ECO102: Principles of Macroeconomics Lecture 10 PDF

# ECO102: Principles of Macroeconomics ## Lecture 10 - Monetary Policy ### Big Picture - Last lecture: Full Model: IS-MP-PC - This lecture: How can monetary policy affect business cycle fluctuations? - Answer: Monetary policy can help close the output gap - Larger context: Financial markets and m...

# ECO102: Principles of Macroeconomics ## Lecture 10 - Monetary Policy ### Big Picture - Last lecture: Full Model: IS-MP-PC - This lecture: How can monetary policy affect business cycle fluctuations? - Answer: Monetary policy can help close the output gap - Larger context: Financial markets and macroeconomics - Core concepts: Central bank policy rule of thumb, reserves - Key tool: IS-MP-PC-model (MP!) - Recap: Real and nominal rates; loanable funds market ### Lecture 10 – Monetary Policy (Chapter 22) - A. The Bank of Canada 22.1 - B. Central Bank Policy Goals 22.2 - C. Monetary Policy 22.3 - D. Unconventional Monetary Policy 22.4 ### Additional Readings - *(required)* Monetary policy: The right tool for the right job - Monetary policy decision-making: Behind the scenes ### The Bank's Core Functions - Bank of Canada Act (1934): created BoC as central bank - The Bank has four core functions: 1. **Monetary policy:** keep inflation low, stable and predictable. 2. **Financial system:** promote safe, sound and efficient financial systems within Canada and internationally. 3. **Currency:** design, issue and distribute Canada's bank notes. 4. **Funds management:** act as fiscal agent for the Government of Canada, managing its public debt programs and foreign exchange reserves. - In general, central banks set **monetary policy** – the process of setting interest rates to influence economic conditions. ### The Objective of Monetary Policy - The BoC is an **inflation-targeting central bank**: The objective of Canada's monetary policy is to promote the economic and financial well-being of Canadians. Experience has shown that the best way monetary policy can achieve this goal is by maintaining a low and stable inflation environment. - **Recently this objective has been expanded**: The Government and the Bank also agree that monetary policy should continue to *support maximum sustainable employment*. - Joint Statement by Government and BoC on Monetary Policy Framework, 12/13/21 - The Federal Reserve Bank of the U.S. has an explicit “**dual mandate**”: promote maximum employment and stable prices - 1977 amendment to the Federal Reserve Act - **Maximum sustainable employment**: unemployment *(u= unatural)* consistent with economy at potential *(Y = Y)* ### Central Bank Independence - Central Bank owned by the federal government - … but operates largely *independently*! - What happens when governments can interfere with central banks? - Incentive to overheat economy to get short-term boost to economic activity - Problematic due to vicious cycle caused by inflation expectations - ↓ if ⇒↓ r ⇒↑ Ỹ, ↑ π ⇒ ↑ πº ↑↑ π - Two types of independence: 1. **Instrument**: freedom to choose values for monetary tools *(if)* 2. **Objective**: freedom to choose the goals of monetary policy - Federal Reserve (US) and ECB in (Euro) have both types - BoC only has instrument independence ### Lecture 10 – Monetary Policy (Chapter 22) - A. The Bank of Canada 22.1 - B. Central Bank Policy Goals 22.2 - C. Monetary Policy 22.3 - D. Unconventional Monetary Policy 22.4 ### Additional Readings - Monetary policy: The right tool for the right job - Monetary policy decision-making: Behind the scenes ### The Inflation Target - Low and stable inflation promotes economic growth - Preserves value of money - Facilitates easier planning for how, where, and when households and firms spend (predictability) - The **BoC targets a range of 1-3%, with 2% mid-point (since 1995)**. - Primary target of 2% - Flexibility to achieve max. sustainable emp. as long as within 1-3% range - Publicly commits to inflation target → promotes anchored inflation expectations and virtuous cycle (recall Lecture 8) ### The Policy Rate An image of a chart with **policy rate** data from 1999 - 2023. The chart displays a line graph showing a fluctuation of the policy rate across the years. The chart also specifies the following information: - 1 Start of dot-com bubble burst - 2 9/11 Attack - 3 Lehman Brothers collapse - 4 Oil price shock (peak) - 5 Pandemic hits ### Inflation Target – Why Not Target 0%? 1. **Low but stable inflation aids labor market adjustment** - Ex: firms need to lower *real* wages by 1% (instead of job cuts!) - With 2% inflation: increase *nominal* wages by +1% - With 0% inflation: lower *nominal* wages by 1% (workers dislike this!) 2. **Zero lower bound**: *Nominal* rates *(if)* cannot go below zero - When *if* ≈ 0 and π=2%, *r*≈*i*-π=-2%⇒ increase spending - When *if* ≈ 0 and π=0%, *r*≈*i*-π=0%⇒ cannot increase spending as much when needed 3. Aiming for 0% inflation can create **deflation** - πº 0 leads to higher inflation ### The inflation-control target was adopted by the Bank and the Government of Canada in 1991 An image of a chart with data from 1960-01-01 - 2022-01-01. The chart displays a line graph showing the fluctuation of the *inflation rate* vs. the *inflation target*. The chart also emphasizes an arrow pointing towards the time when the inflation target was first adopted in 1991. ### A rule of thumb: "The Taylor Rule" - **Taylor rule**: systematic rule for how central bank sets interest rates: rf + rp = r* + 1/2*(π-πe) + Ỹ - Central bank controls *rf* through *if*. - Assume for now rp = 0. - When economy is in long-run equilibrium, π = πe (inflation at target) and Ỹ = 0% (zero output gap) - ⇒ *rf* = r* (central bank sets policy rate to long-run rate) - A rise in current inflation π above target inflation πe ↑ *rf* - A decline in the output gap ↓Ỹ ### Main tool of the Central Bank: Interest Rates From the policy rate to the real interest rate in IS-MP model 1. Bank of Canada sets nominal interest rate: *if* 2. Subtract inflation: *rf* = *if* - π 3. Add the risk premium: *r* = *rf* + rp *Example:* | Step | Calculation | Result | |---|---|---| | 1. *if* | *if* = | 3.75% | | 2. *rf* | *rf* = *if* - π = 3.75% - 1.5% | 2.25% | | 3. *r* | *r* = *rf* + *rp* (e.g. *rp* =1%) = 2.25% + 1% | 3.25% | ### Question: Taylor rule Suppose there is a shock to aggregate spending which pushes actual output 2% higher than potential. This causes inflation to rise 1.4% above the target rate of 2%. If the natural real interest rate is 3% and the risk premium is 1%, what will the central bank set their policy rate to in response to the shock? Answer in percentage terms, rounded to two decimals. ### Central bank response mitigates shocks When *rf* responds to π and Ỹ, shocks will have less impact - With a positive spending shock from previous example, - Without central bank response: Ỹ = 0.02, (π − πe) = 0.014 - With central bank response: ↑ *rf* → Ỹ, π will fall! - Computing Ỹ, π requires using all curves: IS-MP-PC (ECO202) - We've considered ad-hoc central bank responses previously - Taylor rule suggests automatic response to shocks - Do central banks follow this explicitly? ### Actual policy often deviates from the rule-of-thumb An image of a chart displaying two line graphs. The chart represents the fluctuation of two interest rates across the years: - The *actual policy interest rate* - blue line - The *policy rule of thumb* - red line. The chart suggests that the rule-of-thumb generally does a good job at approximating actual policy actions, but it does not perfectly capture the deviations that central banks often make in practice. - Rule-of-thumb does good job of predicting policy actions - Policy depends on **discretion**: central bank uses expertise and superior info - Explicit inflation target ensures commitment to long-term π - Constrained discretion ### The BoC's Monetary Policy Instruments - **Overnight rate** (*if*): cost of borrowing funds between banks overnight - the cost of borrowing of “reserves” or short-term funds. - **Reserves**: cash on hand maintained by banks - **Bank overnight reserves market**: supply and demand for short-term funds - **Demand**: Banks with low reserves but need to make payments on a given day. - Ex: When you write a cheque to pay your utilities, you expect the Bank A to transfer payment to Toronto Hydro. But what if Bank A lent out too much money that day? - Banks may face short-term fund deficits on a given day due to excess lending. - **Supply**: Banks with spare cash and willing to lend them overnight -Price so that reserves market clear: **effective overnight rate** - Not directly controlled by BoC. So, how does the BoC influence this? ### The Market for Overnight Funds An image depicting two lines that intersect. The image represents the supply and demand curves of overnight funds. - The y-axis represents the *overnight rate* - The x-axis represents the *quantity of overnight funds* The intersection of the supply and demand curve determines the *effective overnight rate*. ### Tool 1: BoC offers to lend and borrow overnight funds - Banks can lend their excess cash to the BoC and earn a *deposit rate*. - Banks that are short on funds can borrow from the BoC at a borrowing rate called the *bank rate*. - **Ceiling = Bank rate** - Lending banks can't charge more, otherwise, borrowing banks will just borrow from BoC! Overnight rate cannot be above this. - **Overnight rate** - **Operating band** - usually ¼ pp - **Floor = Deposit rate** - Financial institutions with extra cash can always deposit to the BoC at this rate. Overnight rate cannot be lower than this. - BoC can always keep overnight rate (*if*) within operating band! ### Policy rate *if* = Target overnight rate! An image of a chart displaying two line graphs showing the fluctuation of the *overnight rate target* and the *overnight rate* across the months. The chart also includes a table listing the following information: - *Bank rate* - *Operating Band/Low = Deposit Rate = Target Rate* - *Operating Band/High* ### How can the BoC track the overnight rate so closely? An image of a chart with data from 1995-2020. The chart displays a line graph showing the fluctuation of the *target policy interest rate* and the *effective overnight rate*. ### Tool 2: Inject or withdraw overnight funds - Deposit and bank rate set floor and ceiling to overnight rate. - How does the BoC hit the exact target? - The BoC holds excess cash from the federal government's account. - E.g. tax receipts (property, GST, income), to pay for government employees - **BoC can use excess cash and participate in the overnight market.** - To raise overnight rate, it can withdraw supply of overnight funds. - To lower overnight rate, it can inject supply of overnight funds. ### The Market for Overnight Funds An image depicting two lines that intersect. The image represents the supply and demand curves of overnight funds. This image highlights the role of the BoC in influencing the overnight rate: - The BoC can either *inject* funds into the market, shifting the supply curve to the right and decreasing the overnight rate. - The BoC can also *withdraw* funds from the market, shifting the supply curve to the left and increasing the overnight rate. - The y-axis represents the *overnight rate* - The x-axis represents the *quantity of overnight funds* The intersection of the supply and demand curve determines the *effective overnight rate*. ### Detour: What is a bond? **Bond**: a legal promise to repay a debt (just an IOU!) - **Face value (principal):** amount originally lent - **Coupon rate:** promised interest rate when bond first issued - **Coupon payment:** coupon rate × principal - **Example:** A newly-issued one-year bond with principal = $100, coupon rate = 5% → After one year, bond holder receives $100 + 0.05 × $100 = $105 ### Detour: Bond price is inversely related to its yield **Yield**: the rate of return on an investment (i.e. interest rate) - Ex: Paying $100 for a bond that pays $105 after one year Yield = (105-100)/100 = 5% **Key feature of bonds: future stream of payments is fixed** - Principal and coupon rate are set when bond is first issued - Paying **more** for a fixed stream of income → lower yield! - Ex: Paying $103 for a bond that pays $105 after one year Yield = (105-103)/103 = 1.94% - Price of bond depends on market: return on comparable bonds - If similar bonds give higher yield, then my bond's price will fall ### Tool 3: Sell/purchase bonds from financial institutions - Alternative way to inject or withdraw funds: **overnight repurchase agreements** a.k.a. “**repos**” - **Repo**: BoC **buys** bonds with cash, cash goes into overnight markets (raises supply of funds), sell back the next day - **Reverse repo**: BoC **sells**** bonds for cash, cash withdrawn from overnight markets (lowers supply of funds), buy back the next day An image depicting the BoC and financial institutions engaging in a **repo** transaction: - The BoC (on the left) is purchasing bonds from the financial institutions using cash. - This injection of cash into the overnight fund market increases the supply of funds and can potentially decrease the overnight rate. - The next day, the BoC will sell the bonds back to the financial institutions. An image depicting the BoC and financial institutions engaging in a **reverse repo** transaction: - The BoC (on the left) is selling bonds to the financial institutions and receiving cash in return. - This withdrawal of cash from the overnight fund market decreases the supply of funds and can potentially increase the overnight rate. - The next day, the BoC will buy the bonds back from the financial institutions. ### The Market for Overnight Funds An image depicting two lines that intersect. The image represents the supply and demand curves of overnight funds. This image depicts the impact of repos and reverse repos on the overnight rate by highlighting the movements of the supply curve: - Conducting **repos** shifts the supply curve to the right (green dashed line), increasing the supply of funds and lowering the overnight rate. - Conducting **reverse repos** shifts the supply curve to the left (red dashed line), decreasing the supply of funds and increasing the overnight rate. - The y-axis represents the *overnight rate* - The x-axis represents the *quantity of overnight funds* The intersection of the supply and demand curve determines the *effective overnight rate*. ### Tool 4: Sell or purchase government bonds “Open market operations” - Older approach - Differences from repos: sale/purchase of bond is permanent - If BoC wants to **raise rates**: - Sell bonds to financial markets - Bank buys bonds with money from its reserves - BoC receives cash - **Lower** supply of reserves - If BoC wants to **lower rates** - Buy bonds from financial markets - BoC pays cash - Bank sells bonds and adds proceeds into reserves - **Higher** supply of reserves An image depicting the BoC and financial institutions engaging in an open market operation: - The BoC (on the left) is either selling or purchasing government bonds from the financial institutions. - If the BoC is **selling**, the supply of reserves decreases, potentially increasing the overnight rate. - If the BoC is **buying**, the supply of reserves increases, potentially decreasing the overnight rate. ### Why does the overnight rate set prevailing borrowing costs? - Ultimately, BoC sets overnight rates. - Question: How do overnight rates affect economy-wide interest rates? - **Cost-benefit principle:** If the bank wants to lend money, it can always do so at the overnight rate (opportunity cost of lending). - So, the bank will *not* lend at a lower rate than the overnight rate. - Affects credit card rates, mortgage rates, etc. ### Lecture 10 – Monetary Policy (Chapter 22) - A. The Bank of Canada 22.1 - B. Central Bank Policy Goals 22.2 - C. Monetary Policy 22.3 - D. Unconventional Monetary Policy 22.4 ### Additional Readings - Monetary policy: The right tool for the right job - Monetary policy decision-making: Behind the scenes ### Unconventional Monetary Policy Zero lower bound - Primary tool: overnight rate - But during a deep recession, the BoC may already set the overnight rate to **zero**. - At that point, the central bank has hit the “**zero lower bound (ZLB)**”. - Ex. 2008 Great Financial Crisis, 2020 Covid-19 Recession - Cannot have negative interest rates! - What other tools does BoC have? ### Aside: Negative Interest Rates? - In very rare occasions, central banks have lowered policy rates to negative territory (ECB, Bank of Japan). - Idea: stimulate economy further by making it costly to “hold reserves”. - Will banks or large financial institutions just hold on to cash then? - Large financial institutions may still lend money (even with negative rates due to cost of holding cash!) - Will this mean negative rate loans for consumers? - Not really. Banks still charge fees and there’s a risk-premium. ### Forward Guidance - Give info to markets about future short-term rates. - Suppose BoC wants to stimulate economy but is at the ZLB. - It can promise low rates to continue into the future. - Pushes down long-term interest rates on long-term loans such as mortgages, auto loans, business loans - Effect: households buy cars, houses, businesses invest → stimulate economy even at ZLB! ### Quantitative easing (QE) - Similar to open market operations - BUT instead of buying short-term government bonds, BoC engages in large-scale purchases long-term bonds (long maturity) or assets. - How does it work? - Suppose Person X owns a 30-year government bond. - BoC purchases bond from Person X. - This frees up Person’s X’s cash to lend to other long-term borrowers. - Increases supply of long-term funds → Lower long-term interest rates → More borrowing and spending ### Lender of Last Resort - BoC can also prevent financial crises by lending money to failing banks who do not have enough cash to service their obligations. - Example: Bank X is struggling to pay its depositors who want to withdraw cash. - Bank X is unstable so no one else wants to lend it money. - Can cause a bank run! - BoC steps in and lends money to cover deficit (a “bail out”)! ### Next week - This week: Monetary Policy - Next week: Fiscal Policy