Monetary Policy A process by which the government
affects the economy by influencing the expansion of money and credit
Central Banks A public authority charged with
regulating and controlling a country’s monetary and financial institutions and markets
Two Models: Independence: complete autonomy to
determine nation’s monetary policy Subservience: in the event of a
difference of opinion, the Government has the final say
The Bank of CanadaCanada’s “Biggie” Bank
Canada’s central bank, in operation since 1935 During great
depression Aimed to add
stability to system and prevent a run on chartered banks
The Bank of CanadaCanada’s “Biggie” Bank
Originally the bank was expected to: Regulate credit and
currency Control external
value of the Canadian Currency
Reduce fluctuations in production, trade, prices and inflation
Structure of the BofC The Governor (Mark
Carney – 7 year term)
Board of Directors (meet once a month)
Senior Staff (economists and central bankers with considerable national and international experience)
Please let the
economy recover
Key roles of BofC To control the amount of money
circulating in the economy Deciding and implementing
monetary policy Issuing paper currency affecting the activities of chartered
banks to adjust the interest rate and the supply of money
Inflation Inflation Premium
Interest rates take into account inflation Therefore interest rates have an inflation
premium built in
Interest rates Two components
Nominal Rate of interest Premium for risk of non repayment Premium for delayed consumptions
Inflation Premium Expected rate of inflation
Real Rate of interest Nominal – Inflation Premium
Inflation and interest rates A dollar tomorrow is worth less than
dollar today Ex you borrow $1000 (interest free) Inflation is 4% per annum You repay $1000 in a year In terms of purchasing power you have
paid back $960 = ($1000 – ($1000 x 4%) Inflation hurts lenders (why?)
Interest rates Inflation premium is key component
of any interest rate An interest rate should be at least
be equal to the rate of inflation to protect the purchasing power of the money
Interest rates How do interest rates affect
purchases? What type of purchases should you
finance with debt? What effect do interest rates have
on the dollar? How do interest rates effect
government spending?
Interest rates How do they affect demand? When rates rise major purchases
become more expensive When rates rise investments
become less attractive Rate of Return = 7% Interest Rate = 3% Rate of Return = 7% Interest Rate = 7%
When rates rise governments (tax payers) pay more for borrowed money
Interest rates How do they affect supply for money? When rates increase savings rates
increases increases amount available for banks to
loan Decreases amount in circulation (spend
less) When rates increase banks want to
lend more
Types of interest rate Prime rate: Rate offered by
commercial banks to their best customers (?) Prime plus “x”
Bank rate: Rate charged by bank of Canada to chartered banks
Overnight Rate: The main tool used by the BofC. Key way of indicating monetary policy
Overnight Rate Overnight rate
Tool of monetary policy The rate that large financial institutions borrow money
from each other Operating band – difference between Bank of Canada’s
loan rate (bank rate) 4% and their interest rate 3.5% Therefore the overnight rate is somewhere between 3.5% and 4%
Overnight rate is less than the bank rate so it encourages banks to lend to one another rather than from the BOC.
What happens if the Bank of Canada increases the bank rate?
Decrease in Overnight Rate1. Dollar goes down and Interest Rates
Drop
2. Increase in demand
3. Increase prices
4. Rate of inflation increased
STIMULATES THE ECONOMY
Increase in Overnight Rate1. Dollar goes up and Interest Rates
go up
2. Decrease in demand
3. Decrease prices
4. Rate of inflation decrease
SLOWS THE ECONOMY
Monetary Policy Easy Money: Increase the money
supply (expansionary) Tight Money: Restricts the money
supply (contractionary)
Tight Money Used when economic times are good
Sales are up Employment is up Investment is up
Commercial banks are willing to lend money
Too much money in the economy will cause inflation
Limiting the money supply will slow the economy down
Easy Money Used when economic times are bad
Sales are down Employment is down Investment is down
Commercial banks are scared to lend money
Too little money in the economy will cause deflation
Increasing the money supply will jump start the economy
Easy Money Policy 4 stages
Stage 1: Bank shifts money to the chartered banks
to increase reserves and encourage lending
Stage 2: Lower interest rates to encourage more
borrowing for large purchases (homes, car, education, business, etc.). Business then responds by investing and borrowing more.
Easy Money Policy Stage 3:
Increased borrowing = increased money supply resulting in increased output (GDP)
Stage 4: This increases aggregate demand and GDP
leading to full employment
Tight Money Policy 4 stages
Stage 1: Banks takes it’s deposits from chartered banks
back to the BOC This means less money for banks to lend This leads to decreased money supply resulting
in increased interest rates
Stage 2: Higher interest rates =less borrowing Business responds by cutting back (stock,
equipment, expansion)
Stage 3: Less borrowing = less money supply
Stage 4: Decreased spending by consumers and
businesses shifts AD to the left This results in decreased prices (deflation)
Hardship Caused by Inflation Pressure Sadness Not enough Fear Divorce Marriages of convenience Bankruptcy Lay offs Welfare Raise Taxes Resentful Affected everyone
Mark Carney and the 3 bears
I want the Economy …Not too Hot (Inflation)
Not too cold (Unemployment)Just Right! (Full Employment)
I hate Bear markets!
Aggregate Demand and Aggregate Supply Graph AD AS curve shows the Total amount
of supply and demand for economy
Pric
e le
vel
Real GDP (Output)
AS
AD
Aggregate Demand and Aggregate Supply Graph The AS curve goes vertical because
there is a limit (CP) to production
Pric
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vel
Real GDP (Output)
AS
AD
Aggregate Demand and Aggregate Supply Graph FE: Full employment. In Canada
approx 6-7% unemployment. 1-3% Inflation.
Pric
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vel
Real GDP (Output)
AS
AD
FE
Aggregate Demand and Aggregate Supply Graph If AD < FE then there is a recession.
Low inflation/deflation. High Unemployment
Pric
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Real GDP (Output)
AS
FE
AD
Aggregate Demand and Aggregate Supply Graph If AD > FE then there is a boom.
High inflation. Low unemployment
Pric
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Real GDP (Output)
AS
FE
AD
Monetary Policy (Easy Money) P277
1. Bank shifts government deposits to chartered banks. Increasing their reserves. Banks able to lend more.
2. Lower interest rates. Encourages borrowing. 1. Consumers spend on big ticket items goods
2. Businesses spend on capital goods (equipment)
3. Borrowing and spending by increases money supply. Which triggers more borrowing and spending
Monetary Policy (Easy Money)4. Increased spending shifts AD1 to
AD2 thus reaching FE
Pric
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Real GDP (Output)
AS
AD2
FE
AD1
Monetary Policy (Tight Money) P277
1. Bank shifts government deposits from chartered banks. Decreasing their reserves. Banks lend less.
2. Increase interest rates. Discourage borrowing.
1. Consumers delay on big ticket items goods
2. Businesses delay on capital goods (equipment)
3. Less borrowing and spending decreases money supply. Which triggers less borrowing and spending
Monetary Policy (Easy Money)4. Decrease spending shifts AD1 to
AD2 thus ending high inflation
Pric
e le
vel
Real GDP (Output)
AS
AD2
FE
AD1
P268 question 1-61. The bank of Canada insists on the right
to issue currency in order to meet its function of controlling inflation
2. Accounts at the Bank of Canada1. Chartered Banks: Settle debts among
themselves. Location for short term loans2. Federal Government:
1. Allows monetary policy2. Deposit the proceeds of bond payments3. Paying interest on bonds4. Holding foreign reserves
P268 question 1-63. The BofC provides confidence to the
financial system. In the case of a run on the bank the central bank could “bail out” a bank
4. Spending and Creating money are kept separate in order to resist the temptation to print money to pay for spending
P268 question 1-65. The Minister of finance is
accountable to the voters and the PMO. The Governor of the BofC is accountable to the Minister
6. A directive would show a lack of confidence in the BofC.
P273 4 Real = Nominal - Expected A) Nominal interest rate: 7% B) Real interest rate : 4% C) Real interest rate: 3%
P273 5 Because they want to ensure that
the funds when paid back have at least the same purchasing power as when they were loaned
P276 1, 2 31. The main tool to control inflation is
interest rates. Price stability is key to healthy long term growth
2. Operating Band: Difference between the bank rate (what banks pay BofC) and the rate that BofC pays on deposits. Overnight rate sits in the middle
3. Bonds = assets / Deposits of the Chartered Bank = Liabilities