Ch28new Monetary Policy in Canada PDF

Chapter 28 Monetary Policy in Canada Objectives: 1. How the Bank of Canada Implements Monetary Policy explain why the Bank of Canada chooses to directly target interest rates rather than the money supply. define the O/N rate and explain how the bank achieves its target. 2. Inflation...

Chapter 28 Monetary Policy in Canada Objectives: 1. How the Bank of Canada Implements Monetary Policy explain why the Bank of Canada chooses to directly target interest rates rather than the money supply. define the O/N rate and explain how the bank achieves its target. 2. Inflation Targeting understand why many central banks have adopted formal inflation targets. explain how the Bank of Canada's policy of inflation targeting helps to stabilize the economy. 3. Long and Variable Lags describe why monetary policy affects real GDP and the price level only after time lags. 28a Interest Rate Targets vs. Money Supply Targets For any given MD curve, any central bank must choose between: targeting the money supply, MS targeting the interest rate Source: Ragan’s Macroeconomics Target the Interest Rate or the Money Supply Both? It is impossible to target both independently © Gray Giovannetti 2020 This content is protected and may not be shared, uploaded, or distributed Why target interest rates? 1. Central bank has more direct influence on rates vs. MS 2. Instability of money demand, MD See end-of-chapter Exercise 6b Source: Ragan’s Macroeconomics 3. Easier to communicate its policy through Δi § éi communicates … © Gray Giovannetti 2020 This content is protected and may not be shared, uploaded, or distributed Targeting Money Supply Approach Open Market Operations When a central bank enters the open market and buys or sells government securities Example: An OMO sale of bonds This is a variation on Exercise 4, p.699 Suppose the Bank of Canada sells a $100,000 government bond to an investment dealer. The dealer pays with a cheque drawn on its account at Bank XYZ, a commercial bank. The target reserve ratio for all commercial banks is 25%. All commercial banks operate with no excess reserves. There is no cash drain. What is the maximum change in deposits? Commercial Banks Bank of Canada Assets Liabilities Assets Liabilities Reserves Deposits Bonds Currency Bonds This will cause the interest rate to increase - the interest rate is endogenous © Gray Giovannetti 2020 This content is protected and may not be shared, uploaded, or distributed Targeting Interest Rate Approach Expansionary monetary policy Contractionary monetary policy ↓i leads to an expansion of AD ↑i leads to a contraction of AD Example: End-of-chapter exercise 6c Suppose ↑i. Show this causes the MS to decrease. Conclusion: The MS is endogenous © Gray Giovannetti 2020 This content is protected and may not be shared, uploaded, or distributed 28b The B of C Controls the Overnight Interest Rate The overnight interest rate {in US called the “Federal Funds Rate”} Rate the banks charge one another for overnight loans This is a market for reserves B of C sets a target, currently iON = _____ % – Banks needing reserves can also borrow from the B of C at the bank rate = iON + 0.25% – Banks with excess reserves can also lend them to the B of C at the rate = iON - 0.25% è So B of C keeps actual overnight rate within 0.5% band Suppose the Bank of Canada's announced target for the overnight interest rate is 1.00%. Why should we expect commercial banks to borrow and lend overnight funds at a rate very close to this target? (See Fig.28-2) Source: Ragan’s Macroeconomics © Gray Giovannetti 2020 This content is protected and may not be shared, uploaded, or distributed 28c Monetary Policy Implementation Our text has been showing a single interest rate. In reality firms and consumer borrow are different interest rates reflecting: Risk The length of the loan (i.e. “term to maturity”) When the Bank of Canada changes its target for the overnight rate, the change in the actual overnight rate happens almost instantly. Changes in other market interest rates also happen very quickly, usually within a day or two. As these rates adjust, firms and households begin to adjust their borrowing behaviour. Revised monetary transmission mechanism (for interest targeting): Source: Ragan’s Macroeconomics © Gray Giovannetti 2020 This content is protected and may not be shared, uploaded, or distributed