Monetary Policy (Chapter 13): Key Dates & Approaches

• Key dates for the course
• The last class is Thursday, April 3rd.
• Problem Set 6 is due Friday, April 4th.
• Quiz 10 is due Friday, April 4th.
• Office hours are available:
• April 1 & 3, from 2:30-4pm
• April 7, from 10am-12pm
• April 8, from 2pm-4pm
• At room AVDX G23

Monetary Policy in Canada (Chapter 13)

• This is the topic for the last class
• Quantitative Easing will be covered in this chapter
• A Bank of England handout on QE can be found on Moodle

How the Bank of Canada Implements Monetary Policy

• A central bank has two approaches to implementing monetary policy
• Target the money supply (MS)
• Target the interest rate (i)
• Both cannot be targeted independently if the MD curve is given
• The Bank of Canada targets the interest rate rather than the money supply
• The BoC can control the interest rate
• Uncertainty about the MD curve does not prevent the BoC from establishing its desired interest rate
• The BoC can easily communicate its interest-rate policy to the public

Approaches to Monetary Policy

• The central bank can set MS and let the market determine the rate of interest i
• Alternatively, the central bank can set the interest rate, and let the market determine the money supply

BoC and Interest Rates

• Bank Rate is the interest rate that the BoC charges commercial banks for loans
• Overnight interest rate is the rate commercial banks charge one another for overnight loans
• The BoC announces a target for the overnight interest rate eight times per year
• By influencing the overnight interest rate, the BoC also influences longer-term interest rates
• Longer term rates are relevant for determining aggregate consumption and investment expenditure
• Mortgage rates, credit line rates, and bond rates
• Investment and durable consumption are sensitive to interest rate changes
• When the BoC announces its target for the overnight rate, it also announces the bank rate
• The bank rate is set to 0.25% points above the target rate
• The BoC offers to borrow from commercial banks at an interest rate 0.25% points below the target
• Actual Overnight Rate target is between Target-0.25 and Target+0.25 = Bank Rate

BoC Rate Announcements

• BoC makes interest rate announcements 8 times per year
• As of March 21, 2024, the BoC anticipates cutting rates this year, but officials are split on timing
• Cuts will occur if the economy and inflation evolve as projected

Endogenous Money Supply

• When the BoC changes its target for the overnight rate, the actual overnight rate changes almost instantly
• Changes in other market interest rates are also quick
• As rates adjust, firms and households change borrowing behavior
• When the demand for new loans adjusts, commercial banks may want to change their reserve holdings
• Banks can sell government securities to the BoC for cash to replenish reserves or extend new loans
• Purchasing or selling of government securities on the open market by the central bank is an open-market operation
• The Bank of Canada influences reserves and currency in circulation through open-market operations
• The amount of currency in circulation and bank deposits are endogenous
• The money supply is not directly controlled by the BoC
• The money supply is determined by economic decisions of households, firms, and commercial banks
• The BoC is passive in its decisions regarding the money supply

Expansionary or Contractionary Policies

• To stimulate aggregate demand (AD), the BoC will reduce its target for the overnight interest rate, affecting longer-term market interest rates
• Reducing the interest rate is an expansionary monetary policy, expanding AD
• To reduce AD, the BoC will raise its target for the overnight interest rate
• Raising the interest rate is a contractionary monetary policy, contracting AD

Inflation Targeting

• High Inflation is costly
• Unexpected inflation
• Fixed income
• Price system
• Monetary Policy is the cause of sustained inflation
• Inflation targeting in Canada began in 1991 with a target of 2% ± 1%
• Keeping inflation near 2% requires monitoring the output gap (Y-Y*)
• Also, any associated pressures that may be pushing inflation above or below the target
• Persistent output gaps can create pressure for the rate of inflation to change
• The BoC designs its policy to keep real GDP close to potential output

Stabilizing Policy

• Positive shocks that create an inflationary gap
• Shocks that threaten to increase inflation will be met by contractionary monetary policy
• Negative shocks to the economy that create a recessionary gap
• These will be met with expansionary monetary policy
• Central bank policy adjustments act to stabilize real GDP if it is committed to achieving its inflation target

Complications in Inflation Targeting

• Volatile Food and Energy Prices
• Volatility of food and energy prices is often unrelated to the level of the output gap
• Prices of Internationally traded goods are determined in the Rest of World (RoW).
• Changes in CPI comes from food and energy
• BoC’s don't necessarily have to react
• Core CPI is one way to ignore food and energy prices from the CPI
• Exchange Rates and Monetary Policy
• Changes in exchange rates can signal the need for changes in monetary policy stance
• Exchange rates affect AD through net exports (NX)

BoC Reaction in Change of the Exchange Rate

• The reaction depends on the situation:
• Case 1: Higher foreign demand for domestic exports leads to domestic currency appreciation
• Case 2: Higher foreign demand for domestic assets (not goods) leads to domestic currency appreciation

Long and Variable Lags

• Monetary policy operates with a long and variable time lag
• Changes in expenditure take time
• The multiplier process takes time
• Initial effects appear after ~9 months
• Full effects are seen after ~18-24 months

Quantitative Easing

• If the economy is in a recession, the BoC lowers the target overnight rate
• Once the overnight rate is at the effective lower bound, the BoC cannot provide further stimulus using interest rates.
• Quantitative Easing (QE) can provide monetary stimulus is through large-scale asset purchases by the BoC
• Involves injecting new money into the economy to stimulate expenditures
• It works through changes in the money supply, unlike interest rate targeting
• In QE, the BoC buys $100 worth of bonds from a pension fund
• Assets of the pension fund: Reserves at BoC gains $100 Liabilities sees Deposits of Pension Fund increase by $100

Quantitative Easing In Economy

• Pension funds
• QE has two direct and one indirect effects:
• Lowers borrowing costs for private firms
• Increases wealth for households holding private corporate bonds, leading to higher expenditures
• Banks may be willing to lend more with higher bank reserves (indirect effect)