MONETARY POLICY
26
CHAPTER
Objectives After studying this chapter, you will able to Describe the structure of the Bank of Canada Describe the tools used by the Bank of Canada to conduct monetary policy Explain what an open market operation is and how it works Explain how the Bank of Canada changes the quantity of money Explain how the Bank of Canada influences interest rates Explain how the Bank of Canada influences the economy
© Pearson Education Canada, 2003
Fiddling with the Knobs
Almost every month, the financial news reports on the Bank of Canada’s views about interest rates. What is the Bank of Canada? Why might the Bank of Canada want to change interest rates? How does it change interest rates?
© Pearson Education Canada, 2003
The Bank of Canada
The Bank of Canada is Canada’s central bank. A central bank is the public authority that supervises financial institutions and markets and conducts monetary policy. Monetary policy is the attempt to control inflation and moderate the business cycle by changing the quantity of money and adjusting interest rates and the exchange rate.
How do interest rates influence the economy?
© Pearson Education Canada, 2003
The Bank of Canada The Bank of Canada was established in 1935. The governor of the Bank is appointed by the federal government. The current governor, who was appointed in 2001, is David Dodge. There are two possible models for the relationship between a central bank and government: Independent central bank Subordinate central bank © Pearson Education Canada, 2003
© Pearson Education Canada, 2003
The Bank of Canada An independent central bank sets its own goals and makes its own decisions about how to pursue those goals and might listen to the views of government but is not obliged to pay any attention to those views. A subordinate central bank pursues goals set by the government and sometimes takes directions from the government on how best to achieve those goals. The Bank of Canada pursues inflation targets laid down by the government but makes its own decisions on how best to achieve those goals. © Pearson Education Canada, 2003
1
The Bank of Canada
The Bank of Canada
The Bank of Canada’s Balance Sheet The Bank of Canada’s assets are government securities and loans to banks (plus some other small items). The Bank of Canada’s liabilities are its notes (the $5, $10, $20, $50, and $100 notes), banks deposits, and government deposits. The monetary base is the sum of Bank of Canada notes outside the Bank, chartered bank deposits at the Bank of Canada, and coins held by households, firms, and banks.
Making Monetary Policy Monetary policy making involves three elements: Monetary policy objectives Monetary policy indicators Monetary policy tools
(Coins are issued by the government, not the Bank of Canada.) © Pearson Education Canada, 2003
© Pearson Education Canada, 2003
The Bank of Canada
The Bank of Canada
Monetary Policy Objectives The objectives of monetary policy, as stated in the Bank of Canada Act, are to
Monetary Policy Indicators
…regulate credit and currency in the best interests of the economic life of the nation…and to mitigate by its influence fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action… Current objective: keep the inflation rate between 1 percent and 3 percent a year and smooth fluctuations as much as possible. © Pearson Education Canada, 2003
Monetary policy indicators are the current features of the economy that the Bank looks at to determine whether it needs to apply the brake or the accelerator to influence future inflation, real GDP, and unemployment. The indicators change as the Bank learns more about how the economy works. Currently, the overnight loans rate, the interest rate on large-scale loans that chartered banks make to each other, is the main monetary policy indicator. © Pearson Education Canada, 2003
The Bank of Canada
Figure 26.1 shows the overnight loans rate since the mid 1970s. The Bank’s actions raise this interest rate to slow future inflation and lower this interest rate to boost real GDP.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
2
The Bank of Canada
Monetary Policy Tools The four monetary policy tools are: Required reserve ratio Bank rate and bankers’ deposit rate Open market operations Government deposit shifting
© Pearson Education Canada, 2003
The Bank of Canada
The Bank of Canada The Bank of Canada no longer requires chartered banks to hold a minimum level of reserves. The required reserve ratio in Canada is zero. Bank rate is the interest rate that the Bank of Canada charges the chartered banks on the reserves it lends them. The bankers’ deposit rate is the interest rate that the Bank of Canada pays to chartered banks on their deposits at the Bank. The Bank of Canada sets the bankers’ deposit rate at bank rate minus half a percent. © Pearson Education Canada, 2003
Controlling the Quantity of Money
How an Open Market Operation Works An open market operation is the purchase or sale of government of Canada securities by the Bank of Canada in the open market.
When the Bank of Canada conducts an open market operation by buying a government security, it increases banks’ reserves.
Government deposit shifting is the transfer of government funds by the Bank of Canada from the government’s account at the Bank to a government account at a chartered bank.
Banks loan the excess reserves.
© Pearson Education Canada, 2003
Controlling the Quantity of Money
Although the details differ, the ultimate process of how an open market operation changes the money supply is the same regardless of whether the Bank of Canada conducts its transactions with a commercial bank or a member of the public.
By making loans, they create money. The reverse occurs when the Bank of Canada sells a government security. © Pearson Education Canada, 2003
Controlling the Quantity of Money
Figure 26.2(a) illustrates an open market operation in which the Bank of Canada buys securities from a chartered bank.
An open market operation that increases banks’ reserves also increases the monetary base.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
3
Controlling the Quantity of Money
Figure 26.2(b) illustrates an open market operation in which the Bank of Canada buys securities from the public.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
Controlling the Quantity of Money Monetary Base and Bank Reserves The money multiplier is the amount by which a change in the monetary base is multiplied to calculate the final change in the money supply. An increase in currency held outside the banks is called a currency drain. Such a drain reduces the amount of banks’ reserves, thereby decreasing the amount that banks can loan and reducing the money multiplier.
© Pearson Education Canada, 2003
Controlling the Quantity of Money
The money multiplier differs from the deposit multiplier. The deposit multiplier shows how much a change in reserves affects deposits.
© Pearson Education Canada, 2003
Controlling the Quantity of Money The Money Multiplier When the Bank of Canada increases the monetary base, a sequence of nine events follows. They are: 1.Banks have excess reserves 2.Banks lend excess reserves 3.Bank deposits increase
The money multiplier shows how much a change in the monetary base affects the money supply.
4.The quantity of money increases 5.New money is used to make payments 6.Some of the new money remains on deposit 7.Some of the new money is a currency drain 8.Desired reserves increase because deposits have increased
© Pearson Education Canada, 2003
9.Excess reserves decrease, remain positive © Pearsonbut Education Canada, 2003
4
Controlling the Quantity of Money Figure 26.3 illustrates a round in the multiplier process following an open market operation.
© Pearson Education Canada, 2003
Controlling the Quantity of Money The Canadian Money Multiplier The Canadian money multiplier is the change in the quantity of money divided by the change in the monetary base. Because there are two definitions of money, M1 and M2+, there are two money multipliers. The M1 multiplier is about 2.2.
Controlling the Quantity of Money Figure 26.4 keeps track of the magnitude of the multiplier effect of an open market operation.
© Pearson Education Canada, 2003
Ripple Effects of Monetary Policy Figure 26.5 summarizes the ripple effects of the Bank of Canada’s monetary policy actions. The AS-AD model helps to see how monetary policy influences real GDP and the price level.
The M2+ multiplier is about 10.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
Ripple Effects of Monetary Policy
Monetary Policy to Lower Unemployment Figure 26.6 shows an economy that is experiencing unemployment. Monetary policy increases aggregate demand to restore full employment.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
5
Ripple Effects of Monetary Policy Monetary Policy to Lower Inflation Figure 26.7 shows an economy that is experiencing inflation. Monetary policy decreases aggregate demand to restore full employment and avoid inflation.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
Ripple Effects of Monetary Policy
Time Lags in the Adjustment Process The Bank of Canada needs a combination of good judgment and good luck to achieve its monetary policy goal of low and stable inflation and full employment. The Bank is handicapped by the fact that the ripple effect of its actions are long drawn out and not entirely predictable.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
Ripple Effects of Monetary Policy Interest Rate Fluctuations Figure 26.8 shows how interest rates respond to the Bank’s actions. Short-term interest rates move closely with the overnight loans rate. Long-term interest rates move in the same direction but fluctuate less. © Pearson Education Canada, 2003
© Pearson Education Canada, 2003
6
Ripple Effects of Monetary Policy
Figure 26.9 shows how interest rates respond to changes in the monetary base. During the 1970s, a decreasing monetary base increased interest rates. But the demand for monetary base fluctuates. © Pearson Education Canada, 2003
Ripple Effects of Monetary Policy
Money Target Versus Interest Rate Target Because the demand for monetary base fluctuates, the Bank of Canada prefers to target the interest rate and change the quantity of money automatically if the demand for money changes. Figure 26.10 on the next slides illustrates the distinction between targeting the quantity of money and targeting the interest rate.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
Ripple Effects of Monetary Policy
In Figure 26.10(a), the Bank targets the quantity of money. Fluctuations in the demand for monetary base bring unwanted fluctuations in the interest rate.
© Pearson Education Canada, 2003
Ripple Effects of Monetary Policy
In Figure 26.10(b), the Bank targets the interest rate. Fluctuations in the demand for monetary base now bring fluctuations in the quantity of money and hold the interest rate steady. © Pearson Education Canada, 2003
© Pearson Education Canada, 2003
7
Ripple Effects of Monetary Policy
The Exchange Rate The exchange rate responds to changes in the interest rate. But other factors also influence the exchange rate, as Figure 26.11 shows.
© Pearson Education Canada, 2003
© Pearson Education Canada, 2003
Ripple Effects of Monetary Policy Interest Rates, Aggregate Demand, and Real GDP Fluctuations The AS-AD model show how real GDP responds to changes in the interest rate. Figure 26.12 shows that these effects take about a year, on the average, to occur. © Pearson Education Canada, 2003
© Pearson Education Canada, 2003
The Bank of Canada in Action
Gerald Bouey’s Fight Against Inflation In the early 1980s, when Gerald Bouey was governor of the Bank of Canada, the Bank slowed the growth rate of money and interest rates rose dramatically. Real GDP decreased in a deep recession. The unemployment rate increased and remained high through the 1980s. The inflation rate slowed. © Pearson Education Canada, 2003
© Pearson Education Canada, 2003
8
The Bank of Canada in Action
The Bank of Canada in Action Gordon Thiessen’s and David Dodge’s Balancing Acts
John Crow’s Push for Price Stability John Crow became governor of the Bank of Canada in 1987. Crow was a fierce inflation fighter. He brought the inflation rate down to less than three percent, but at the cost of another recession during 19901991.
© Pearson Education Canada, 2003
MONETARY POLICY
Gordon Thiessen succeeded John Crow as governor of the Bank of Canada in 1994. Thiessen held the inflation rate inside its target range and helped set the scene for the strong expansion of the late 1990s and early 2000s. David Dodge succeeded Thiessen in 2001. Dodge attempted to keep the economy expanding through a U.S. recession and permitted inflation to exceed its target for the first time since inflation targeting began. © Pearson Education Canada, 2003
26
CHAPTER
THE END © Pearson Education Canada, 2003
9