1. Chapter 28: Monetary Policy in Canada
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2. Chapter Outline/Learning Objectives
Section
Learning Objectives
After studying this chapter, you will be able to
28.1
How the Bank of
Canada Implements
Monetary Policy 1.
explain why the Bank of Canada chooses to directly
target interest rates rather than the money supply. '
s policy of inflation
28.2
Inflation Targeting 2.
understand why many central banks have adopted formal
inflation targets. 3.
explain how the Bank of Canada
targeting helps to stabilize the economy.
28.3
Long and
Variable Lags 4.
describe why monetary policy affects real GDP and
the price level only after long time lags.
28.4
Thirty Years of
Canadian Monetary
Policy 5.
discuss the main economic challenges that the Bank
of Canada has faced over the past three decades.
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3. 28.1 How the Bank of Canada Implements Monetary Policy
Money Supply Versus the Interest Rate
Any central bank has two alternative approaches for implementing its monetary policy:
Target the money supply
Target the interest rate
But for a given MD curve, both cannot be targeted independently.
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4. Fig. 28-1 Two Approaches to the Implementation of Money Policy
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5. Money Supply Versus the Interest Rate
The Bank of Canada chooses to conduct monetary policy by targeting the interest rate (rather than the money supply) because:
The Bank of Canada is able to control a particular interest rate.
Uncertainty about the slope and position of the MD curve does not prevent the Bank of Canada from establishing its desired interest rate.
The Bank of Canada can easily communicate its interest-rate policy to the public.
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6. The Bank of Canada and the Overnight Interest Rate
The overnight interest rate is the interest rate that commercial banks charge one another for overnight loans. By influencing the overnight interest rate, the Bank of Canada also influences the longer-term interest rates that are more relevant for determining aggregate consumption and investment expenditure. The Bank establishes a target for the overnight interest rate and announces this target eight times per year.
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7. The Bank of Canada and the Overnight Interest Rate
When the Bank announces its target for the overnight rate, it also announces the bank rate—the interest rate the Bank of Canada charges commercial banks for loans—0.25 percentage points above the target rate. The Bank promises to lend at this bank rate any amount that commercial banks want to borrow. At the same time, the Bank offers to borrow (accept deposits) in unlimited amounts from commercial banks and pay them an interest rate 0.25 percentage points below the target. The actual overnight interest rate stays within the 0.5-percentage- point range centred around the target rate.
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8. Fig. 28-2 The Overnight Interest Rate: Target and Actual
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9. The Money Supply is Endogenous
When the Bank of Canada changes its target for the overnight rate, the change in the actual overnight rate happens almost instantly. Changes in other market interest rates also happen very quickly, usually within a day or two. As these rates adjust, firms and households begin to adjust their borrowing behaviour. As the demand for new loans gradually adjusts, commercial banks often find themselves in need of more cash reserves with which to make loans.
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10. The Money Supply is Endogenous
Banks can sell some of their government securities to the Bank of Canada in exchange for cash (or electronic reserves) and then use this cash to extend new loans. The purchase or sale of government securities on the open market by the central bank is an open-market operation. Through its open-market operations, the Bank of Canada changes the amount of currency in circulation.
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11. The Money Supply is Endogenous
The amount of currency in circulation (and also the money supply) is endogenous. It is not directly controlled by the Bank of Canada, but instead is determined by the economic decisions of households, firms, and commercial banks. The Bank of Canada is passive in its decisions regarding the money supply. It conducts its open-market operations to accommodate the changing demand for currency coming from the commercial banks.
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12. Expansionary and Contractionary Monetary Policies
If the Bank of Canada wants to stimulate aggregate demand, it will reduce its target for the overnight interest rate, and the effect will soon be felt on longer-term market interest rates. Reducing the interest rate is an expansionary monetary policy because it leads to an expansion of aggregate demand. If the Bank of Canada wants to reduce aggregate demand, it will raise its target for the overnight interest rate. Raising the interest rate is a contractionary monetary policy because it leads to a contraction of aggregate demand.
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13. Fig. 28-3 The Monetary Transmission Mechanism
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14. 28.2 Inflation Targeting Why Target Inflation?
Central banks’ focus on inflation comes from two fundamental observations regarding macroeconomic relationships:
High and uncertain inflation leads to arbitrary income redistributions and also hampers the ability of the price system both to allocate resources efficiently and to produce satisfactory rates of economic growth.
Most economists and central banks accept that monetary policy is the most important determinant of a country’s long-run rate of inflation.
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15. Why Target Inflation?
In 1990, New Zealand became the first country to adopt a form system of inflation targeting. Canada was second in Canada has renewed its inflation targets several times since The Bank of Canada’s current target range for inflation is 1 to 3 percent a year with emphasis on the 2 percent midpoint.
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16. Fig. 28-4 Canadian CPI and Core Inflation, 1992–2015
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17. Inflation Targeting and the Output Gap
Keeping inflation close to its formal 2-percent target, requires the Bank of Canada to monitor the output gap and the associated pressures that may be pushing inflation above or below the target. Persistent output gaps generally create pressure for the rate of inflation to change. So the Bank of Canada designs its policy to keep real GDP close to potential output.
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18. Inflation Targeting as a Stabilizing Policy
Positive shocks to the economy that create an inflationary gap and threaten to increase the rate of inflation will be met by contractionary monetary policy. Negative shocks to the economy that create a recessionary gap will be met with expansionary monetary policy. Inflation targets are not as “automatic” a stabilizer as the fiscal stabilizers built into the tax-and-transfer system. However, as long as the central bank is committed to achieving its inflation target, its policy adjustments will act to stabilize real GDP.
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19. Complications in Inflation Targeting
Volatile Food and Energy Prices
The volatility of food and energy prices is often unrelated to the level of the output gap in Canada.
So the Bank of Canada closely monitors the rate of “core” inflation even though its formal target of 2 percent applies to the rate of CPI inflation.
Change in core inflation are a better indicator of domestic inflationary pressures than are changes in CPI inflation.
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20. Complications in Inflation Targeting
The Exchange Rate and Monetary Policy
Changes in the exchange rate can signal the need for changes in the stance of monetary policy.
The Bank of Canada needs to determine the cause of the exchange- rate change before it can design a policy response appropriate for keeping real GDP close to potential and inflation close to the 2 percent range.
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21. What Are the Lags in Monetary Policy?
28.3 Long and Variable Lags
What Are the Lags in Monetary Policy?
Monetary policy operates with a time lag that is long and variable for two main reasons:
changes in expenditure take time
the multiplier process takes time
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22. Destabilizing Policy?
The fact that monetary-policy actions taken today will not affect output and inflation until one to two years in the future means that the Bank of Canada must design its policy for what is expected to occur in the future rather than what has already been observed. The long time lags in the effectiveness of monetary policy increase the difficulty of stabilizing the economy. Monetary policy may have a destabilizing effect.
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23. Communications Difficulties
Fig Forward-Looking Monetary Policy
Time lags in monetary policy require that decisions regarding a loosening or tightening of monetary policy be forward-looking.
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24. Review
The Bank of Canada implements an expansionary monetary policy by A) directly increasing the money supply. B) selling government securities on the open market. C) buying government securities on the open market. D) raising its target for the overnight interest rate. E) reducing its target for the overnight interest rate.
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25. Review
Suppose the Bank of Canada raises its target for the overnight interest rate and longer-term rates in the market rise as a result. Households' and firms' demand for loans from the commercial banks would ________. In order to accommodate this change, the commercial banks require ________. A) rise; more government securities B) rise; more currency C) fall; more cash reserves D) fall; fewer cash reserves E) remain stable; no change to their reserves
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