Mehdi Arzandeh, University of Manitoba PowerPoint Presentation by

15-2 © 2016 McGraw ‐ Hill Education Limited LEARNING OBJECTIVES LO15.1Discuss how the equilibrium interest rate is determined in the market for money. LO15.2List and explain the main functions of the Bank of Canada. LO15.3List and explain the goals and tools of monetary policy. LO15.4Describe the overnight lending rate and how the Bank of Canada directly influences it. LO15.5Identify the mechanisms by which monetary policy affects GDP and the price level. LO15.6Explain the effectiveness of monetary policy and its shortcomings. LO15.7Describe the effects of the international economy on the operation of monetary policy. 15 Interest Rates and Monetary Policy

LO1 © 2016 McGraw ‐ Hill Education Limited 15.1 The Market for Money and the Determination of Interest Rates 15-3

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 15-1 KEY GRAPH - The Demand for Money, the Supply of Money, and the Equilibrium Interest Rate Rate of interest, i percent Amount of money demanded (billions of dollars) Amount of money demanded (billions of dollars) Amount of money demanded and supplied (billions of dollars) = + (a) Transactions demand for money, D t (b) Asset demand for money, D a (c) Total demand for money, D m and supply DtDt DaDa DmDm SmSm 5

The Equilibrium Interest Rate Interest rate The price paid for the use of money Equilibrium interest rate Demand for money combined with supply of money determine the equilibrium rate of interest LO1 © 2016 McGraw ‐ Hill Education Limited The Market for Money and the Determination of Interest Rates

Interest Rates and Bond Prices When the interest rate increases, bond prices fall; and vice versa. Example A $1,000 bond pays $50 annual interest. Interest yield on this bond is ___ $50/$1000 = 5% Interest rate rises to 7.5%, bond price will fall to ____ $50/7.5% = $667 Interest rate falls to 2.5%, bond price will rise to ____ $50/2.5% = $2000 LO1 © 2016 McGraw ‐ Hill Education Limited The Market for Money and the Determination of Interest Rates

1.Acting as the “Bankers’ Bank” 2.Issuing Currency 3.Acting As Fiscal Agent 4.Supervising the Chartered Banks 5.Regulating the Supply of Money LO2 © 2016 McGraw ‐ Hill Education Limited 15.2 Functions of the Bank of Canada 15-7

Bank of Canada Independence Voters hold Parliament responsible Bank must be protected from political pressures LO2 © 2016 McGraw ‐ Hill Education Limited 15.2 Functions of the Bank of Canada 15-8

Consolidated Balance Sheet of the Bank of Canada Assets 1.Securities 2.Advances to Chartered Banks Liabilities 1.Chartered Banks Deposits 2.Government of Canada Deposits 3.Notes in Circulation LO2 © 2016 McGraw ‐ Hill Education Limited 15.2 Functions of the Bank of Canada 15-9

© 2016 McGraw ‐ Hill Education Limited LO TABLE 15-1 Bank of Canada Statement of Assets and Liabilities, December 31, 2014 (in millions) Source: Adapted from Bank of Canada, Weekly Financial Statements, February 20, accessed July 23, AssetsLiabilities Advances to chartered banks $ 26 Notes in circulation $69,980 Treasury bills of Canada 19,998 Government of Canada deposits 21,874 Other securities issued or guaranteed by Canada 71,022 Chartered bank deposits 176 Securities purchased under resale agreement 1,397 Other liabilities 2,263 Other assets 850 Total $93,293 Total $93,293

Goals of Monetary Policy To keep inflation low, stable and predictable, to moderate the business cycle, and help the economy achieve full employment and sustained growth. By altering the money supply to influence interest rates Inflation target range of 1-3% annually LO3 © 2016 McGraw ‐ Hill Education Limited 15.3 Goals and Tools of Monetary Policy 15-11

15.1 GLOBAL PERSPECTIVE Central Banks, Selected Nations © 2016 McGraw ‐ Hill Education Limited LO

Tools of Monetary Policy Open-Market Operations Bank Rate LO3 © 2016 McGraw ‐ Hill Education Limited Goals and Tools of Monetary Policy

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 LO3 © 2016 McGraw ‐ Hill Education Limited Goals and Tools of Monetary Policy

© 2016 McGraw ‐ Hill Education Limited LO AssetsLiabilities Bank of Canada + Securities+ Deposits of Chartered Banks (b) Reserves Chartered Banks -Securities (a) +Reserves (b) Assets Liabilities and Net Worth (a) Securities 15.3 Goals and Tools of Monetary Policy Bank of Canada Buys Bonds from Chartered Banks

Open-Market Operations Bank of Canada BUYS bonds from the public Public gives up bonds for cheque Cheque is deposited in chartered bank Chartered bank’s reserves increase LO3 © 2016 McGraw ‐ Hill Education Limited Goals and Tools of Monetary Policy

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 15-2 The Bank of Canada’s Purchase of Bonds and the Expansion of the Money Supply Bank of Canada buys $1,000 bond from a chartered bank. New Reserves $5000 Bank System Lending Total Increase in the Money Supply, ($5,000) $1000 Excess Reserves

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 15-2 The Bank of Canada’s Purchase of Bonds and the Expansion of the Money Supply Bank of Canada buys $1,000 bond from the public. New Reserves $1000 Total Increase in the Money Supply, ($5000) $200 Desired Reserves $800 Excess Reserves $1000 Initial Chequable Deposit $4000 Bank System Lending

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 LO3 © 2016 McGraw ‐ Hill Education Limited Goals and Tools of Monetary Policy

© 2016 McGraw ‐ Hill Education Limited LO AssetsLiabilities and Net Worth Bank of Canada - Securities- Reserves of Chartered Banks Chartered Banks + Securities (a) - Reserves (b) Assets Liabilities and Net Worth (a) Securities (b) Reserves 15.3 Goals and Tools of Monetary Policy Bank of Canada Sells Bonds to Chartered Banks

Open-Market Operations Bank of Canada SELLS bonds to the public Public pays bonds with cheque Cheque is cleared in chartered bank Chartered bank’s reserves decrease The Bank of Canada bond sales of $1000 to the chartered banking system reduce the system’s actual and excess reserves by $1000. But a $1000 bond sale to the public reduces excess reserves by $800 LO3 © 2016 McGraw ‐ Hill Education Limited Goals and Tools of Monetary Policy

The Bank Rate and the Overnight Lending Rate The 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 LO3 © 2016 McGraw ‐ Hill Education Limited Goals and Tools of Monetary Policy

The Bank of Canada sets a target level for the overnight rate, often referred to as the key policy rate or key interest rate Overnight lending Rate The interest rate charged by banks on overnight loans Bank of Canada conducts open market operations to achieve the target LO4 © 2016 McGraw ‐ Hill Education Limited 15.4 Targeting the Overnight Lending Rate 15-23

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 15-3 Targeting the Overnight Lending Rate Federal Funds Rate, Percent 3.5 DfDf S f S f 1 S f 2 Qf3Qf3 Qf1Qf1 Qf2Qf2 Increase in Supply Decrease in Supply Quantity of Reserves

Monetary Policy Expansionary monetary policy Economy faces a recession Lower target for overnight lending rate Bank of Canada buys securities Expanded money supply Downward pressure on other interest rates LO4 © 2016 McGraw ‐ Hill Education Limited 15.4 Goals of Monetary Policy 15-25

Monetary Policy Restrictive monetary policy Periods of rising inflation Increases target for overnight lending rate Bank of Canada sells securities Increases money supply Increases other interest rates LO4 © 2016 McGraw ‐ Hill Education Limited 15.4 Goals of Monetary Policy 15-26

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 15-4 The Prime Interest Rate, the Bank Rate, the Overnight Target Rate, and the Overnight Lending Rate in Canada, 1998–2014

The Taylor Rule If real GDP rises by 1% above potential GDP, the Bank should raise the overnight rate by 0.5 percentage point If inflation rises by 1% above its target of 2 percent, the bank should raise the overnight lending rate by 0.5% When real GDP is equal to potential GDP and inflation is equal to its target, the overnight rate should remain about 4%, implying a real interest rate of 2%. LO4 © 2016 McGraw ‐ Hill Education Limited 15.4 Goals of Monetary Policy 15-28

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 LO5 © 2016 McGraw ‐ Hill Education Limited 15.5 Monetary Policy, Real GDP and Price Level 15-29

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 15-5 KEY GRAPH - Monetary Policy and Equilibrium GDP Rate of Interest, i (Percent) Amount of money demanded and supplied (billions of dollars) Amount of investment (billions of dollars) Price Level Real GDP (billions of dollars) Q1Q1 QfQf Q3Q3 $125$150$175$15$20$25 P2P2 P3P3 S m1 S m2 S m3 DmDm ID AD 1 I=$15 AD 2 I=$20 AD 3 I=$25 (a) The market for money (b) Investment demand (c) Equilibrium real GDP and the Price level AS

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 15-5 Price Level Real GDP (billions of dollars) Q1Q1 QfQf Q3Q3 P2P2 P3P3 AD 1 I=$15 AD 2 I=$20 AD 3 I=$25 (c) Equilibrium real GDP and the Price level AS Price Level Real GDP (billions of dollars) Q1Q1 QfQf Q3Q3 P2P2 P3P3 AD 1 I=$15 AD 2 I=$20 AD 3 I=$25 (d) Equilibrium real GDP and the Price level AS a b c AD 4 I=$22.5 KEY GRAPH - Monetary Policy and Equilibrium GDP

© 2016 McGraw ‐ Hill Education Limited LO TABLE 15-2 Monetary Policy: The Transmission Mechanism (1) Expansionary Monetary Policy Problem: unemployment and recession  Bank of Canada buys bonds and lowers the bank rate  Excess cash reserves increase  Overnight rate falls  Money supply rises  Interest rate falls  Investment spending increases  Aggregate demand increases  Real GDP rises

© 2016 McGraw ‐ Hill Education Limited LO TABLE 15-2 Monetary Policy: The Transmission Mechanism (2) Restrictive Monetary Policy Problem: Inflation  Bank of Canada sells bonds and raises the bank rate  Excess cash reserves decrease  Overnight rate rises  Money supply falls  Interest rate rises  Investment spending decreases  Aggregate demand decreases  Inflation declines

Dominant component of Canadian national stabilization policy Two key advantages over fiscal policy: Speed and flexibility Isolation from political pressure LO6 © 2016 McGraw ‐ Hill Education Limited 15.6 Monetary Policy: Evaluation and Issues 15-34

Recent Monetary Policy in Canada Economy slowed at the end of 2000, so Bank cut interest rates in Expansion in 2002 led to increased rates. Reduced rate to stimulate the economy in 2004 Interest rate hikes from 2005 – Started dropping again in 2008 to an all time low of 0.25% in Began to increase the overnight lending rates in the autumn of 2010, but rates stayed at historic lows throughout LO6 © 2016 McGraw ‐ Hill Education Limited Monetary Policy: Evaluation and Issues

Problems and Complications Monetary policy has certain limitations and faces real-world complications: Lags Cyclical asymmetry and liquidity trap Inflation Targeting  Increased transparency of monetary policy and accountability LO6 © 2016 McGraw ‐ Hill Education Limited Monetary Policy: Evaluation and Issues

LO7 © 2016 McGraw ‐ Hill Education Limited  Net exports effects reinforce monetary policy (1) Expansionary monetary policy(2) Restrictive monetary policy Problem: recession, slow growthProblem: inflation  Expansionary monetary policy (lower interest rate) Restrictive monetary policy (higher interest rate)  Decreased foreign demand for dollarsIncreased foreign demand for dollars  Dollar depreciatesDollar appreciates  Net exports increase (aggregate demand increases, strengthening the expansionary monetary policy) Net exports decrease (aggregate demand decreases, strengthening the restrictive monetary policy) TABLE 15-3 Monetary Policy and the Net Export Effect

LO7 © 2016 McGraw ‐ Hill Education Limited 15.7 Monetary Policy and the International Economy  Macroeconomic Stability and the Trade Balance The easy money policy that is appropriate for the alleviation of unemployment and 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.

The LAST WORDWorries about ZIRP, QE, and Twist © 2016 McGraw ‐ Hill Education Limited ZIRP, QE, and Operation Twist provided massive economic stimulus during and after the Great Recession. But there remain many worries about unintended consequences. The Fed lowered the short-term interest rates to nearly zero (a.k.a. zero interest rate policy, ZIRP) The Fed also engaged in bond purchasing (Quantitative Easing, QE) The policy known as Operation Twist lowered longer-term interest rates. The U.S. federal government was running a large annual budget deficits.  Concern about huge interest costs after ZIRP ended  ZIRP punishes savers

LO15.1 Discuss how the equilibrium interest rate is determined in the market for money. LO15.2 List and explain the main functions of the Bank of Canada. LO15.3 List and explain the goals and tools of monetary policy. LO15.4 Describe the overnight lending rate and how the Bank of Canada directly influences it. LO15.5 Identify the mechanisms by which monetary policy affects GDP and the price level. LO15.6 Explain the effectiveness of monetary policy and its shortcomings. LO15.7 Describe the effects of the international economy on the operation of monetary policy. Chapter Summary © 2016 McGraw ‐ Hill Education Limited 15-40