ECON 2200 Readings Ch. 28 PDF

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Macroeconomics 4th Custom Ed. for BCIT
Author: Ragan
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ECON 2200 Readings Ch. 28: Monetary Policy in Canada  28.1 HOW THE BANK OF CANADA IMPLEMENTS MONETARY POLICY -Bank of Canada “targets” the money supply/interest rates rather than setting them directly -bank can’t directly control the money supply -slope and position of MD curve is uncertain MONEY SUPPLY VS. THE INTEREST RATE -2 alternative choices for implementing monetary policy: 1. target money supply -does this by selling/buying gov. securities in financial markets: open-market operations -ex. Bank of Canada buys $100k in gov. bonds from willing seller and Bank of Canada increases amount of cash reserves in banking system by $100k -this increases the amount of deposit money in economy =in increase of money supply, and shift of MS curve to the right, leading to reduction in interest rate, increase in aggregate demand 2. target interest rate – most effective – most chosen method -can’t do both WHY THE BANK OF CANADA DOES NOT TARGET THE MONEY SUPPLY 1. Bank of Canada can’t control process of deposit expansion carried by commercial banks a. Ex: if Bank increase amount of cash reserves, commercial banks might not choose to expand their lending 2. Uncertainty regarding slope of MD curve a. Unsure about the change in interest rate b. Uncertainty makes conduct of monetary policy difficult 3. Unable to accurately predict position of MD curve at any given time a. Change in real GDP/price level causes changes in money demand that bank can only approximate b. Unpredictable fluctuations in demand for money make monetary policy based on direct control of money supply difficult to implement WHY THE BANK OF CANADA TARGETS INTEREST RATES -bank must accommodate change in amount of money demanded – must alter supply of money in order to satisfy change in desired money holdings by firms and households 1. Bank of Canada able to control a particular interest rate 2. Uncertainty about slope/position of MD curve doesn’t prevent them from establishing its desired interest rate 3. Bank of Canada can easily communicate interest-rate policy to public BANK OF CANADA AND THE OVERNIGHT INTEREST RATE -term structure of interest rates: overall pattern of interest rates corresponding to gov. securities of different maturities -overnight interest rate: interest rate that commercial banks charge one another for overnight loans -market-determined interest rate – fluctuates daily as cash requirements of commercial banks change -influences longer-term market interest rates -by influencing overnight interest rate, Bank of Canada also influences longer-term interest rates that are more relevant for determining aggregate consumption and investment expenditure -bank rate: interest rate the Bank of Canada charges commercial banks for loans

-when bank announces target for overnight rate, also announces bank rate, an interest rate of 0.25 percentage points above the target rate (the Bank stands ready to lend any amount to commercial banks) -bank offers to borrow in unlimited amounts from commercial banks and pay an interest rate 0.25 percentage points below target rate (the Bank stands ready to accept deposits from commercial banks and pay that rate of interest) -ex: announced target overnight interest rate = 2% -bank willing to lend 2.25%, willing to pay 1.75% on any deposits it receives -actual overnight interest rate is between 1.75-2.25% -changes in overnight interest rate leads to changes in other longer-term interest rates MONEY SUPPLY IS ENDOGENOUS -change in actual overnight rate happens almost instantly -mortgage rates, prime interest rates change quickly -firms/household changes in borrowing behavior take longer to occur -borrowers consider how interest-rate changes affect their own economic situations -open-market operations: purchase/sale of government securities on the open market by the central bank -Bank of Canada changes amount of currency in circulation -banks can sell government securities to Bank of Canada in exchange for cash to extend new loans -operations not initiated by Bank of Canada -amount of currency in circulation is endogenous (not controlled by the Bank of Canada, but determined by economic decisions of households, firms, commercial banks) -Bank of Canada is passive in its decisions regarding money supply -conducts open-market operations to accommodate changing demand for currency coming from commercial banks -reduction in Bank’s target for overnight rate reduces market interest rates and lead to greater demand for borrowing/spending by firms/households -increase in Bank’s target for overnight rate increases market interest rates/reduce demand for borrowing/spending by firms/households -open-market purchase: Bank of Canada purchasing government bonds from commercial banks -when banks increase their cash reserves -open-market sale: Bank of Canada is selling government bonds to commercial banks -when banks reduce their excess cash reserves EXPANSIONARY AND CONTRACTIONARY MONETARY POLICIES -no clear relationship between changes in interest rate/changes in quantity of money in circulation -expansionary monetary policy: reducing interest rate – leads to expansion of aggregate demand -contractionary monetary policy: increasing interest rate – leads to contraction of aggregate demand  28.2 INFLATION TARGETING WHY TARGET INFLATION? -why central banks focus on targeting inflation rates: 1. costs associated w/ high inflation 2. ultimate cause of sustained inflation HIGH INFLATION IS COSTLY -reduces real purchasing power for people whose incomes stated in nominal terms and insufficiently indexed (linked in value) to adjust for changes in the price level

-undermines ability of price system to provide accurate signals of changes in relative scarcity through changes in relative prices -uncertainty of inflation – difficult to predict future courses of prices -risk of unexpected inflation – makes it difficult to make long-range plans (R&D investment activities) – harmful to economic growth MONETARY POLICY IS THE CAUSE OF SUSTAINED INFLATION -inflation is a monetary phenomenon -shocks unrelated to monetary policy causes shifts in the AD and AS curves, causing temp. changes in rates of inflation as economy responds to shocks -sustained inflation: not caused by shocks – occurs only in those situations in which monetary policy was allowing continual and rapid growth in money supply -caused by monetary policy -central banks can prevent sustained inflation by adopting appropriate monetary policy -adopting policies that target the rate of inflation ADOPTION OF INFLATION TARGETING -inflation targeting: used to control inflation rates INFLATION TARGETING AND THE OUTPUT GAP -in order to keep inflation at its target, Bank of Canada must monitor the output gap and associated pressures that is pushing inflation above/below the target -monetary policy has potential to alter size of current output gap from which comes the pressure for inflation to rise/fall -persistent recessionary gap (Y < Y*)  reduces inflation below Bank’s 2-percent target -Bank can pursue expansionary monetary policy to increase real GDP/reduce the gap -persistent inflationary gap (Y > Y*)  inflation tends to rise above Bank’s 2-percent target -Bank can pursue contractionary monetary policy to bring real GDP back towards Y* and inflation closer to 2% -when GDP is below Y*, deflationary gap opens up -when GDP above Y*, inflationary gap opens up INFLATION TARGETING AS A STABILIZING POLICY -expansionary monetary policy  Bank responds by reducing interest rates and shifting AD curve right -contractionary monetary policy  Bank increases interest rates and shifts AD curve left – policy reduces size of output gap and pushes rate of inflation back toward 2 percent COMPLICATIONS IN INFLATION TARGETING VOLATILE FOOD AND ENERGY PRICES -sometimes commodities’ prices rise, unrelated to change in output gap -ex: Oil (included in CPI) rise because of political instability – prices determined by world markets -if they rise, the measured rate of inflation of CPI also rises -price increases have nothing to do w/ size of output gap in Canada -if focusing only on inflation of CPI, BOC would be misled about extent of inflationary pressures coming from excess demand in Canada -bc of this, BOC measures only the “core” rate of inflation: rate of growth of a special price index, one that is constructed by extracting food, energy, effects of indirect taxes from CPI -excludes the effects of changes in indirect taxes -better indicator of domestic inflationary pressures than changes in CPI inflation THE EXCHANGE RATE AND MONETARY POLICY -changes in exchange rates can have many different causes

-appreciation of Canadian dollar: -bank tightens monetary policy by raising target for overnight interest rate -ex: increase in demand for Canadian dollar; increase in demand adds directly to aggregate demand – leads to domestic inflationary pressures -positive demand shock to net exports -use contractionary monetary policy -depreciation of Canadian dollar: -bank loosens monetary policy by reducing target for overnight interest rate -both done to stabilize real GDP/keep inflation rate near 2 percent target -ex: increase in demand of Canadian assets rather than Canadian goods -leads to increase in demand for Canadian dollar, leads to appreciation of Canadian dollar  but exports get more expensive to foreigners, so there’s a reduction in Canadian net exports and a reduction in Canadian aggregate demand  creates a recessionary gap -positive shock to asset market, but reduced demand for net exports -use expansionary monetary policy  28.3 LONG AND VARIABLE LAGS -monetarists: argued that a change in money supply leads to substantial change in aggregate demand -fall in money supply was major cause of fall in output and employment in Great Depression -keynesians: argued that monetary policy was much less powerful -cause of Great Depression due to reduction in autonomous expenditure WHAT ARE LAGS IN MONETARY POLICY? -2 reasons why change in monetary policy doesn’t quickly effect the economy: 1. CHANGES IN EXPENDITURE TAKE TIME -change of target in overnight interest rate can change instantly -takes more time for firms/households to adjust their spending/borrowing behaviours -takes time to modify investment plans and to put them into effect -change in interest rate leads to flows of financial capital/change in exchange rate quickly -but subsequent effect on net exports takes more time – purchasers of internationally traded goods/services may switch to lower-cost supplies 2. THE MULTIPLIER PROCESS TAKES TIME -monetary policy capable of exerting expansionary/contractionary forces on economy, but operates with time lag that is long and difficult to predict -BOC estimates 9-12 months for change in monetary policy action to have main effect on real GDP, and further 9-12 months for policy action to have main effect on price level (or rate of inflation) DESTABILIZING POLICY? -BOC must design policy for what is expected to occur in future rather than what has already been observed -long time lags in effectiveness of monetary policy increases difficulty of stabilizing the economy; monetary policy may have a destabilizing effect -must carefully assess causes of shocks in Canadian economy; if BOC responds to every shock, it can destabilize the economy -BOC only responds to shock that are significant in magnitude and are expected to persist for several months/more COMMUNICATIONS DIFFICULTIES -if economy is below target right now and inflation is expected to rise in near future, monetary policy must be changed now in order to counteract future inflation -this action generates criticism b/c current inflation is low,

-Banks find itself in awkward position of advocating a tightening monetary policy in order to fight expectation of future inflation, when at the time the current inflation rate suggests no need for tightening -monetary policy must be forward-looking  often leads to criticism especially by those who don’t recognize the long time lags  28.4 THIRTY YEARS OF CANADIAN MONETARY POLICY -stagflation: reductions in GDP growth rates and increases in inflation in Canada FINANCIAL CRISIS AND RECESSION: 2007-2010 -2002-2006, US housing prices rising rapidly, then crashed -market values fell below total amount of owing on associated mortgages -people walked away from their homes, financial institutions no longer received regular mortgage payments -banks/financial institutions on brink of bankruptcy and insolvency -became global financial crisis -widespread fear in financial markets led to disappearance on short-term interbank lending -flow of credit declined -Canadian banks however weren’t in danger of bankruptcy -but because of globalized nature of financial markets, short-term credit markets in Canada are highly integrated with those in other countries  Canada also experienced decline in interbank lending and rise in short-term interest rates -BOC took 2 sets of actions during 2007-2008: 1. reduced target for overnight rate by more than 3.5 percentage points between Fall 2007-2008 2. eased terms which it was prepared to make short-term loans to financial institutions -both set to help restore flow of credit/reduce interest rates, helping maintain economic level of activity -still experience recession -sharp decline in demand for Canadian exports -real Canadian GDP slowed sharply in late 2008, began to fall early 2009 -experienced significant recession in 2009  returned to positive GDP growth in 2010 -significant recessionary gap persisted -2 external forces played part in dampening growth of real GDP 1. US economy experiencing slow/gradual recovery; low US growth implied low demand for economy’s traditional imports of Canadian goods/services 2. Global financial crisis of 2008 led to a sovereign debt crisis in Europe; gov. debt increased dramatically in response to recession and provision of financial support to failing banks SLOW ECONOMIC RECOVERY: 2011-PRESENT -recession  lack of confidence in future  banks/firms/households strive to reduce debts  contributes to weak growth in aggregate demand  slow growth in GDP -recovery was gradual  result that monetary policy remained very expansionary for longer period of time than normal following more conventional recessions -2011-2014: BOC’s target for overnight interest rate remained at 1% -inflation slightly below 2% target, real GDP remained very below Y*  unemployment high...