1. Slides are prepared by Dr. Amy Peng, Ryerson University Chapter Ten Central Banking and Monetary Policy Macroeconomics by Curtis, Irvine, and Begg Canadian Edition, McGraw-Hill Ryerson, 2007

2. ©2007 McGraw-Hill Ryerson Ltd.Chapter 102 Learning Outcomes This chapter explains: Central banking and the Bank of Canada Central banking operating techniques to control money supply and interest rates Monetary policy targets in Canada Monetary policy instruments and policy rules The effects of monetary policy on aggregate demand The long-run neutrality of money Monetary policy indicators

3. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.13 Central Banking and the Bank of Canada Central Bank Monetary Policy –central bank action to change money supply, interest rates, and exchange rates, to change aggregate demand and economic performance

4. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.14 The Balance Sheet of the Bank of Canada, 2005 (year-end, millions of dollars) AssetsLiabilities Government of Canada securitiesNotes in circulation46,078 Treasury bills16,835 Government bondsDeposits ≤ = 3 years10,337 Government911 > 3 years19,689 Chartered banks33 Advances to members of the Canadian Payments Association -- Other Canadian Payments Association Foreign central banks143 Foreign currency deposits88Foreign currency liabilities -- Other assets1,821Other liabilities1,138 Total48,320Total48,320 17

5. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.25 Central Bank Operating Techniques Three main techniques to manage Monetary Base and Money supply 1.Establishing reserve requirements –Required Reserve Ratio –Determines money multiplier in money supply function 2.Using open-market operations –Main technique –Determines monetary base in money supply function 3.Setting the bank rate –Sets cost of borrowing monetary base –Signals monetary policy change

6. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.26 An Open-Market Purchase and the Money Supply Central BankCommercial Banks AssetsLiabilitiesAssetsLiabilities 1. Open-market purchase of $100 million in government bonds 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 +100 3. 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 If rr = 0.05, excess reserves +95

7. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.27 An Open-Market Purchase and the Money Supply Central BankCommercial Banks AssetsLiabilitiesAssetsLiabilities 4. Commercial banks increase lending and create new deposits No changeLoans +1900 Deposits +1900 5. Final effect of central bank open market purchase Govt bond +100 Cash (ΔH) +100 Cash reserves +100 Loans +1900 +2000 Deposits +2000 6. Change in Money Supply ΔM = ΔH/rr = $100/0.05 = $2,000

8. ©2007 McGraw-Hill Ryerson Ltd.Chapter 108 Money Supply Control or Interest Rate Control either or not bothThe Bank can control either money supply or interest rates but not both at the same time. –If money supply is controlled by the central bank, the market determines the interest rate. –If interest rate is controlled by the central bank, the market determines the money supply. Illustrate ➙

9. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.29 Money Supply Control or Interest Rate Control Interest Rate i M 0 /P L(Y 0 ) i0i0 i1i1 Real Money Balances E L(Y 1 ) (a) Money Supply Control A money supply fixed by the central bank results in an interest rate set by the money market M/P

10. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.210 Money Supply Control or Interest Rate Control Interest Rate i M 0 /P L(Y 0 ) i0i0 M 1 /P Real Money Balances E L(Y 1 ) (b) Interest Rate Control An interest rate fixed by the central bank results in a money supply set by the money market. M/P

11. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.311 Monetary Policy Targets and Instruments in Canada Exchange rate target Money supply target Inflation rate target Monetary policy instrument –The variable the central bank manages in pursuit of its policy target

12. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.312 Monetary Policy Targets and Instruments in Canada Bank of Canada Operating Techniques Policy instrument - the overnight rate Set and announce target for the overnight interest rate SPRA: special purchase and resale agreement –Temporarily increases monetary base –Offsets upward pressure on the overnight rate SRA: sale and repurchase agreement –Temporarily reduces monetary base –Offsets downward pressure on the overnight rate

13. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.313 The Bank of Canada’s Operating Band for Overnight Rates

14. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.314 Setting and Maintain the Overnight Rate MB 0 D0D0 Overnight rate Bank Rate MB 1 Set overnight rate target Short term increase in demand for MB Upward pressure on Overnight rate SPRA to offset the upward pressure Temporary increase in MB SRA would offset downward pressure on overnight rate. D1D1 Deposit rate Monetary Base Interest Rate

15. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.315 Bank of Canada Special Purchase and Resale Agreements and Sale and Repurchase Agreements (monthly averages of daily data)

16. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.316 Government Deposit Accounts Central BankCommercial Banks AssetsLiabilitiesAssetsLiabilities No changeReserve deposits of banks +10 Reserve deposits of banks +10 Government deposits +10 Government deposits -10 A Transfer of Government Deposits

17. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.417 Monetary Policy Rules The Taylor Rule When output temporarily exceeds potential output, the central bank raises interest rates. At levels of output below potential output, it lowers interest rates.

18. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.418 Interest Rates and Output with a Simple Taylor Rule Nominal Interest Rate i YpYp YpYp i i0i0 i1i1 Real GDP Y1Y1 (a) The Taylor Rule Y2Y2 i2i2

19. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.419 Interest Rates and Output with a Simple Taylor Rule Expenditure YpYp AE(i 0 ), Real GDP Y1Y1 (b) Equilibrium Output AE′(i 0 ) AE′(i 1 ) Y = AE YpYp

20. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.420 Monetary Policy Rules Policy Rules when Prices Change Setting inflation targets  * Setting nominal interest rate i Real interest rate (r = i -  *) affects the expenditure decision bb measures how the interest rate responds to an output gap.

21. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.521 The Neutrality of Money Quantity Theory of Money MV = PY assume V constant (inverse of demand) where V = 1/k and L = kY- hi So P = M x V/Y

22. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.522 The Neutrality of Money Nominal Interest Rate i YpYp YpYp MP 0 i0i0 i1i1 Output (a) Expansionary monetary policy MP 1

23. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.523 The Neutrality of Money Price Level YpYp AS 0 Output Y1Y1 (b) Short run and long run effects of expansionary monetary policy AD 1 AS 1 P1P1 P0P0 AD 0

24. ©2007 McGraw-Hill Ryerson Ltd.Chapter 10.624 Monetary Policy Indicators Monetary policy indicators provide information about the stimulus or restraint coming from the central bank’s policy. –Interest rates –Exchange rates

25. ©2007 McGraw-Hill Ryerson Ltd.Chapter 1025 Chapter Summary The Bank of Canadacentral bank. monetary policyThe Bank of Canada is Canada’s central bank. It conducts monetary policy through its control of the monetary base and interest rate. reserve requirements imposed on commercial banksopen-market operations, and bank rateThree operating techniques: reserve requirements imposed on commercial banks, open-market operations, and bank rate. inflation rate target the overnight interest rate policy instrumentThe Bank of Canada sets an inflation rate target and uses the overnight interest rate as its policy instrument. Overnight interest rate setting, SPRAs and SRAsOvernight interest rate setting, SPRAs and SRAs Taylor RuleMonetary Policy Rule – A Taylor Rule neutralIn the long run, when all prices are flexible, money is neutral.