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The Bank of Canada and Monetary Policy SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 1 In this chapter you will learn 13.1 The main functions of the Bank of Canada 13.2 The goals and tools of monetary policy 13.3 The mechanism by which monetary policy affects GDP and the price level 13.4 The effectiveness of monetary policy and its shortcomings 13.5 About the effects of the international economy on the operation of monetary policy © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 2 Chapter 13 Topics 13.1 Functions of the Bank of Canada 13.2 Goals & Tools of Monetary Policy 13.3 Monetary Policy, Real GDP, & Price Level 13.4 Problems & Complications 13.5 Monetary Policy & the International Economy © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 3 Functions of the Bank of Canada 1. 2. 3. 4. 5. Acting as the “Bankers’ Bank” Issuing Currency Acting As Fiscal Agent Supervising the Chartered Banks Regulating the Supply of Money © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 4 Bank of Canada Independence controversial voters hold Parliament responsible Bank must be protected from political pressures © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 5 Balance Sheet Of The Bank Of Canada Table 13-1 ASSETS LIABILITIES AND NET WORTH Advances to chartered banks Treasury bills of Canada Other government securities Foreign currency deposits Other assets © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 6 Balance Sheet Of The Bank Of Canada Table 13-1 ASSETS LIABILITIES AND NET WORTH Advances to chartered banks Notes in circulation Treasury bills of Canada Gov’t of Canada deposits Other government securities Chartered bank deposits Foreign currency deposits Other deposits Other assets Other liabilities © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 7 Balance Sheet Of The Bank Of Canada Table 13-1 ASSETS LIABILITIES AND NET WORTH Advances to chartered banks Notes in circulation Treasury bills of Canada Gov’t of Canada deposits Other government securities Chartered bank deposits Foreign currency deposits Other deposits Securities are bought & sold to Other liabilities Other assets influence chartered bank reserves © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 8 Balance Sheet Of The Bank Of Canada Table 13-1 ASSETS LIABILITIES AND NET WORTH Advances to chartered banks Notes in circulation Treasury bills of Canada Gov’t of Canada deposits Other government securities Chartered bank deposits Chartered banksOther can deposits increase reserves by borrowing from the Bank Other liabilities Other assets of Canada Foreign currency deposits © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 9 Balance Sheet Of The Bank Of Canada Table 13-1 ASSETS LIABILITIES AND NET WORTH Advances to chartered banks Notes in circulation Treasury bills of Canada Gov’t of Canada deposits Other government securities Chartered bank deposits Other deposits These deposits necessary for cheque clearing; they areOther partliabilities of banks’ Other assets reserves Foreign currency deposits © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 10 Balance Sheet Of The Bank Of Canada Table 13-1 ASSETS LIABILITIES AND NET WORTH Advances to chartered banks Notes in circulation Treasury bills of Canada Gov’t of Canada deposits Other government securities Chartered bank deposits Foreign currency deposits Other deposits Assets to the federal government, Other liabilities Other assets liabilities to the Bank of Canada © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 11 Balance Sheet Of The Bank Of Canada Table 13-1 ASSETS LIABILITIES AND NET WORTH Advances to chartered banks Notes in circulation Treasury bills of Canada Gov’t of Canada deposits Other government securities Chartered bank deposits Foreign currency deposits Other deposits Paper money in circulation is claim Other liabilities Other assets against the Bank of Canada © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 12 Chapter 13 Topics 13.1 Functions of the Bank of Canada 13.2 Goals & Tools of Monetary Policy 13.3 Monetary Policy, Real GDP, & Price Level 13.4 Problems & Complications 13.5 Monetary Policy & the International Economy © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 13 Goals of Monetary Policy to keep inflation low, stable & predictable, to moderate the business cycle, & help the economy achieve full employment & sustained growth by altering the money supply to influence interest rates inflation target range of 1—3% annually © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 14 Tools of Monetary Policy Three instruments: Open-Market Operations Government Deposit Shifting Bank Rate © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 15 Open-Market Operations Bank of Canada’s buying bonds from & selling them to chartered banks & the general public © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 16 Open-Market Operations Bank of Canada BUYS bonds From the chartered banks… – Chartered bank gives up bonds – Bank of Canada pays chartered bank by increasing chartered bank’s reserves © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 17 Open Market Operations Bank Of Canada BUYS $1,000 Of Securities From The Chartered Banks Bank of Canada Assets Liabilities © 2005 McGraw-Hill Ryerson Ltd. Chartered Banks Assets Liabilities Macroeconomics, Chapter 13 18 Open Market Operations Bank Of Canada BUYS $1,000 Of Securities From The Chartered Banks Bank of Canada Assets Liabilities Chartered Banks Assets Liabilities + Securities - Securities © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 19 Open Market Operations Bank Of Canada BUYS $1,000 Of Securities From The Chartered Banks Bank of Canada Assets Liabilities + Securities + Reserves of chartered banks © 2005 McGraw-Hill Ryerson Ltd. Chartered Banks Assets Liabilities - Securities + Reserves Macroeconomics, Chapter 13 20 Open-Market Operations Bank of Canada BUYS bonds From the chartered banks… – Chartered bank gives up bonds – Bank of Canada pays chartered bank by increasing chartered bank’s reserves From the public… – Public gives up bonds for cheque – Cheque is deposited in chartered bank – Chartered bank’s reserves increase © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 21 Open Market Operations Bank Of Canada BUYS $1,000 Of Securities From The Public Bank of Canada Assets Liabilities © 2005 McGraw-Hill Ryerson Ltd. Chartered Banks Assets Liabilities Macroeconomics, Chapter 13 22 Open Market Operations Bank Of Canada BUYS $1,000 Of Securities From The Public Bank of Canada Assets Liabilities + Securities © 2005 McGraw-Hill Ryerson Ltd. Chartered Banks Assets Liabilities +Deposits Macroeconomics, Chapter 13 23 Open Market Operations Bank Of Canada BUYS $1,000 Of Securities From The Public Bank of Canada Assets Liabilities + Securities + Reserves of chartered banks Chartered Banks Assets Liabilities + Reserves +Deposits some reserves must be kept on hand against this deposit © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 24 Bank Of Canada Bond Purchase Purchase of a $1000 bond from a chartered bank.... Figure 13-1 New reserves $1000 Excess reserves D=E X m = $1000 X 1/.20 =$1000 X 5 $5,000 Chartered bank system lending Total increase in money supply ($5,000) © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 25 Bank Of Canada Bond Purchase Purchase of a $1000 bond from the public.... Figure 13-1 New reserves $800 Excess reserves $200 Desired reserves D=E X m = $800 X 1/.20 =$800 X 5 $1000 $4000 Initial Chartered bank system lending deposit Total increase in money supply ($5,000) © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 26 Open-Market Operations Bank of Canada BUYS bonds – Chartered bank’s reserves increase – Banks increase lending – Money supply increases Bank of Canada SELLS bonds – Chartered bank’s reserves decrease – Banks decrease lending – Money supply decreases © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 27 Switching Government of Canada Deposits Bank of Canada is the federal government’s bank Switching deposits FROM the chartered banks to the Bank of Canada reduces deposits & reserves Switching deposits TO the chartered banks from the Bank of Canada increases deposits & reserves © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 28 The Bank Rate & the Overnight Loans Rate Bank rate is the interest rate the Bank of Canada charges on the loans to the chartered banks Bank rate is set at the upper end of the Bank of Canada’s operating band for the overnight lending rate Bank has a publicized target for the overnight lending rate © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 29 Easy Money & Tight Money Recession & unemployment easy money policy buy securities, or switch government deposits to chartered banks, or reduce the bank rate © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 30 Easy Money & Tight Money Inflation tight money policy sell securities, or switch government deposits from chartered banks, or increase the bank rate © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 31 Relative Importance of the three policy instruments, buying & selling securities in the open market is by far the most important switching government deposits used occasionally, but on a small scale bank rate is a signalling device © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 32 Chapter 13 Topics 13.1 Functions of the Bank of Canada 13.2 Goals & Tools of Monetary Policy 13.3 Monetary Policy, Real GDP, & Price Level 13.4 Problems & Complications 13.5 Monetary Policy & the International Economy © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 33 Monetary Policy, Real GDP & the Price Level Cause-Effect Chain: The Transmission Mechanism Money supply impacts interest rates Interest rates affect investment Investment is a component of AD Equilibrium GDP is changed © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 34 Real rate of interest, i Monetary Policy and Equilibrium GDP- Fig.13-2 i% i% Sm0 10 10 8 8 6 6 Dm 0 $billions $125 Investment Demand 0 $15 $billions Price level potential AS GDP P1 AD0 GDP0 If the money supply increases to stimulate the economy.... Real GDP 35 Real rate of interest, i Monetary Policy and Equilibrium GDP- Fig.13-2 i% i% Sm0 Sm1 10 10 8 8 6 6 Dm 0 $125 $150 $billions Investment Demand 0 $15 $billions Price level potential AS GDP P1 AD0 GDP0 Real GDP 36 Real rate of interest, i Monetary Policy and Equilibrium GDP- Fig.13-2 i% i% Sm0 Sm1 10 10 8 8 6 6 Dm 0 $125 $150 $billions Investment Demand 0 $15 $billions Price level potential AS GDP P1 AD0 GDP0 Interest rates fall as people work off excess money by buying bonds Real GDP 37 Real rate of interest, i Monetary Policy and Equilibrium GDP- Fig.13-2 i% i% Sm0 Sm1 10 10 8 8 6 6 Dm 0 $125 $150 $billions Investment Demand 0 $15 $20 $billions Price level potential AS GDP Investment increases in response to lower interest costs P1 AD0 GDP0 Real GDP 38 Real rate of interest, i Monetary Policy and Equilibrium GDP- Fig.13-2 i% i% Sm0 Sm1 10 10 8 8 6 6 Dm 0 $125 $150 $billions Investment Demand 0 $15 $20 $billions Price level potential AS GDP Investment increase increase in AD (multiplier effect) P1 AD0 GDP0 AD1 Real GDP 39 Real rate of interest, i Monetary Policy and Equilibrium GDP- Fig.13-2 i% i% Sm0 Sm1 10 10 8 8 6 6 Dm 0 $125 $150 $billions Investment Demand 0 $15 $20 $billions Price level potential AS GDP Increase in GDP and price level P2 P1 AD0 GDP0 GDPf AD1 Real GDP 40 Real rate of interest, i Monetary Policy and Equilibrium GDP- Fig.13-2 i% i% Sm0 Sm1 10 10 8 8 6 6 Dm 0 $125 $150 $billions Investment Demand 0 $15 $20 $billions Price level potential AS GDP If the money supply increases again... P2 P1 AD0 GDP0 GDPf AD1 Real GDP 41 Real rate of interest, i Monetary Policy and Equilibrium GDP- Fig.13-2 i% i% Sm0 Sm1 Sm3 10 10 8 8 6 6 0 Dm $125 $150 $175 $billions Price level potential AS GDP P3 P2 P1 AD0 GDP0 AD1 GDPf GDP1 AD2 Investment Demand 0 $15 $20 $25 $billions GDP doesn’t increase as much-multiplier effect weaker because of shape of AS Real GDP 42 Table 13-2 Problem: Recessionary Gap Bank of Canada buys bonds, switches deposits to chartered banks, or lowers the bank rate Reserves increase Money supply rises Interest rate falls Investment spending increases Aggregate demand increases Real GDP rises by a multiple of the increase in investment © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 43 Table 13-2 Problem: Inflationary Gap Bank of Canada sells bonds, switches deposits from chartered banks, or both Reserves decrease Money supply falls Interest rate rises Investment spending decreases Aggregate demand decreases Inflation declines © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 44 Monetary Policy in Action dominant component of Canadian national stabilization policy two key advantages over fiscal policy: – speed & flexibility – isolation from political pressure © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 45 Focus on the Overnight Lending Rate Bank of Canada communicates changes in monetary policy by announcing changes in the upper limit for the operating band for the overnight lending rate – increase in upper limit signals tighter monetary policy – decrease in upper limit signals easier monetary policy © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 46 Changes in the prime interest rate generally track changes in the bank rate Figure 13-3 © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 47 Focus on the Overnight Lending Rate Bank of Canada does not set the overnight lending rate or the prime rate – each is set by the interaction of borrowers & lenders Bank achieves desired interest rate by changing reserves Banks uses special purchase & resale agreements (SPRA) & sale & repurchase agreements (SRA) to reinforce target overnight rate © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 48 Recent Monetary Policy early 1990s: restrictive monetary policy after the recession of 1991-2 made growth slow easing encouraged growth in the second half of the 1990s vigorous economy & stock market bubble led to tightening at the end of the 1990s economy slowed at the end of 2000, so Bank cut interest rates in 2001 expansion in 2002 led to increased rates © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 49 Chapter 13 Topics 13.1 Functions of the Bank of Canada 13.2 Goals & Tools of Monetary Policy 13.3 Monetary Policy, Real GDP, & Price Level 13.4 Problems & Complications 13.5 Monetary Policy & the International Economy © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 50 Problems & Complications monetary policy has certain limitations – lags – changes in velocity – cyclical asymmetry inflation targeting – has increased transparency of monetary policy & accountability – critics say inflation targeting is too narrow © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 51 Chapter 13 Topics 13.1 Functions of the Bank of Canada 13.2 Goals & Tools of Monetary Policy 13.3 Monetary Policy, Real GDP, & Price Level 13.4 Problems & Complications 13.5 Monetary Policy & the International Economy © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 52 Monetary Policy & the International Economy Net exports effects reinforce monetary policy © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 53 Table 13-3 Problem: recession, slow growth Easy money policy (lower interest rate) Decreased foreign demand for dollars Dollar depreciates Net exports increase Aggregate demand increases Monetary policy is reinforced © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 54 Table 13-3 Problem: inflation Tight money policy (higher interest rate) Increased foreign demand for dollars Dollar appreciates Net exports decrease Aggregate demand decreases Monetary policy is reinforced © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 55 Monetary Policy & the International Economy Macro Stability & the Trade Balance The easy money policy that is appropriate for the alleviation of unemployment & sluggish growth is compatible with the goal of correcting a balance-of-trade deficit The tight money policy used to alleviate inflation conflicts with the goal of correcting a balance-of-trade deficit © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 56 The Big Picture Key graph 13-4 (see the text) integrates the various components of macroeconomic theory & stabilization policy © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 57 Chapter 13 Topics 13.1 Functions of the Bank of Canada 13.2 Goals & Tools of Monetary Policy 13.3 Monetary Policy, Real GDP, & Price Level 13.4 Problems & Complications 13.5 Monetary Policy & the International Economy © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 13 58