Chapter 14 - TBP PDF

14 MONETARY POLICY Learning Outcomes: After studying this chapter, you will be able to: ◆ Describe Canada’s monetary policy objective and the framework for setting and achieving it ◆ Explain how the Bank of Canada makes its interest rate decision and achieves its interest rate targe...

14 MONETARY POLICY Learning Outcomes: After studying this chapter, you will be able to: ◆ Describe Canada’s monetary policy objective and the framework for setting and achieving it ◆ Explain how the Bank of Canada makes its interest rate decision and achieves its interest rate target ◆ Explain the transmission channels through which the Bank of Canada influences real GDP, jobs, and inflation  Monetary Policy Objective and Framework ❑ Canada’s monetary policy objective and the framework for setting and achieving that objective stem from the relationship between the Bank of Canada and the Government of Canada. ✓ What is the objective? ✓ Who is responsible for monetary policy? © 2025 Pearson Canada  Monetary Policy Objective and Framework Monetary Policy Objective ❑ It stems from the mandate of the Bank of Canada, which is set out in the Bank of Canada Act 1935. ❑ Basically, the Bank’s job is to control the quantity of money and interest rates in order to avoid inflation and, … when possible, prevent excessive swings in real GDP growth and unemployment. © 2025 Pearson Canada  Monetary Policy Objective and Framework Joint Statement of the Government of Canada and the Bank of Canada The agreement of 2021: 1. The target is defined in terms of the 12-month rate of change in the total CPI. 2. The inflation target is the 2 percent midpoint of the 1 to 3 percent inflation-control range. 3. The agreement will run until December 31, 2026. Such a monetary policy strategy is called inflation rate targeting. © 2025 Pearson Canada  Monetary Policy Objective and Framework ❑ The inflation-control target uses the CPI as the measure of inflation. ❑ So, the Bank has agreed to keep the trend CPI inflation rate at a target of 2 percent a year. ❑ But the Bank pays close attention to core inflation, which it calls its operational guide. ❑ The Bank believes that core inflation is a better measure of the underlying inflation trend and better predicts future CPI inflation. © 2025 Pearson Canada  Monetary Policy Objective and Framework Actual Inflation Figure 14.1(a) shows the Bank’s inflation-control target range: The Bank did a good job of holding inflation close to its 2 percent target until 2021... When it was confronted with a massive deviation from its goal. © 2025 Pearson Canada  Monetary Policy Objective and Framework Two features of the Bank’s inflation performance: ▪ Persistence success and spectacular failure. ▪ Success: Inflation remained inside target range and mostly under 2 percent until 2021. ▪ Failure: Inflation soaring well above 3 percent, the upper limit of the target range in 2021. © 2025 Pearson Canada  Monetary Policy Objective and Framework Rationale for an Inflation-Control Target Two main benefits flow from adopting an inflation-control target: 1. Fewer surprises and mistakes on the part of savers and investors. 2. The target anchors expectations about future inflation. © 2025 Pearson Canada  Monetary Policy Objective and Framework Controversy About the Inflation-Control Target Critics of inflation targeting fear that: 1. By focusing on inflation, the Bank might permit the unemployment rate to rise or real GDP growth to slow. 2. If inflation edges up above the upper limit, the Bank will rein in aggregate demand and push the economy into recession … or permit the value of the dollar to rise on the foreign exchange market and make exports suffer. © 2025 Pearson Canada  Monetary Policy Objective and Framework Supporters of inflation targeting respond: 1. Keeping inflation low and stable is the best way to achieve full employment and sustained economic growth. 2. The Bank’s record is good. The last time the Bank created a recession was at the beginning of the 1990s when it was faced with double-digit inflation. Since that time, monetary policy has been sensitive to the state of employment while focusing on inflation. © 2025 Pearson Canada  Monetary Policy Objective and Framework Responsibility for Monetary Policy ❑ The Bank of Canada’s Governing Council is responsible for the conduct of monetary policy. ❑ The Governor and the Minister of Finance must consult regularly. ❑ If the Governor and the Minister disagree in a profound way, the Minister may direct the Bank to follow a specified course and the Bank would be obliged to accept the directive. © 2025 Pearson Canada  The Conduct of Monetary Policy How does the Bank of Canada conduct monetary policy? 1. What are the Bank of Canada’s monetary policy instruments? 2. How does the Bank of Canada make its policy decisions? 3. How does the Bank implement its policy? © 2025 Pearson Canada  The Conduct of Monetary Policy Monetary Policy Instruments A monetary policy instrument is a variable that the Bank of Canada can directly control or closely target. The Bank of Canada policy instruments are: 1. The quantity of bank reserves 2. The interest rates at which banks can borrow, hold, or lend reserves overnight © 2025 Pearson Canada  The Conduct of Monetary Policy Bank Reserves ❑ The quantity of bank reserves is currency held by banks plus the balance on their reserve accounts at the Bank of Canada. ❑ The Bank changes the quantity of bank reserves by conducting an open market operation—when it buys or sells Treasury bills and government bonds in the open market. ❑ When the Bank buys securities, it pays with newly created bank reserves. When the Bank sells securities, the buyer pays with bank reserves. © 2025 Pearson Canada  The Conduct of Monetary Policy The Interest Rates The Bank of Canada’s interest rate instruments are the overnight rate, the deposit rate, and the bank rate. ❑ The overnight rate is the interest rate banks charge each other on overnight loans. ❑ The deposit rate is the interest rate paid by the Bank of Canada to banks on the balances of their reserve accounts. ❑ The bank rate is the interest rate paid by a bank to the Bank of Canada on an overnight loan of reserves. © 2025 Pearson Canada  The Conduct of Monetary Policy ❑ The Bank of Canada sets a target for the overnight rate, called the Bank’s policy rate. ❑ The Bank also sets the bank rate and the deposit rate to create a “corridor” called the operating band. ❑ A bank can borrow from the Bank of Canada at bank rate, so a bank will never pay more than bank rate on an overnight loan. The bank rate caps the overnight rate. ❑ A bank earns the deposit rate on its reserves at the Bank of Canada, so a bank will never lend reserves at an overnight rate below the deposit rate. The deposit rate acts as a floor on the overnight rate. © 2025 Pearson Canada  The Conduct of Monetary Policy Monetary Policy Decisions ❑ To make its interest rate and bank reserves decisions, the Bank of Canada gathers data about the economy, the way it responds to shocks, and the way it responds to policy. ❑ The Bank must then process the data and come to a judgement about the best level for the overnight rate, the operating band, and bank reserves. ❑ The Bank uses a sophisticated version of the AS–AD model to make its interest rate decision and then engages in public communication to explain its reasons. © 2025 Pearson Canada  The Conduct of Monetary Policy ❑ Since 2000, the Bank has announced the interest rate target for the upcoming six-week period. Before 2000, the Bank changed the target when it thought it was needed. ❑ Although the Bank can change the overnight rate by any (reasonable) amount, it normally changes the rate by only a quarter of a percentage point. © 2025 Pearson Canada  The Conduct of Monetary Policy Hitting the Overnight Rate Target ❑ The Bank keeps the overnight rate at its target by using open market operations to change the quantity of reserves supplied. ❑ The details of the process depend on the Bank’s operating systems:  Corridor system  Floor system © 2025 Pearson Canada  The Conduct of Monetary Policy Open Market Operations in a Corridor System In the corridor system, the Bank keeps the overnight rate close to the centre of the operating band by using open market operations to adjust the quantity of bank reserves. © 2025 Pearson Canada  The Conduct of Monetary Policy ▪ The x-axis measures the quantity of bank reserves held at the Bank of Canada. ▪ The y-axis measures the overnight rate. ▪ Bank rate caps the operating band and the deposit rate acts as the floor. ▪ The curve RD0 shows the banks’ demand for reserves. © 2025 Pearson Canada  The Conduct of Monetary Policy ▪ The overnight rate cannot exceed the bank rate because, if it did, a bank could make a profit by borrowing from the Bank of Canada and lending to another bank. ▪ But all banks can borrow from the Bank of Canada at the bank rate, so no bank is willing to pay more than the bank rate to borrow reserves. © 2025 Pearson Canada  The Conduct of Monetary Policy ▪ The overnight rate cannot fall below the deposit rate. ▪ If it did, a bank could make a profit by borrowing from another bank and increasing its reserves at the Bank of Canada. ▪ But all banks can earn the deposit rate, so no bank will lend at an interest rate below the deposit rate. © 2025 Pearson Canada  The Conduct of Monetary Policy ▪ The banks’ demand for reserves in the corridor system is the curve RDC. ▪ The Bank’s open market operations determine the actual quantity of reserves. ▪ So the Bank supplies the quantity of limited reserves RSL to hit the overnight rate target at the centre of the operating band. © 2025 Pearson Canada  The Conduct of Monetary Policy Open Market Operation in a Floor System In the floor system, the Bank keeps the overnight rate target at the floor of the operating band by using open market operations to adjust the quantity of bank reserves. © 2025 Pearson Canada  The Conduct of Monetary Policy ▪ The x-axis measures the quantity of bank reserves held at the Bank of Canada. ▪ The y-axis measures the overnight rate. ▪ Bank rate caps the operating band and the deposit rate acts as the floor—overnight rate target. ▪ The curve RD0 shows the banks’ demand for reserves. © 2025 Pearson Canada  The Conduct of Monetary Policy ▪ The banks’ demand for reserves in the floor system is the curve RDF. ▪ The Bank uses massive QE open market operations to supply ample reserves. ▪ The Bank supplies RSA ample reserves to hit the overnight rate target at the floor of the operating band. © 2025 Pearson Canada  Monetary Policy Transmission ❑ The Bank of Canada’s goal is to keep the inflation rate as close as possible to 2 percent a year. ❑ When the Bank uses its policy tools to move the overnight rate closer to its desired level, a series of events occur. ❑ We’re now going to trace the events that follow a change in the overnight rate and see how those events lead to the ultimate policy goal-keeping inflation on target. © 2025 Pearson Canada  Monetary Policy Transmission Quick Overview When the Bank of Canada lowers the overnight rate: 1. The Bank buys securities in an open market operation. 2. Other short-term interest rates and the exchange rate fall. 3. The quantity of money and the supply of loanable funds increase. 4. The long-term real interest rate falls. 5. Consumption expenditure, investment, and net exports increase. © 2025 Pearson Canada  Monetary Policy Transmission 6. Aggregate demand increases. 7. Real GDP growth and the inflation rate increase. When the Bank of Canada raises the overnight rate, the ripple effects go in the opposite direction. © 2025 Pearson Canada Monetary Policy Transmission © 2025 Pearson Canada  Monetary Policy Transmission Interest Rate Changes As soon as the overnight rate target is announced, interest rates change. Figure 14.6 shows the fluctuations in three interest rates since 2000: ▪ Overnight rate ▪ Long-term bond rate ▪ 3-month Treasury bill rate © 2025 Pearson Canada  Monetary Policy Transmission ▪ Short-term rates move closely together and follow the overnight rate. ▪ Long-term rates move in the same direction as the overnight rate but are only loosely connected to the overnight rate. © 2025 Pearson Canada  Monetary Policy Transmission Exchange Rate Fluctuations ❑ The exchange rate responds to changes in the interest rate in Canada relative to the interest rates in other countries—the Canadian interest rate differential. ❑ But other factors are also at work, which makes the exchange rate hard to predict. © 2025 Pearson Canada  Monetary Policy Transmission Money and Bank Loans ❑ When the Bank lowers the overnight rate, the quantity of money and the quantity of bank loans increase. Long-Term Real Interest Rate ❑ Equilibrium in the market for loanable funds determines the long-term real interest rate, which equals the nominal interest rate minus the expected inflation rate. ❑ The long-term real interest rate influences expenditure plans. © 2025 Pearson Canada  Monetary Policy Transmission Expenditure Plans ❑ The ripple effects that follow a change in the overnight rate change three components of aggregate expenditure: ▪ Consumption expenditure ▪ Investment ▪ Net exports ❑ A change in the overnight rate changes aggregate expenditure plans, which in turn changes aggregate demand, real GDP, and the price level. ❑ So the Bank influences the inflation rate and output gap. © 2025 Pearson Canada  Monetary Policy Transmission Bank of Canada Fights Recession ▪ If inflation is low and real GDP is below potential GDP, the Bank acts to restore full employment. ▪ The Bank, using the floor system, lowers the overnight rate target … and increases reserves to hit the new target. © 2025 Pearson Canada  Monetary Policy Transmission ▪ An increase in reserves increases the supply of money. ▪ The short-term interest rate falls, and the quantity of money demanded increases. ▪ The short-term interest rate and the overnight rate change by similar amounts. © 2025 Pearson Canada  Monetary Policy Transmission ▪ The increase in the supply of bank loans increases the supply of loanable funds. ▪ The real interest rate falls and investment increases. © 2025 Pearson Canada  Monetary Policy Transmission ▪ The increase in investment increases aggregate planned expenditure. ▪ Aggregate demand increases. ▪ Eventually, the multiplier effect increases aggregate demand. ▪ Real GDP increases to potential GDP and full employment is restored. © 2025 Pearson Canada  Monetary Policy Transmission Bank of Canada Fights Inflation ▪ If inflation is too high and real GDP exceeds potential GDP, the Bank acts to lower inflation and restore price stability. ▪ The Bank raises the overnight rate target … ▪ and decreases reserves to hit the new target. © 2025 Pearson Canada  Monetary Policy Transmission ▪ The decrease in bank reserves decreases the supply of money. ▪ The short-term interest rate rises, and the quantity of money demanded decreases. ▪ The short-term interest rate and the overnight rate change by similar amounts. © 2025 Pearson Canada  Monetary Policy Transmission ▪ The decrease in the supply of bank loans decreases the supply of loanable funds. ▪ The real interest rate rises and investment decreases. © 2025 Pearson Canada  Monetary Policy Transmission ▪ The decrease in investment decreases aggregate planned expenditure. ▪ Eventually, the multiplier decreases aggregate demand. ▪ Real GDP decreases to potential GDP and the price level falls. © 2025 Pearson Canada