E0 • E1 • AE =Y AE0 ( at P0) AE1 (at P1 > P0) AE2 (at P2 > P1) E2 • Y2 Y1 Y0 P P2 Y The AE curve shifts down, but we move along the AD curve. • • P1 P0 Y2 Y1 Consider a rise in the price level, from P0 to P2: • Y0 AD Y Copyright © 2011 Pearson Canada Inc. 29 of 80 Price Level Shifts in the Aggregate Supply Curve Anything that increases firms’ costs causes the AS curve to shift up: AS1 • P1 AS0 - factor prices - technology P0 • Y1 • Y0 - regulation Real GDP Why does AS get steeper as output rises? Copyright © 2011 Pearson Canada Inc. 30 of 80 What does the Aggregate Supply Curve look like? Price Level Unless, the economy is in a serious recession and firms have a lot of unused capacity, unit costs rise with output (Marginal Costs generally increases as output increases) firms will produce more output only if prices increase. The AS curve is therefore upward sloping (except at very levels of output). AS1 • P1 P0 In the short run firms generally find that MC increases as output increases so they will increase production only if they get higher prices. • Y0 This is straight out of the microeconomics of the firm. Y1 Y (GDP) MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 31 of 80 23.3 Macroeconomic Equilibrium E0 is the macroeconomic equilibrium. AD AS Price Level Demand behaviour is consistent with supply behaviour only at the intersection of the two curves. E0 P0 P1 • Y1 • • Y0 Y2 Real GDP Copyright © 2011 Pearson Canada Inc. 32 of 80 Aggregate Demand Shocks Possible causes: - ΔG > 0 AD1 Price Level Demand shocks cause P and Y to change in the same direction. AS AD0 P1 P0 E0 • E1 • - ΔI > 0 - ΔX > 0 Y0 Y1 Real GDP - ΔC > 0 Copyright © 2011 Pearson Canada Inc. 33 of 80 Aggregate Supply Shocks Aggregate supply shocks cause P and Y to change in opposite directions. Possible causes: - Δ price of inputs - Δ wages - Δ technology - Δ regulation P AS1 AS0 P1 P0 E1 • • Y1 E0 AD Y0 Copyright © 2011 Pearson Canada Inc. 34 of 80 Chapter 24 From the Short Run to the Long Run: The Adjustment of Factor Prices Copyright © 2011 Pearson Canada Inc. 35 of 80 24.1 The Adjustment Process Potential Output and the Output Gap AS P AS P E0 E1 • Output gap Y* Y0 • AD AD Output gap Y Output Gap = Y - Y1 Y* Y Y* NOTE: The adjustment to E0 or E1 occurs fairly quickly Copyright © 2011 Pearson Canada Inc. MFC2007,MFC2007MFC2007MFC2007 36 of 80 Factor Prices and the Output Gap Really, what we are interested in is: How fast are wages rising relative to productivity growth? If productivity (output per person hour) grows at 2% then wages can grow at 2% without any effect on cost per unit (the AS curve will not shift). Y > Y* => excess demand for labour => wages tend to rise faster than productivity (AS shifts up and back) Y < Y* => excess supply for labour => wages tend to rise more slowly than productivity (AS shift down and out) Y = Y* => no excess supply/demand => wages rise and the same rate as productivity (AS does not shift) Copyright © 2011 Pearson Canada Inc. 37 of 80 24.2 Aggregate Demand and Supply Shocks Expansionary AD Shocks The economy’s adjustment process eventually eliminates any boom caused by a demand shock, returning Y to Y*. P P2 P1 P0 AS1 Price level rises further Price level rises AS0 • E2 • • E0 Inflationary gap opens Inflationary Y* gap closes E1 AD1 AD0 Y1 Y Copyright © 2011 Pearson Canada Inc. 38 of 80 Contractionary AD Shocks The economy’s adjustment process works following negative demand shocks, too. - although it may be slower because of “sticky wages” P P0 P1 AS0 AS1 Price level falls further • E0 • P2 Recessionary gap closes opens Y1 E1 • E2 AD0 AD1 Y* Y Copyright © 2011 Pearson Canada Inc. 39 of 80 Aggregate Supply Shocks P P1 AS1 Price level rises falls AS0 E1 • After a negative supply shock, the adjustment of factor prices reverses the AS shift and returns real GDP to Y*. • E0 P0 Recessionary gap closes opens Y1 AD Y* Y Example: Consider an increase in the world price of some important raw materials. Copyright © 2011 Pearson Canada Inc. 40 of 80 P In the long run, Y is determined only by potential output — aggregate demand determines P. E1 • P1 E0 • P0 AD1 AD0 Y Y0* P For a given AD curve, long-run growth in Y* results in a lower price level. P0 E0 • • P1 Y0* E2 Y1* AD0 Y Copyright © 2011 Pearson Canada Inc. 41 of 80 The Basic Theory of Fiscal Stabilization P P AS0 AS AS1 P1 P0 E0 • • E1 P0 P1 AD1 E0 • • AD0 Y0 Y* E1 AD Y Y0 Y* Y A recessionary gap may be closed by a rightward shift in AD or by a (possibly slow) rightward shift in the AS curve. Copyright © 2011 Pearson Canada Inc. 42 of 80 P P AS1 AS0 AS E1 • E0 P0 P1 E1 • Y* P1 P0 AD0 • • E0 AD AD1 Y0 Y Y* Y0 Y An inflationary gap may be removed by a leftward shift in AD, or by a leftward shift of AS. Copyright © 2011 Pearson Canada Inc. 43 of 80 Practical Limitations of Discretionary Fiscal Policy Most economists agree that automatic fiscal stabilizers are desirable and generally work well, but they have concerns about discretionary fiscal policy. Limitations come from: • long and uncertain lags • temporary versus permanent changes in policy • the impossibility of “fine tuning” • regionalized nature of Canada • Federal/Provincial powers Copyright © 2011 Pearson Canada Inc. MFC2007,MFC2007MFC2007MFC2007 44 44 of of 80 18 Chapter 25 The Difference Between Short-Run and Long-Run Macroeconomics Copyright © 2011 Pearson Canada Inc. 45 45 of of 80 18 GDP = F x (FE/F) x (GDP/FE) What are the three separate terms? 1. F is the factor supply. 2. FE/F is the factor utilization rate. 3. GDP/FE is a simple measure of productivity. Any change in GDP must be associated with a change in one or more of these things. How do these three components change over time? Copyright © 2011 Pearson Canada Inc. 46 of 80 1. Factor Supplies - supplies of labour and capital change only gradually labour – population growth, immigration, higher participation rates) capital – more investment 2. Productivity - productivity changes only gradually improved labour – healthier, better trained and educated improved capital – embodied technical change improved technology – disembodied technical change 3. Factor Utilization Rate – output gap as a percentage of Y* (Y-Y*)/Y * 100 - fluctuates a lot in the short run - fluctuates very little in the long run MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 47 of 80 Chapter 26 Long-Run Economic Growth Copyright © 2011 Pearson Canada Inc. 48 of 80 Investment, Saving, and Growth Our model has two parts: Investment — increases in the stock of capital — lead to increases in the future level of Y*. Saving by households (and firms) is used to finance this investment. interest rate is the “price” that equilibrates this market Copyright © 2011 Pearson Canada Inc. 49 of 80 Suppose the supply of national saving increases: the NS curve shifts to the right Increased national saving reduces the real interest rate and encourages more investment NS0 NS1 - change in tax laws E0 i0* i1* • - change in taste - gov’t surpluses • E1 I0* I1* I Loanable Funds Greater flow of investment leads to a higher growth rate of potential output. MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 50 of 80 Now suppose that investment demand increases the I curve shifts to the right Increased investment demand pushes up the interest rate and encourages more saving by households - new products/technology NS - change in expectations i1* i0* E0 • • E1 I1 I0 I0* I1* Greater flow of saving (and investment) leads to a higher growth rate of Y*. Loanable Funds MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 51 of 80 Neoclassical Growth Theory This theory begins with the idea of an aggregate production function: GDP = FT(L,K,H) - L is the total amount of labour - K is the stock of physical capital (including natural resources) - H is the quality of human capital - T is the state of technology The notation FT reflects the assumption that changes in technology will change the production function. Copyright © 2011 Pearson Canada Inc. 52 of 80 In the Neoclassical growth model, technological change is necessary for sustained growth in living standards. Much technological change is embodied in new capital equipment investment is crucial Measuring the extent of technological change is difficult – because it is not directly observable. Copyright © 2011 Pearson Canada Inc. 53 of 80 Average Product of Labour In terms of Average Product of labour The economy can keep getting bigger – more capital and more labour – but it does not get any better – no increase in APL (no increase in living standards – GDP per capita) APL Population Labour force = σ population The APL curve just keep shifting to the right as more labour and capital are added – we technical change to make the APL curve shift upwards. MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 54 of 80 26.3 New Growth Theories Endogenous Technological Change New growth theory emphasizes the process of innovation and the incorporation of new technology: • learning-by-doing ‘the more you do the more you can do’ • knowledge transfer ‘hands on’ experience • market structure and innovation • shocks and innovation competitive pressure spur innovation Copyright © 2011 Pearson Canada Inc. 55 of 80 Chapter 27 Money and Banking 56 of 80 27.1 THE NATURE OF MONEY What Is Money? Modern Money: Deposit Money Modern Money - two components Currency in the hands of the non-bank public - bills and coins about 5% of the total money supply Deposit with commercial banks and other financial institutions (deposit money) – chequing accounts, savings accounts, etc. about 95% of the total money supply MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 57 of 80 What is money? Money is a TECHNOLOGY (of exchange) Money is TRUST (in the monetary authorities) Money is CREDIT (created by banks as they create money) Money is a claim on a goods and services. You get a claim on goods and services by selling (producing) something of value in exchange for money, or someone gives you some of their claims which they got by selling (producing) something of value. As long as the number of claims grows at the same rate as the output of goods and services produced each period (GDP), then the money is good in the sense that it retains its value – the amount of goods and services that you can get with one unit of the money remains constant. A Simple Rule The money supply should grow at the same rate as the growth in GDP (not everyone agrees with this rule). MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 58 of 80 27.2 THE CANADIAN BANKING SYSTEM Most modern banking systems have: - a central bank - many commercial banks A central bank acts as a bank to the banking system: - usually a government-owned institution - the sole money-issuing authority 59 of 80 Excess Reserves and Cash Drains Deposit creation does not happen automatically; it depends on the decisions of bankers. Bankers must find appropriate borrowers to lend their excess reserves to. A cash drain: - if households hold a fraction of their deposits in cash, the deposit-creation process is dampened If c is the currency-deposit ratio, the final change in deposits will be given by: Re serves Deposits c v 60 of 80 Chapter 28 Money, Interest Rates, and Economic Activity 61 of 80 Present Value and the Interest Rate Present value: - the value now of one or more payments or receipts made in the future Consider an asset that pays $X in one year’s time. If the interest rate is i% per year, the PV of the asset is PV = $X/(1+i) Notice that, ceteris paribus, the PV is negatively related to the interest rate. 62 of 80 A Sequence of Future Payments - the general formula PV = R1 + R2 + … + RT (1+i) (1+i)2 (1+i)T This simple present value formula tells how to price any promise of future payments. MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 63 of 80 Interest Rates, Market Prices and Bond Yields Conclusion: The price of bonds is inversely related to the market rate of interest As a simplification we can say that the price of bonds = 1/i Note it works both ways: If the demand for bonds increases this drives up the price of bonds and i falls (since Pb = 1/i). But also If interest rates fall, then the price of bonds will increase (since Pb = 1/i). MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 64 of 80 There are three reasons for holding money: • the transactions motive f (P, real GDP) • the precautionary motive - liquidity f (P, real GDP, i) • the speculative motive f (i, expectations) The Determinants of Money Demand We focus on three variables: - real GDP (+) - the price level (+) - the interest rate (-) MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 65 of 80 28.3 MONETARY EQUILIBRIUM AND NATIONAL INCOME Monetary Equilibrium MS excess supply of money i2 i0 i1 • • excess demand for money • M1 M2 M0 Quantity of Money MD Monetary equilibrium occurs when the quantity of money demanded equals the quantity of money supplied: equilibrium interest rate 66 of 80 Monetary Equilibrium – what’s happening in the bond market? If MS > MD (excess supply of money) at the current i BS pB2 The public will want to decrease their money holdings. • By buying bonds. pB0 pB1 B’D • • B1 B2 B0 Quantity of Bonds BD The demand for bonds shifts out and the equilibrium price of bonds increases – but an increase in the price of bonds means the interest rate must have fallen. MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 67 of 80 What’s happening in the financial (asset) markets in general? If MS > MD (excess supply of money) at the current i, the public might buy bonds but they might also buy other assets (anything that promises a return on their investment (money). Equities S • TSXB2 TSXB0 In general this situation means that the public will want to look for a place to ‘invest’ the excess money that they hold. Equities D’ • Equities D E0 We keep the story simple by focusing on the bond market but the excess money might end up flowing into any asset – the stock market, junk bonds, housing, foreign debt, etc. Sub-prime mortgages E1 Quantity of Equities MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 68 of 80 What’s happening in the financial (asset) markets in general? If MS > MD (excess supply of money) at the current i What determines where the ‘new money’ shows up? Many things but basically banks must find new borrowers – so the demand for loans often leads the way. HS • hB2 hB0 H’D • HD H2 H0 H1 Quantity of Housing If banks have too much money to lend they may be tempted to lend to higher risk borrowers (higher defaults and financial instability follow). Maybe they lend to borrowers investing in housing sub-prime mortgages, maybe ‘dot com companies’, maybe junk bonds. MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 69 of 80 The Monetary Transmission Mechanism Monetary transmission mechanism: - connects changes in MD and/or MS with aggregate demand Three stages: 1. ΔMD or ΔMS Δ in equilibrium interest rate 2. Δi Δ in desired investment (and consumption) expenditure 3. ΔID and ΔC and Δ NX Δ in AD 70 of 80 An increase in the supply of money or A decrease in the demand for money Excess supply of money A fall in interest rates An increase in desired investment expenditure Capital outflow and currency depreciation Increase in net exports An upward shift in the AE curve A rightward shift in the AD curve AS0 Interest Rate Price Level 71 of 80 MS0 i0 P1 P0 • • E0 E1 Y0 Y* AD1 AD0 i1 i1’ E0 MS1 • • E1 • MD0 MD1 Quantity of Money Real GDP But in the long-run - P increases (in short-run) causing MD to shift out a bit - But Y0 goes to Y* (normal level of employment) therefore no unusual increases in wages and no shift in AS P1 P0 AS0 • • E1 E0 Y0 Y* AD1 AD0 Interest Rate Price Level 72 of 80 MS0 MS1 i0 • i1 • E1 • i1’ MD0 MD1 Quantity of Money Real GDP Finally after the long-run adjustment is finished - i is lower - Y has returned to Y* (we are out of the recession – money is not neutral) - P has changed (increased – inflation) – more M, higher P 73 of 80 Chapter 29 Monetary Policy in Canada 74 of 80 29.1 HOW THE BANK OF CANADA IMPLEMENTS MONETARY POLICY Money Supply Versus the Interest Rate For any given money demand curve, any central bank must choose between: - setting the money supply - setting the interest rate Both cannot be set independently. 75 of 80 76 of 80 How could the Bank of Canada actually try to increase the MS? 1. Simply lend reserves to commercial banks 2. Open Market Operations 1. B of C buys G of C bonds in the open market 2. B of C pays for the bonds by writing a cheque cashable at the B of C 3. Seller of G of C bonds deposits the cheque in her commercial bank account 4. Her commercial bank deposits the cheque at the B of C – commercial bank reserves have just increased How to decrease the MS? Do the reverse MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 77 of 80 The Bank of Canada and the Overnight Interest Rate The Overnight Interest Rate Commercial banks borrow and lend reserves to each other overnight. The Overnight Interest Rate is the interest rate in this overnight market. You can think of this rate as the cost of reserves to commercial banks. MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 78 of 80 The Bank of Canada can more-or-less control the overnight interest rate. It does this by: 1. Setting a target for the overnight interest rate 2. Establishing the Bank Rate 0.25% above this target B of C will lend any amount of reserves at this rate 3. Establishing a borrowing rate 0.25% below target B of C will borrow any amount of reserves at this rate keep actual overnight rate within 0.5% band 79 of 80 29.2 INFLATION TARGETING Inflation Targeting as a Stabilizing Policy What Are the Lags in Monetary Policy? Monetary policy operates with a time lag that is long and variable for two main reasons: MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 80 of 80 Destabilizing Policy? Long and variable lags some monetarists argued that central banks should not try to stabilize national income. They argued that attempts to stabilize will more likely be destabilizing - they advocate the use of a monetary rule - increase bank reserves at a constant rate Most economists now agree that monetary policy can lead to more economic stability. ???? MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007