MACROECONOMICS BY CURTIS, IRVINE, AND BEGG SECOND CANADIAN EDITION MCGRAW-HILL RYERSON, © 2010 Chapter 10 Central Banking & Monetary Policy.

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MACROECONOMICS BY CURTIS, IRVINE, AND BEGG SECOND CANADIAN EDITION MCGRAW-HILL RYERSON, © 2010 Chapter 10 Central Banking & Monetary Policy

Learning Outcomes ©2010 McGraw-Hill Ryerson Ltd. Chapter 10 2 This chapter explains: Central banking and the Bank of Canada Central banking operating techniques to control money supply and interest rates Monetary policy targets and instruments in Canada Monetary policy rules The long-run neutrality of money Monetary policy indicators

Central Banking and the Bank of Canada ©2010 McGraw-Hill Ryerson Ltd. Chapter A central bank conducts monetary policy Monetary policy is: Central bank action to: ∆AD & economic performance using its power to: ∆M or ∆i or ∆er (cannot do all changes simultaneously)  ∆AD  ∆Y + ∆Employment + ∆P Central bank balance sheet illustrates operations

©2010 McGraw-Hill Ryerson Ltd. Chapter The Balance Sheet of the Bank of Canada, 2007 (year-end, millions of dollars) Notes in circulation 50,565Government of Canada Securities Treasury bills 20,281 Government bonds of maturity <= 3 years 11,091 > 3 years 18,269 AssetsLiabilities Advances to members of the Canadian Payment Association 1 Securities from Resale Agreements 3,963 Foreign currency deposits 3 Other assets 289 Total 53,897 Deposits Government of Canada 1,970 Chartered banks and other members 502 Canadian Payment Association - Foreign central banks 143 Foreign currency liabilities - Other liabilities 717 Total 53,897

Central Banking and the Bank of Canada ©2010 McGraw-Hill Ryerson Ltd. Chapter Central bank:  Is the source of monetary base, H  Creates H by buying bonds & issuing central bank liabilities (notes & central bank deposits) Bank of Canada:  Govt bonds = 90+% of assets  Notes in circulation = 90+% of liabilities Bank of Canada:  Also promotes stability in financial markets  E.g. “purchase and resale agreements” to provide liquidity when needed.

Central Bank Operating Techniques ©2010 McGraw-Hill Ryerson Ltd. Chapter Three main techniques to control Monetary Base (H) & Money supply 1. Establishing reserve requirements – Legally Required Reserve Ratio (rr = rr*) – Determines money multiplier in money supply function 2. Using open-market operations – Main technique: buy or sell govt bonds – Determines monetary base (H) in money supply function 3. Setting the bank rate – Sets cost of borrowing monetary base – Signals monetary policy change

Open Market Operations ©2010 McGraw-Hill Ryerson Ltd. Chapter Central bank purchase or sale of govt bonds in financial market:  Open market purchase  ↑ assets & ↑ liabilities  ↑ monetary base (H)  Open market sale  ↓ assets & ↓ liabilities  ↓ monetary base (H) Open market operations: main instrument for longer term management of monetary base (H)

An Open-Market Purchase and the Money Supply Central BankCommercial Banks AssetsLiabilitiesAssetsLiabilities 1. Open-market purchase: $100 million govt bonds from pension fund Govt bond +100Cheque +100No change 2. Pension fund deposits proceeds of bond sale in a commercial bank No change Central bank cheque +100 Pension fund deposit acct Central bank cheque clears giving commercial banks $100 million cash No changeCheque o/s -100 Central bank cheque -100 No change Cash issued +100 Cash reserves +100 ©2010 McGraw-Hill Ryerson Ltd. Chapter If rr = 0.05, excess reserves +95

An Open-Market Purchase and the Money Supply Central BankCommercial Banks AssetsLiabilitiesAssetsLiabilities 4. Commercial banks increase lending and create new deposits No changeLoans Deposits Final effect of central bank open market purchase Govt bond +100 Cash (ΔH) +100 Cash reserves +100 Loans Deposits Change in Money Supply ΔM = ΔH/rr = $100/0.05 = $2,000 ©2010 McGraw-Hill Ryerson Ltd. Chapter

Money Supply Control vs Interest Rate Control ©2010 McGraw-Hill Ryerson Ltd. Chapter

Money Supply Control or Interest Rate Control ©2010 McGraw-Hill Ryerson Ltd. Chapter Interest Rate i M 0 /P L(Y 0 ) i0i0 i1i1 L(Y 1 ) A money supply fixed by the central bank results in an interest rate determined by the money market ∆L  ∆i M/P ∆i ∆L

Money Supply Control or Interest Rate Control ©2010 McGraw-Hill Ryerson Ltd. Chapter Interest Rate i M 0 /P L(Y 0 ) i0i0 M 1 /P L(Y 1 ) An interest rate fixed by the central bank results in a money supply set by the money market. ∆L  ∆M M/P ∆M ∆L

Monetary Policy Targets and Instruments in Canada ©2010 McGraw-Hill Ryerson Ltd. Chapter A central bank monetary policy targets: - Three possible targets: Control the foreign exchange rate, or Control the money supply, or Control the inflation rate A central bank must choose: - It can only pursue one of these targets at a time.

Monetary Policy Targets ©2010 McGraw-Hill Ryerson Ltd. Chapter Exchange rate target: Central bank buys/sells foreign exchange to fix the exchange rate. Foreign exchange operations  ∆H, ∆M & ∆i Money supply target: Central bank sets i & H to fix M Inflation target: Central bank sets i & H  π* the target inflation rate.

Monetary Policy Targets & Instruments in Canada ©2010 McGraw-Hill Ryerson Ltd. Chapter Bank of Canada’s monetary policy target:  An inflation rate ( π*) = 1% - 3% on the CPI Bank of Canada’s monetary policy instrument:  The overnight interest rate (onr)  The overnight rate is the interest rate large financial institutions receive or pay on loans of H from one day until the next

Monetary Policy Targets & Instruments in Canada ©2010 McGraw-Hill Ryerson Ltd. Chapter Bank of Canada Operating Techniques: Set the overnight rate  AD required for inflation target π* Set operating band for overnight rate = onr +/- 25 basis points. (100 basis points = 1%) Overnight rate set by Bank drives commercial bank prime rates and mortgage rates

Monetary Policy Targets & Instruments in Canada A change in the Bank’s overnight rate setting:  Changes commercial bank lending rates  Changes costs of financing and lines of credit for businesses and households  Works through the monetary transmission mechanism to change AD  π = π* ©2010 McGraw-Hill Ryerson Ltd. Chapter

The Bank of Canada’s Settings for Overnight Rates ©2010 McGraw-Hill Ryerson Ltd. Chapter

The Overnight Rate, Prime Rate and 5-Year Mortgage Rate ©2010 McGraw-Hill Ryerson Ltd. Chapter

Commercial Banks and the ONR 20 Chapter 10.3 ©2010 McGraw-Hill Ryerson Ltd. Commercial banks: Zero settlement balance in Bank of Canada requirement Settlement balance <0 must borrow: From other onr, or From Bank of Bank Rate = onr + 25bp Settlement balance >0 may: Lend to other onr, or Hold in Bank of Deposit Rate = onr – 25bp Settlement balance requirement + Bank Rate-Deposit Rate spread  market for overnight funds

Monetary Policy Targets and Instruments in Canada Bank of Canada interventions to maintain ONR setting: To offset upward pressure on the rate: SPRA: special purchase & resale agreement Buy securities today, sell back tomorrow Price difference  onr Temporarily increases monetary base, H To offset downward pressure on the rate SRA: sale and repurchase agreement Sell securities today and buy back tomorrow Price difference  onr Temporarily reduces monetary base, H ©2010 McGraw-Hill Ryerson Ltd. Chapter

Setting and Maintain the Overnight Rate ©2010 McGraw-Hill Ryerson Ltd. Chapter MB 0 D0D0 Overnight rate Bank Rate MB 1 Set overnight rate target onr 0 Short term increase in demand for MB Upward pressure on Overnight rate SPRA to offset the upward pressure Temporary increase in H  MB 1 SRA would offset downward pressure on overnight rate. D1D1 Deposit rate Monetary Base (H) Interest Rate onr 0 SPRA

Bank of Canada Special Purchase and Resale Agreements and Sale and Repurchase Agreements (monthly averages of daily data) ©2010 McGraw-Hill Ryerson Ltd. Chapter

Central Bank Interest Setting Central Bank policy target(s): Pursue Y = Y P or π = π * With constant equilibrium price level (π = 0):  Policy Target is Y = Y P Policy instrument is the interest rate Set interest rate based on knowledge of transmission mechanism  AD  Y = Y P ∆i to offset ∆A  stabilize AD  Y P ©2010 McGraw-Hill Ryerson Ltd. Chapter

Policy Rules for Setting Interest Rates A ‘Taylor Rule’ :  Policy target: Y = Y P  Current conditions set i = i 0  AD required for Y = Y P,  React to transitory ∆A by ∆i to stabilize AD  React to fundamental ∆A with ∆setting for i 0 Then:  If Y = Y P  i = i 0  If Y≠ Y p  ∆i = b(Y – Y P )  ∆A  ∆i 0 ©2010 McGraw-Hill Ryerson Ltd. Chapter

A Simple Taylor Rule in a Diagram ©2010 McGraw-Hill Ryerson Ltd. Chapter i YpYp YpYp i = i 0 + b(Y – Y P ) i0i0 Y A Taylor Rule in action: i = i 0 + b(Y – Y P ) Y2Y2 i2i2 Interest rate settingY & AE YPYP Y=AE AE(i 0 ) AE’(i 1 ) AE’(i 0 ) AE A’(i 0 ) A’(i 1 ) A(i 0 ) 45 0 YPYP Y2Y2 Y ∆A ∆A(i) ∆Y b(Y 2 -Y P ) If ∆A is persistent then reset i 0  i = i 1 + b(Y – Y P ) to keep Y = Y P

Monetary Policy Rules with Inflation Target and Output Targets Bank sets i to get π = π* & Y = Y P With π > 0 real interest rate (r = i -  *) affects AD & Y through transmission mechanism a b a and b indicate weights Bank gives to π* and Y P targets (Y – Y P ) indicator of future ∆π ©2010 McGraw-Hill Ryerson Ltd. Chapter

Monetary Policy for “Exceptional” Times ( Recession of ) Monetary policy in deep financial crisis & recession: Lowering i is first policy response i as policy instrument constrained by ‘zero’  i cannot be < 0 Additional policy instruments may be needed Bank of Canada lowered the overnight rate to 0.25% -- effectively zero. Federal Reserve lowered federal funds rate to %. ©2010 McGraw-Hill Ryerson Ltd. Chapter

Monetary Policy for “Exceptional” Times ( Recession of ) Further monetary policy actions:  Moral suasion – assure financial markets of continuing central bank support  Quantitative easing – increase financial market liquidity by expanding central asset holdings  putting more cash into the financial system  Credit easing – provide central bank liquidity to specific markets by targeted purchases of assets from those markets eg commercial paper and mortgage markets ©2010 McGraw-Hill Ryerson Ltd. Chapter

Evidence of Quantitative Easing in the US Currency Component of U.S. Money Supply ©2010 McGraw-Hill Ryerson Ltd. Chapter

Evidence of increased liquidity in Canada: The Currency Component of Money Supply in Canada ©2010 McGraw-Hill Ryerson Ltd. Chapter

The Long-Run Neutrality of Money Money is neutral if: ∆M has no effect on output or other real variables. The ‘Quantity Theory of Money ’: MV = PY  M ≡ money supply  V ≡ velocity of circulation of money (1/k)  P ≡ price level  Y ≡ real GDP Assume V & Y constant in long run ∆M  ∆P but ∆Y = 0  money is neutral Monetary policy can change P & π but not Y P ©2010 McGraw-Hill Ryerson Ltd. Chapter

Monetary Policy Indicators Monetary policy indicators:  Indicate AD stimulus or restraint from monetary policy. Some monetary policy indicators: Nominal & real interest rates Exchange rates Rates of growth of money aggregates ie M1+ & M2+ Money supply growth minus GDP growth ©2010 McGraw-Hill Ryerson Ltd. Chapter

Chapter Summary ©2010 McGraw-Hill Ryerson Ltd. Chapter Central banks operate to affect behaviour of commercial banks and financial markets Central banks have responsibility for monetary policy The Bank of Canada is Canada’s central bank. It is the source of the monetary base and acts as banker to banks and government. Bank of Canada conducts monetary policy using its control of the monetary base and interest rate to pursue economic and financial market stability. Central banks have three main operating techniques: reserve requirements, open-market operations, and bank rate setting. The Bank of Canada sets an inflation rate target and uses the overnight interest rate as its policy instrument.

Chapter Summary 35 Chapter 10 ©2010 McGraw-Hill Ryerson Ltd. The Bank of Canada uses SPRAs and SRAs to maintain its overnight rate setting A monetary policy rule like a Taylor Rule for setting i provides a useful description of central bank policy actions Changes in the policy instrument (i) change AD through the transmission mechanism Quantitative easing: central bank securities purchases to increase the monetary base and financial system liquidity Credit easing: central bank purchases of assets to provide liquidity to specific markets In the short run fixed or sticky prices allow the central bank to change real interest rates, AD and Y In the long run, flexible prices mean money is neutral.