Questions and Answers
Why does the Bank of Canada choose to directly target interest rates rather than the money supply?
The central bank has more direct influence on rates compared to the money supply.
What is the overnight interest rate?
The rate that banks charge one another for overnight loans.
What is the target reserve ratio for all commercial banks discussed in the example?
It is possible for a central bank to target both the money supply and interest rates independently.
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What happens when the Bank of Canada increases the interest rate?
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What impact does a change in the overnight interest rate have on other market interest rates?
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What does the Bank of Canada do to maintain the actual overnight rate within a band?
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The overnight interest rate is kept within a ___% band by the Bank of Canada.
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Study Notes
Implementing Monetary Policy
- The Bank of Canada targets interest rates instead of the money supply due to greater direct influence over rates and instability in money demand.
- Targeting the overnight (O/N) rate involves the rate banks charge each other for overnight loans, akin to the U.S. Federal Funds Rate.
- The Bank controls the O/N rate by setting a target, ensuring actual rates stay within a 0.5% band around this target.
Inflation Targeting
- Many central banks adopt formal inflation targets to stabilize the economy.
- The Bank of Canada's inflation targeting policy helps manage inflation expectations and encourages responsive behavior from businesses and consumers.
Long and Variable Lags
- Changes in monetary policy have delayed effects on real GDP and price levels.
- The transmission of policy changes through interest rates influences borrowing behaviors over time.
Interest Rate vs. Money Supply Targets
- A central bank can only independently target either interest rates or the money supply, not both, due to interdependence.
- Targeting the money supply involves open market operations, affecting interest rates indirectly.
- Interest rate targeting facilitates clearer communication of policy changes, impacting aggregate demand directly through borrowing costs.
Open Market Operations
- The Bank of Canada conducts open market operations by buying or selling government securities to influence the money supply and interest rates.
- A sale of bonds leads to decreased bank reserves and an increase in interest rates, making the interest rate endogenous.
Monetary Policy Implementation Mechanics
- Changes in the Bank of Canada’s target for the O/N rate result in rapid adjustments in actual rates and other market interest rates, typically within days.
- Different interest rates exist for firms and consumers based on borrowing risks and loan terms (length of maturity).
Conclusion on Interest Rate Dynamics
- Commercial banks tend to borrow and lend close to the Bank of Canada's announced target for the O/N rate due to market mechanisms adjusting to maintain stability in interest rate levels.
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Description
This quiz explores the implementation of monetary policy by the Bank of Canada, particularly its focus on interest rates and inflation targeting. You will learn about the overnight rate, the significance of formal inflation targets, and the impact of these policies on the economy. Test your knowledge on how the Bank stabilizes the economy through these mechanisms.
