Monetary Policy in Canada Quiz

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Questions and Answers

What happens when the Bank of Canada raises the overnight rate target?

Real GDP exceeds potential GDP.

The quantity of money demanded decreases. (correct)

Investment increases due to more available funds.

Aggregate planned expenditure increases immediately.

What was the primary success of the Bank's inflation performance until 2021?

Inflation was below 3 percent until 2021 (correct)

Inflation fluctuated wildly without a clear trend

Inflation consistently exceeded 2 percent

Inflation remained inside the target range (correct)

Which effect occurs after the Bank of Canada decreases bank reserves?

The supply of loanable funds decreases. (correct)

Aggregate demand increases significantly.

Real interest rates fall resulting in higher investments.

The short-term interest rate remains unchanged.

How does a decrease in investment affect real GDP?

It decreases real GDP to potential GDP. Signup and view all the answers

What is one of the main benefits of adopting an inflation-control target?

It reduces surprises for savers and investors Signup and view all the answers

What concern do critics of inflation targeting have regarding unemployment rates?

The focus on inflation might allow unemployment to rise Signup and view all the answers

What is a consequence of high inflation if real GDP exceeds potential GDP?

The Bank of Canada lowers inflation and restores price stability. Signup and view all the answers

What role does the multiplier effect play in the economy following an increase in investment?

It gradually increases aggregate demand. Signup and view all the answers

What was a key response from supporters of inflation targeting regarding its impact on employment?

Maintaining low and stable inflation is vital for full employment Signup and view all the answers

Who is responsible for conducting monetary policy in Canada?

The Bank of Canada’s Governing Council Signup and view all the answers

What happens if there is a profound disagreement between the Governor of the Bank and the Minister of Finance?

The Minister can instruct the Bank to follow a specific course Signup and view all the answers

Which of the following was a notable failure in the Bank's inflation performance in 2021?

Inflation rose above the target range Signup and view all the answers

How does the Bank of Canada approach its policy decisions?

Through regular consultation between the Governor and the Minister of Finance Signup and view all the answers

What is the primary objective of Canada's monetary policy as established by the Bank of Canada?

To control the quantity of money and interest rates in order to avoid inflation Signup and view all the answers

What does the agreement of 2021 state regarding Canada's inflation target?

The inflation target is the 2 percent midpoint of a 1 to 3 percent range Signup and view all the answers

What measure does the Bank of Canada primarily use to set its inflation-control target?

Total Consumer Price Index (CPI) Signup and view all the answers

What is the role of core inflation according to the Bank of Canada?

To predict future CPI inflation more accurately Signup and view all the answers

When does the current monetary policy agreement between the Government of Canada and the Bank of Canada expire?

December 31, 2026 Signup and view all the answers

What economic factors does the Bank of Canada try to stabilize through its monetary policy?

Real GDP growth and unemployment, in addition to inflation Signup and view all the answers

What is the underlying premise of inflation rate targeting employed by the Bank of Canada?

Maintaining a consistent trend inflation rate over time Signup and view all the answers

How does the Bank of Canada view interest rate decisions in relation to monetary policy?

Interest rate decisions must align with achieving the inflation target Signup and view all the answers

What is the role of open market operations in the floor system?

They adjust the quantity of bank reserves to maintain the overnight rate target. Signup and view all the answers

What does the curve RD0 illustrate in the context of bank reserves?

The banks' demand for reserves. Signup and view all the answers

How does the Bank of Canada aim to achieve its goal regarding inflation?

By keeping the inflation rate as close to 2 percent as possible. Signup and view all the answers

What is the immediate effect when the Bank of Canada lowers the overnight rate?

Long-term real interest rates decrease. Signup and view all the answers

What happens to consumption expenditure when the overnight rate is decreased?

It significantly increases. Signup and view all the answers

In the context of monetary policy, what does QE stand for?

Quantitative Easing. Signup and view all the answers

What is indicated by the y-axis in the graph of bank reserves?

The overnight rate. Signup and view all the answers

What occurs immediately upon announcing a change in the overnight rate target?

Interest rates adjust. Signup and view all the answers

What is the primary purpose of open market operations in the corridor system?

To maintain the overnight rate at its target by adjusting the quantity of bank reserves Signup and view all the answers

Since which year has the Bank of Canada announced its interest rate target for the upcoming six-week period?

2000 Signup and view all the answers

Which statement best describes the relationship between the overnight rate and the bank rate?

The overnight rate will always be less than or equal to the bank rate. Signup and view all the answers

Which of the following describes the role of the deposit rate in the corridor system?

It acts as a floor, meaning the overnight rate cannot fall below this rate. Signup and view all the answers

What amount does the Bank of Canada typically change the overnight rate by?

A quarter of a percentage point Signup and view all the answers

What determines the actual quantity of reserves in the corridor system?

The Bank's open market operations Signup and view all the answers

Why would a bank not be willing to lend at an interest rate below the deposit rate?

They can earn the deposit rate from the Bank. Signup and view all the answers

What happens to the demand for reserves if the overnight rate is set too high?

Demand for reserves decreases. Signup and view all the answers

What happens to the quantity of money and bank loans when the overnight rate is lowered by the Bank of Canada?

Both increase Signup and view all the answers

How do short-term interest rates behave in relation to the overnight rate?

They are closely tied together Signup and view all the answers

What is the relationship between the long-term real interest rate and the nominal interest rate?

The long-term real interest rate equals the nominal interest rate minus expected inflation Signup and view all the answers

Which component of aggregate expenditure is NOT directly influenced by changes in the overnight rate?

Government spending Signup and view all the answers

What impact does an increase in the supply of bank loans have on the real interest rate?

It causes the real interest rate to fall Signup and view all the answers

What does the Canadian interest rate differential refer to?

The difference in interest rates between Canada and other countries Signup and view all the answers

When the Bank of Canada implements a lower overnight rate, which of the following occurs?

The short-term interest rate falls Signup and view all the answers

Which statement accurately describes the effect of the Bank of Canada lowering the overnight rate target?

It increases reserves to help meet the new target Signup and view all the answers

Study Notes

Monetary Policy

Canada's monetary policy objective and framework arise from the relationship between the Bank of Canada and the Government of Canada.
The Bank of Canada's mandate, outlined in the Bank of Canada Act 1935, is to control the money supply and interest rates to avoid inflation and mitigate excessive swings in real GDP growth and unemployment.
The 2021 agreement between the Government of Canada and the Bank of Canada sets the inflation target at the 2% midpoint of the 1-3% inflation range. The agreement runs until December 31, 2026.
This policy is called inflation rate targeting, using the Consumer Price Index (CPI) as the measure of inflation. The Bank closely monitors core inflation as a more accurate gauge of the underlying inflation trend and future CPI inflation.
The Bank did a good job of maintaining inflation close to the 2% target until 2021 but was faced with a significant deviation in 2021.
Critics of inflation targeting worry that prioritising inflation could slow real GDP growth or increase unemployment. Concerns also exist about the Bank's response to high inflation, potentially leading to recession or a stronger Canadian dollar that hurts exports.
Supporters argue that stable inflation is key to sustained economic growth and full employment. Their argument is supported by the Bank's relatively good performance, with a previous recession only occurring in the early 1990s during an era of double-digit inflation.
The Bank of Canada's Governing Council is responsible for monetary policy. The Governor and the Minister of Finance must consult regularly.
- If a deep disagreement arises, the Minister of Finance can direct the Bank of Canada.

Monetary Policy Instruments

Monetary policy instruments are variables the Bank of Canada controls or targets directly.
The Bank of Canada has two key instruments:
- The quantity of bank reserves
- Overnight interest rates at which banks borrow, hold, or lend reserves.

Bank Reserves

Bank reserves are composed of currency held by banks and the balance on their reserve accounts at the Bank of Canada.
The Bank of Canada adjusts the quantity of bank reserves through open market operations, buying or selling Treasury bills and government bonds.
- Buying securities leads to newly created bank reserves; selling securities results in bank reserves being withdrawn.

Interest Rates

The Bank of Canada uses overnight rate, deposit rate, and bank rate as interest rate instruments.
Overnight rate is the interbank interest rate for overnight loans.
Deposit rate is the interest rate Canada's central bank pays banks for reserves.
Bank rate is the interest rate banks pay the central bank on overnight reserve loans.
The Bank of Canada sets overnight rate targets and creates "corridor" for operating bands using bank rate and deposit rate targets to limit the volatility of overnight rates.

Monetary Policy Decisions

The Bank of Canada collects data on the economy, shocks to the economy, and how policy impacts the economy.
It uses an AS-AD model to make interest rate decisions.
It also communicates its reasons publicly.
Since 2000, the Bank has announced overnight rate changes six weeks in advance.
Overnight rates are usually adjusted by a quarter of a percentage point.

Hitting the Overnight Rate Target

The Bank of Canada uses open market operations to adjust overnight rates.
The details of the policy instruments vary in different operating systems (e.g., corridor system or floor system).

Open Market operations in a Corridor System

In this system, the Bank keeps overnight rates near the centre of the operating band by adjusting the quantity of bank reserves via open market operations.

Open Market Operations in a Floor System

In the floor system, the Bank targets overnight rates at the operating band's lower limit.
Open market operations adjust the amount of bank reserves.

Monetary Policy Transmission

The Bank of Canada's goal is to maintain inflation at 2% per annum.
When the Bank changes the overnight rate, there are significant ripple effects throughout the economy.
When the rate decreases, short-term rates, exchange rate, money supply, long-term interest rates, consumption expenditure, investment, and net exports all increase.
Conversely, when rates increase, all those factors reverse direction.
The exchange rate is affected by the interest rate differential between Canada and other nations.
Other factors influence the exchange rate and make it challenging to forecast.
An increase in reserves in a corridor or the floor system increases money supply, changes short-term rates and quantity of money demanded. Also influencing the real interest rate and investment.
The Bank uses open market operation to change the overnight rate and adjust the amount of reserves, to hit the overnight rate target at the operating band's center in a corridor system or target the floor of the operation band in a floor system.

Interest Rate Changes

Interest rates fluctuate frequently following an announcement.
Short-term and long-term rates generally move closely but long-term rates exhibit less sensitivity.

Exchange Rate Fluctuations

Exchange rates are sensitive to interest rate differentials relative to other nations.

Money and Bank Loans

When the Bank lowers the overnight rate, the quantity of money and available bank loans increase.

Long-Term Real Interest Rate

At equilibrium, the long-term real interest rate equals the nominal interest rate, minus expected inflation.
The real interest rate impacts expenditure plans.

Expenditure Plans

A change to the overnight rate affects Consumption spending, Investment, and Net Exports.
These factors influence Aggregate Demand, real GDP, and price level.

Bank of Canada Fights Recession

If inflation is low and real GDP is below potential GDP the Bank of Canada acts to restore full employment.
The Bank of Canada uses the floor system lowering its target rate and increasing reserves to hit the new target.

Bank of Canada Fights Inflation

If inflation is too high and real GDP exceeds potential GDP, the Bank of Canada acts to lower inflation while restoring price stability.
Bank of Canada raises overnight rates, decreases reserves to hit the new target.

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Description

Test your knowledge on the Bank of Canada's monetary policy, its inflation targeting, and the effects of rate changes on the economy. This quiz covers key concepts and questions related to economic performance and the responsibilities of the Bank of Canada.