of 241 Chapter 29 Monetary Policy in Canada

of 242 Copyright © 2005 Pearson Education Canada Inc. Learning Objectives 1. Explain the two methods by which the Bank of Canada can change the level of reserves in the banking system. 4. Explain how the Bank’s policy of inflation targeting helps to stabilize the economy. 3. Differentiate between the Bank’s policy targets and its policy instruments. 2. Explain why the bank rate and the level of reserves cannot be set independently. 5. Explain why monetary policy affects real GDP and the price level only after long lags. 6. List the main challenges that the Bank of Canada has faced over the past two decades.

of 243 Copyright © 2005 Pearson Education Canada Inc The Bank of Canada and the Money Supply Open-Market Operations When the Bank of Canada purchases securities on the open market, the cash reserves of the commercial banks are increased. These banks can then expand deposits, thereby increasing the money supply. When the Bank of Canada sells securities on the open market, the cash reserves of the commercial banks are decreased. These banks must then contract deposits, thereby decreasing the money supply.

of 244 Commercial Bank AssetsLiabilities Reserves100,00 0 Government deposits100,000 Bank of Canada Assets Liabilities No changeGovernment deposits-100,000 Commercial bank deposits 100,000 A transfer of government deposits from the Bank of Canada to a commercial bank increases bank reserves. Through an expansion of bank lending, this increases the money supply. Shifting Government Deposits The Bank of Canada can also shift government deposits between itself and the chartered banks.

of 245 M S1 Quantity of Money M S0 E1E1 E0E0 i0i0 i1i1 Interest Rate The Bank of Canada cannot set the interest rate and the money supply independently. If the Bank wishes to increase the money supply, it must accept the lower interest rate (and vice versa). Money Supply or the Interest Rate? MDMD The Bank actually sets the interest rate, and then provides the necessary change in the money supply.

of Monetary Policy Targets Policy targets are the variables that the policy maker seeks to influence. Policy instruments are the variables that the policy maker controls directly. These can be viewed as the tools available to the policy maker. The Bank of Canada has only one monetary policy instrument: the overnight interest rate.

of 247 Copyright © 2005 Pearson Education Canada Inc. M D = M S ; central bank sets interest rate. Interest rate influences capital flows and exchange rate Exchange rate determines net exports AD = AS; determines equilibrium P and Y Interest rate determines investment Monetary policy works through the transmission mechanism; macroeconomic equilibrium then determines the price level and the level of real GDP. The Monetary Transmission Mechanism Not covered

of 248 Copyright © 2005 Pearson Education Canada Inc. Long-Run Target: Inflation Evidence in support of the long-run neutrality of money has led many central banks, including the Bank of Canada, to target the rate of change of the price level (inflation). Recall that the neutrality of money result argues that the only long-run effects of monetary policy are on the price level (or on the rate of inflation).

of 249 Copyright © 2005 Pearson Education Canada Inc. Short-Run Monitoring: The Output Gap In the short run, when an output gap opens, the central bank has two choices: allow the adjustment process to operate, or intervene with monetary policy. Output gaps put pressure on the rate of inflation. As a result, central banks monitor output gaps and may intervene in order to keep output near potential, and thereby keep inflation within the target band.

of 2410 Copyright © 2005 Pearson Education Canada Inc. Time 1% 3% Inflation Rate Inflation target band t1t1 t0t0 t2t2 t3t3 2% Output Gap 0 Time Bank’s policy closes gap Positive shock opens gap Bank’s policy closes gap Negative shock opens gap Not covered

of 2411 Copyright © 2005 Pearson Education Canada Inc. Inflation Targeting as a Stabilizing Policy Inflation targeting is a stabilizing policy. Positive shocks will be met with a contractionary monetary policy; negative shocks will be met with an expansionary policy. Output gaps put pressure on the rate of inflation. As a result, central banks monitor output gaps and may intervene in order to keep output near potential, and thereby keep inflation within the target band.

of 2412 Complications in Inflation Targeting Inflation targeting is complicated by several details. Among these complications are: 1. Volatile Food and Energy Prices. Many goods included in the Consumer Price Index (CPI) are internationally traded, so their prices are determined in world markets. As a result, prices of these goods may change suddenly and dramatically, but these changes may have nothing to do with the level of excess demand in the domestic economy. Not covered

of 2413 Copyright © 2005 Pearson Education Canada Inc. 2. The Exchange Rate and Monetary Policy. When the exchange rate changes, the central bank must identify the cause of the change before determining the appropriate policy response. Suppose the Canadian Dollar appreciates. How should the Bank of Canada respond? Not covered

of 2414 The appropriate response depends on the reason for the appreciation. This is because the reason for the appreciation will determine its effect on the goods market. If the appreciation was because of increased demand for Canadian goods, it will lead to a positive output gap and generate inflationary pressure. However, if the appreciation was because of increased demand for Canadian assets, it will have the opposite impact in the goods market, and call for the opposite policy response.

of Lags in the Conduct of Monetary Policy What are the Lags in Monetary Policy Monetary policy is capable of exerting expansionary and contractionary forces on the economy, but it operates with a time lag that is long and variable for several reasons: deposit creation takes time, changes in expenditure take time, and the multiplier process takes time.

of 2416 Copyright © 2005 Pearson Education Canada Inc. Destabilizing Policy? The existence of such long and variable lags has led some economists to argue that the Bank of Canada should not use monetary policy in an attempt to stabilize national income. They argue that attempts to stabilize will in fact be destabilizing, and they advocate the use of a monetary rule whereby commercial bank reserves (the monetary base) are increased at a more-or-less constant rate.

of 2417 Copyright © 2005 Pearson Education Canada Inc. Political Difficulties Time Current Period 1% 3% Rate of Inflation A Inflation Forecast Bank of Canada’s target inflation band Monetary policy must be forward-looking. This can create difficulties for the central bank that chooses to tighten its policy even though the current rate of inflation is low. Actual Inflation

of 2418 Copyright © 2005 Pearson Education Canada Inc Years of Canadian Monetary Policy By 1980, inflation in Canada had reached 12 percent as a result of the OPEC oil shocks in the mid and late 1970s. The Bank embarked on a strict policy of monetary restraint. At about the same time, an unanticipated surge in the demand for money led to a much tighter monetary policy than the Bank had intended. The result was the most serious recession since the 1930s. Not covered

of 2419 Copyright © 2005 Pearson Education Canada Inc. Economic Recovery: The main challenge for monetary policy in this period was to create sufficient liquidity to accommodate the recovery without triggering a return to the high inflation rates that prevailed at the start of the decade, Rising Inflation: In 1987, many economists argued that if monetary policy was not tightened, Canada would experience gradually increasing inflation until once again a severe monetary restriction would be necessary. Not covered

of 2420 Copyright © 2005 Pearson Education Canada Inc. Disinflation: Despite the Bank’s new policy, the actual inflation rate increased slightly in the years immediately following John Crow’s policy announcement, from about 4 percent in 1987 to just over 5 percent in The Bank of Canada therefore embarked on its stated policy of “price stability,” beginning in But then the tight monetary policy took effect. Interest rates rose, the dollar appreciated, and inflation fell suddenly. The economy entered a significant recession. Not covered

of 2421 Copyright © 2005 Pearson Education Canada Inc. Price-Stability: 1992-? The ensuing economic recovery was quite gradual. Excessive stimulation by the Bank could have led to a return of inflation whereas insufficient stimulation could have caused the economy to stall. By 2000, Canadian GDP was near its potential level and inflation was just below 2 percent and quite stable. Beginning in 1996, the recovery was more robust — real GDP was growing at a healthy rate and inflation remained well within the 1 to 3 percent target band. Not covered

of 2422 Recent Concerns for Monetary Policy Issues that complicated monetary policy in the late 1990s are varied. The Asian Crisis. This presented a (confusing) combination of aggregate demand and aggregate supply shocks. Is Inflation Too Low? There were some concerns that downward wage rigidity implied that there are costs to having inflation too low. Not covered

of 2423 The Stock Market. The “bull market” of the late 1990s presented some challenges — how should monetary policy respond? Not covered

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