1. © 2003 McGraw-Hill Ryerson Limited. Monetary Policy and the Debate about Macro Policy Chapter 14

2. 14 - 2 © 2003 McGraw-Hill Ryerson Limited. Introduction u Monetary policy influences the economy through changes in the financial system’s reserves that influence the money supply and credit availability in the economy.

3. 14 - 3 © 2003 McGraw-Hill Ryerson Limited. Introduction u Monetary policy is one of the two main traditional macroeconomic tools to control the aggregate economy. u While fiscal policy is controlled by the government directly, monetary policy is controlled by the central bank in Canada.

4. 14 - 4 © 2003 McGraw-Hill Ryerson Limited. Effect of Monetary Policy on the AS/AD Model u Expansionary monetary policy shifts the AD curve to the right. u Contractionary monetary policy shifts the AD curve to the left.

5. 14 - 5 © 2003 McGraw-Hill Ryerson Limited. Effect of Monetary Policy on the AS/AD Model u The effect of monetary policy on equilibrium income and the price level depends on whether inflationary pressures are set in motion. u That in turn depends on how close the economy is to its potential income.

6. 14 - 6 © 2003 McGraw-Hill Ryerson Limited. Effect of Monetary Policy on the AS/AD Model u The supply conditions of the economy are central to the effect one believes monetary policy will have on the economy.

7. 14 - 7 © 2003 McGraw-Hill Ryerson Limited. Effect of Monetary Policy on the AS/AD Model u Its effect on real income depends on how the price level responds. %  Real Income = %  Nominal Income - %  Price Level

8. 14 - 8 © 2003 McGraw-Hill Ryerson Limited. Effect of Monetary Policy on the AS/AD Model u In Keynesian range, real income will rise with expansionary monetary policy and decline with contractionary monetary policy. u The price level is unaffected.

9. 14 - 9 © 2003 McGraw-Hill Ryerson Limited. Effect of Monetary Policy on the AS/AD Model u In the Classical range, real income does not change; the effect is on the price level and inflation.

10. 14 - 10 © 2003 McGraw-Hill Ryerson Limited. Monetary Policy When Prices are Fixed, Fig. 14-1a, p 339 P0P0 SAS Y2Y2 Y0Y0 Y1Y1 AD 0 AD 1 Price level Real output Expansionary monetary policy Contractionary monetary policy AD 2

11. 14 - 11 © 2003 McGraw-Hill Ryerson Limited. P0P0 SAS 0 AD 0 AD 1 Price level Real output P1P1 SAS 1 Y0Y0 LRAS Expansionary Monetary Policy in the Classical Range, Fig. 14-1b, p 339 A B

12. 14 - 12 © 2003 McGraw-Hill Ryerson Limited. Duties and Structure of the Bank of Canada u A central bank is a type of bankers’ bank. u A central bank conducts monetary policy and acts as financial adviser to the government.

13. 14 - 13 © 2003 McGraw-Hill Ryerson Limited. Duties and Structure of the Bank of Canada u In some countries the central bank is a part of the government. u In Canada the central bank is not part of the government – it is a Crown corporation, not under direct day-to-day control of the federal government.

14. 14 - 14 © 2003 McGraw-Hill Ryerson Limited. Structure of the Bank u The head of the Bank of Canada is the Governor of the Bank. u So far the Bank of Canada has had seven governors.

15. 14 - 15 © 2003 McGraw-Hill Ryerson Limited. Structure of the Bank u Monetary policy is set by the governor with the advice of his senior advisers. u The Bank has a Board of Directors made up of 12 non-specialists in monetary policy.

16. 14 - 16 © 2003 McGraw-Hill Ryerson Limited. Structure of the Bank u Price stability has often been the goal of monetary policy. u Price stability is interpreted to mean a low and stable rate of inflation.

17. 14 - 17 © 2003 McGraw-Hill Ryerson Limited. International Considerations u The design and implementation of monetary policy is affected by international considerations. u Exchange rates play a critical role in the process.

18. 14 - 18 © 2003 McGraw-Hill Ryerson Limited. International Considerations u An exchange rate expresses the value of one currency in terms of the value of another. u Exchange rate can be expressed in two ways – it tells us how many units of one currency is needed to buy one unit of another. For example, it takes Can$1.54 to buy US$1 (or, US$0.65 to buy Can$1)

19. 14 - 19 © 2003 McGraw-Hill Ryerson Limited. International Considerations u Exchange rates matter because international trade is an important part of every economy. u Monetary policy is important because it will affect international trade through changes in the money supply.

20. 14 - 20 © 2003 McGraw-Hill Ryerson Limited. International Considerations u The exchange rate as the relative price of one nation’s currency depends on how much of that currency is in circulation. u Therefore, monetary policy cannot be set without consideration of international issues.

21. 14 - 21 © 2003 McGraw-Hill Ryerson Limited. Duties of the Bank u The bank of Canada is responsible for: l Conducting monetary policy l Providing Central banking services l Issuing bank notes l Administering public debt.

22. 14 - 22 © 2003 McGraw-Hill Ryerson Limited. The Importance of Monetary Policy u Monetary policy is the Bank’s most important function, and the most-used policy in macroeconomics. u In practice,the Bank of Canada conducts monetary policy and controls it, whereas fiscal policy is conducted directly by the government.

23. 14 - 23 © 2003 McGraw-Hill Ryerson Limited. The Importance of Monetary Policy u Actual decisions about monetary policy are made by the Governor of the Bank of Canada, with consultation with senior staff.

24. 14 - 24 © 2003 McGraw-Hill Ryerson Limited. The Conduct of Monetary Policy u Bank reserves are IOUs of the Bank of Canada. l Bank reserves – either vault cash or deposits at the Bank. u The monetary base is currency in circulation plus deposits at the Bank.

25. 14 - 25 © 2003 McGraw-Hill Ryerson Limited. The Conduct of Monetary Policy u By controlling the monetary base, the Bank can influence the amount of money in the economy and the activities of banks.

26. 14 - 26 © 2003 McGraw-Hill Ryerson Limited. The Conduct of Monetary Policy u The tools of monetary policy will affect the amount of reserves in the system. u The amount of reserves will affect interest rates. l Other things being equal, as reserves decline, interest rates will rise. l As reserves increase, interest rates will fall.

27. 14 - 27 © 2003 McGraw-Hill Ryerson Limited. Tools of Monetary Policy u The tools of monetary policy include: l Changing the target range for the overnight financing rate. l Cash management operations.

28. 14 - 28 © 2003 McGraw-Hill Ryerson Limited. The Overnight Financing Rate u All chartered banks are members of the Canadian Payments Association. u Among other things, this association runs an electronic funds transfer system called the Large Value Transfer system (LVTS), where payments clear and settle daily.

29. 14 - 29 © 2003 McGraw-Hill Ryerson Limited. The Overnight Financing Rate u If financial institutions have surplus balances resulting from the clearing process at the LVTS, they can loan them on a very short term basis to those members who are in deficit position. u These loans occur in the overnight market.

30. 14 - 30 © 2003 McGraw-Hill Ryerson Limited. The Overnight Financing Rate u The overnight financing rate is the rate of interest associated with these very short-term loans in the overnight market.

31. 14 - 31 © 2003 McGraw-Hill Ryerson Limited. The Overnight Financing Rate u Changes in the overnight financing rate influence all other rates through the term structure of interest rates – the structure of yields on financial instruments with similar characteristics, but different terms to maturity.

32. 14 - 32 © 2003 McGraw-Hill Ryerson Limited. The Overnight Financing Rate u Arbitrage – the buying and selling of similar goods and services across different markets – provides the link between interest rates on dissimilar assets.

33. 14 - 33 © 2003 McGraw-Hill Ryerson Limited. The Overnight Financing Rate u The bank rate is the interest rate charged on advances from the central bank.

34. 14 - 34 © 2003 McGraw-Hill Ryerson Limited. The Overnight Financing Rate u The Bank of Canada has a target range for the overnight financing rate – it falls between the bank rate (maximum) and the rate at which the Bank will pay the LVTS participants who want to leave their surplus funds with the Bank of Canada (minimum).

35. 14 - 35 © 2003 McGraw-Hill Ryerson Limited. The Overnight Financing Rate u The main tool of monetary policy in Canada is the target range for the overnight financing rate. l The AD will decline if the target range for the overnight financing rate is increased. l By decreasing the target range, the AD will increase.

36. 14 - 36 © 2003 McGraw-Hill Ryerson Limited. Relationship Among Interest Rates, Fig. 14-2a, p 348

37. 14 - 37 © 2003 McGraw-Hill Ryerson Limited. Relationship Among Interest Rates, Fig. 14-2b, p 348

38. 14 - 38 © 2003 McGraw-Hill Ryerson Limited. Cash Management Operations u Cash management is the second major tool of monetary policy in Canada. u Cash management operations are the main techniques for implementing monetary policy in Canada.

39. 14 - 39 © 2003 McGraw-Hill Ryerson Limited. Cash Management Operations u Cash management techniques include various open market operations - buying and selling of government bonds and bills. u Cash management techniques also include the transfer of government deposits between chartered banks (and others) and the Bank of Canada.

40. 14 - 40 © 2003 McGraw-Hill Ryerson Limited. Open Market Operations u Open market operations involve the purchase or sale of federal government securities. l When the Bank of Canada buys bonds, the money supply rises. Thus, an open market purchase is an example of expansionary monetary policy.

41. 14 - 41 © 2003 McGraw-Hill Ryerson Limited. Open Market Operations u An open market sale has the opposite effect: l When the Bank of Canada sells bonds, the money supply declines. Thus, an open market sale is an example of contractionary monetary policy.

42. 14 - 42 © 2003 McGraw-Hill Ryerson Limited. Open Market Operations u Open market purchase (expansionary monetary policy) increases the money supply, decreasing the interest rates. u Open market sale (contractionary monetary policy) reduces the money supply, increasing interest rates.

43. 14 - 43 © 2003 McGraw-Hill Ryerson Limited. Government Deposits u A transfer of government deposits from the chartered banks and other financial institutions to the Bank of Canada reduces the liquidity in the banking system. u This puts an upward pressure on interest rates.

44. 14 - 44 © 2003 McGraw-Hill Ryerson Limited. Government Deposits u A transfer of government deposits from the Bank of Canada to the chartered banks and other financial institutions increases the liquidity in the banking system. u This puts a downward pressure on interest rates.

45. 14 - 45 © 2003 McGraw-Hill Ryerson Limited. Open Market Operations, Fig. 14- 3a, p 350 Price of a bond Quantity of bonds D0D0 Supply a) An open market purchase D1D1 A B

46. 14 - 46 © 2003 McGraw-Hill Ryerson Limited. Open Market Operations, Fig. 14- 3b, p 350 Price of a bond Quantity of bonds Demand S0S0 b) An open market sale S1S1 A C

47. 14 - 47 © 2003 McGraw-Hill Ryerson Limited. Monetary Policy in the AS/AD Model u In AS/AD terms, monetary policy works primarily through its effect on interest rates.

48. 14 - 48 © 2003 McGraw-Hill Ryerson Limited. Contractionary Monetary Policy u The Bank decreases the money supply. u The interest rates go up. u As interest rates go up, the quantity of investment goes down, decreasing income and output.

49. 14 - 49 © 2003 McGraw-Hill Ryerson Limited. Contractionary Monetary Policy u The AD curve shifts to the left by a multiple of the shift in investment. u Income and output decrease. M  i  I  Y 

50. 14 - 50 © 2003 McGraw-Hill Ryerson Limited. Expansionary Monetary Policy u Expansionary monetary policy works in the opposite direction. M  i  I  Y 

51. 14 - 51 © 2003 McGraw-Hill Ryerson Limited. Contractionary Monetary Policy When Prices are Fixed, Fig. 14-4a, p 351 M  i  I  Y  AD 1 AD 0 Y1Y1 Y0Y0 P0P0 SAS Price level 0 Real income  I Initial shift Multiplier effect

52. 14 - 52 © 2003 McGraw-Hill Ryerson Limited. Expansionary Monetary Policy When Prices are Fixed, Fig. 14-4b, p 351 M  i  I  Y  AD 0 AD 1 Y0Y0 Y1Y1 P0P0 Aggregate supply Price level 0 Real income Multiplier effect  I Initial shift

53. 14 - 53 © 2003 McGraw-Hill Ryerson Limited. Monetary Policy in the Circular Flow u If monetary and fiscal policy are needed, it is because the financial sector is in some ways clogged and is not correctly translating savings into investment. u Monetary policy works to unclog the financial sector.

54. 14 - 54 © 2003 McGraw-Hill Ryerson Limited. Keynesian Monetary Policy in the Circular Flow, Fig. 14-5, p 352

55. 14 - 55 © 2003 McGraw-Hill Ryerson Limited. Emphasis on the Interest Rate u A rising interest rate indicates a tightening of monetary policy. u A falling interest rate indicates a loosening of monetary policy.

56. 14 - 56 © 2003 McGraw-Hill Ryerson Limited. Emphasis on the Interest Rate u A natural conclusion is that the Bank should target interest rates in setting monetary policy.

57. 14 - 57 © 2003 McGraw-Hill Ryerson Limited. Real and Nominal Interest Rates u There is a problem in using interest rates to measure whether monetary policy is contractionary or expansionary. u That problem is the real/nominal interest rate problem.

58. 14 - 58 © 2003 McGraw-Hill Ryerson Limited. Real and Nominal Interest Rates u Nominal interest rates are those you actually see and pay. u Real interest rates are nominal interest rates adjusted for expected inflation.

59. 14 - 59 © 2003 McGraw-Hill Ryerson Limited. Real and Nominal Interest Rates u The real interest rate cannot be observed since it depends on expected inflation, which cannot be directly observed. Nominal interest rate = Real interest rate + Expected inflation rate

60. 14 - 60 © 2003 McGraw-Hill Ryerson Limited. Real and Nominal Interest Rates and Monetary Policy u Making a distinction between nominal and real interest rates adds uncertainty to the effect on monetary policy.

61. 14 - 61 © 2003 McGraw-Hill Ryerson Limited. Real and Nominal Interest Rates and Monetary Policy u If expansionary monetary policy leads to expectations of increased inflation, nominal interest rates will go up, leaving real interest rates unchanged.

62. 14 - 62 © 2003 McGraw-Hill Ryerson Limited. Real and Nominal Interest Rates and Monetary Policy u The possible effect of monetary policy on expectations of inflation has led most economists to conclude that a monetary regime, not a monetary policy is the best approach to policy.

63. 14 - 63 © 2003 McGraw-Hill Ryerson Limited. Real and Nominal Interest Rates and Monetary Policy u A monetary regime is a predetermined statement of the policy that will be followed in various situations. u A monetary policy, in contrast, is a response to events which is chosen without a predetermined framework.

64. 14 - 64 © 2003 McGraw-Hill Ryerson Limited. Real and Nominal Interest Rates and Monetary Policy u The monetary regime the Bank is currently using involves feedback rules that center on the overnight financing rate.

65. 14 - 65 © 2003 McGraw-Hill Ryerson Limited. Real and Nominal Interest Rates and Monetary Policy u If inflation is above its target the Bank rises the target range, decreasing the money supply. u If inflation is below its target, and if economy is going into recession, the Bank lowers the target range, increasing the money supply.

66. 14 - 66 © 2003 McGraw-Hill Ryerson Limited. Real and Nominal Interest Rates and Monetary Policy u If inflation is below its target and the economy is sliding into a recession the Fed attempts to expand the economy. u The Fed lowers the Federal funds rate by buying bonds thereby increasing the money supply.

67. 14 - 67 © 2003 McGraw-Hill Ryerson Limited. Problems in the Conduct of Monetary Policy u Five problems of monetary policy are: l Knowing what policy to use. l Understanding the policy you're using. l Lags in monetary policy. l Political pressure. l Conflicting international goals.

68. 14 - 68 © 2003 McGraw-Hill Ryerson Limited. Knowing What Policy to Use u The potential level of income must be known. u Otherwise you don’t know whether to use expansionary or contractionary monetary policy.

69. 14 - 69 © 2003 McGraw-Hill Ryerson Limited. Understanding the Policy You’re Using u You must know whether the policy being used is expansionary or contractionary in order to use monetary policy effectively. u The Bank only indirectly controls the monetary base.

70. 14 - 70 © 2003 McGraw-Hill Ryerson Limited. Understanding the Policy You’re Using u The money multiplier is influenced by both the amount of cash people hold as well as the lending process at the bank. u Neither of these are stable numbers.

71. 14 - 71 © 2003 McGraw-Hill Ryerson Limited. Understanding the Policy You’re Using u Then there are interest rates. u If interest rates rise, is it because of expected inflation or is it that the real interest rate is going up?

72. 14 - 72 © 2003 McGraw-Hill Ryerson Limited. Lags in Monetary Policy u Monetary policy, like fiscal policy, takes time to work. u Just because the Bank decreases interest rates, that does not necessarily mean that people will borrow money.

73. 14 - 73 © 2003 McGraw-Hill Ryerson Limited. Lags in Monetary Policy u In the face of a contractionary monetary policy, banks have been creative in circumventing cuts in the money supply.

74. 14 - 74 © 2003 McGraw-Hill Ryerson Limited. Political Pressure u The Bank is not totally insulated from political pressure. u Politicians place great pressure on the Bank to use expansionary monetary policy, especially during an election year.

75. 14 - 75 © 2003 McGraw-Hill Ryerson Limited. Conflicting International Goals u Monetary policy is conducted in an international arena. u It must be coordinated with other governments’ monetary policies.

76. © 2003 McGraw-Hill Ryerson Limited. Monetary Policy and the Debate about Macro Policy End of Chapter 14