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Understanding Economics6th edition
by Mark Lovewell
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UnderstandingEconomics
Chapter 13
Monetary PolicyCopyright © 2012 by McGraw-Hill Ryerson Limited !ll rights reser"ed
#th editionby Mar$ Lo"ewell
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Learning %b&ecti"es!'ter this chapter yo( will be able to)
1 disc(ss the *an$ o' Canada and its '(nctions
2 e+plain the tools the *an$ o' Canada (ses tocond(ct monetary policy
3 identi'y the tradeo, between ination and(nemployment
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.he *an$ o' Canada /a .he *an$ o' Canada per'orms 'o(r basic
'(nctions)t manages the money s(pply
t acts as the ban$ers ban$) holding deposits o' members o' the Canadian
ayments !ssociation
ma$ing ad"ances to C! members at the ban$ rate
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.he *an$ o' Canada /bt acts as the 'ederal go"ernments 4scal agent) holding some o' the go"ernments ban$ deposits
clearing the go"ernments che5(es
handling the 4nancing o' the go"ernments debt byiss(ing bonds /incl(ding Canada 6a"ings *onds andtreas(ry bills
t helps s(per"ise the operations o' 4nancial
mar$ets to ens(re their stability .he *an$ wor$s in con&(nction with the %7ce o' the
6(perintendent o' 8inancial nstit(tions9 and 'ollows theglobal g(idelines o' the *asel Committee on *an$ing6(per"ision
.he s(ccess o' Canadas 4nancial s(per"ision hasrecei"ed considerable attention since the 200: creditCopyright © 2012 by McGraw-Hill RyersonLimited. ll rights reser!ed.
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.he *an$ o' Canada /cCanadian 4nancial instit(tions were less
a,ected by the meltdown than mostind(striali;ed co(ntriesCanadian 4nancial reg(lators had banned high-
ris$ mortgage lending9 while Canadian 4nancialinstit(tions were less acti"e than many o' theirglobal co(nterparts in trading ris$y deri"ati"es
Canadas large ban$s had lower le"erage ratiosthan many o' their global co(nterparts
.he Canadian property mar$et had nots(cc(mbed to the same b(bble conditions as in
some other co(ntriesCopyright © 2012 by McGraw-Hill RyersonLimited. ll rights reser!ed.
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#
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"he Money Mar#et
$%antity o& Money'( billions)
* o m i n a l + n t e r e s t R a t e ' , )
0 0 0 /0 0
1
2
/
"he conomy
Real G3'2002 ( billions)
3 r i c e L e ! e l ' G 3 d e & l a t o r 4
2 0 0 2 5 1 0 0 )
0 670 67/ 800 80/
10
10
120
110
100
a
b
c
d
e
Sm0
Sm1
Dm
AD0
AD1
AS
3otential9%tp%t
+nitial Recessionary Gap
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Contractionary Monetary olicy /a
Contractionary monetary policy is)a policy o' decreasing the money s(pply and
raising interest rates9 which shi'ts != le'twardby a magni4ed amo(nt d(e to an initialdecrease in in"estment and the cons(mption o'd(rable goods
(sed to eradicate an inationary gap
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Contractionary Monetaryolicy /b8ig(re 1329 page 3>?
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"he Money Mar#et
$%antity o& Money'( billions)
* o m i n a l + n t e r e s
t R a t e ' , )
0 0 0 /0 0
1
2
/
Dm
Sm1 Sm0
a
b AD1
AS
AD0
c
d
e
3otential9%tp%t
"he conomy
Real G3'2002 ( billions)
3 r i c e L e ! e l ' G 3 d e & l a
t o r 4
2 0 0 2 5 1 0 0 )
0 670 67/ 800 80/
10
10
120
110
100
1/0
+nitial +n&lationary Gap
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%pen Mar$et %perations%pen mar$et operations are a tool the *an$ o'
Canada (ses to cond(ct monetary policy! sale o' bonds lowers a C! members deposit
liabilities and reser"es9 which ca(ses amagni4ed decrease in the money s(pply (singthe money m(ltiplier! p(rchase o' bonds raises a C! members
deposit liabilities and reser"es9 which ca(ses amagni4ed increase in the money s(pply (singthe money m(ltiplier
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! *ond 6ale8ig(re 1339 age 3>@
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*an$ o' Canada
!ssets Liabilities
Cartier *an$s =eposit -A1000*onds -A1000
Cartier *an$
!ssets Liabilities
*ondholder !s =eposit -A1000Reser"es at *an$ o' Canada -A1000
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! *ond (rchase8ig(re 13B9 age 3#0
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Cartier *an$s =eposit A1000*onds A1000
*ondholder !s =eposit A1000Reser"es at *an$ o' Canada A1000
*an$ o' Canada
!ssets Liabilities
Cartier *an$
!ssets Liabilities
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Changes in the .arget %"ernight
Rate /a Changing the target o"ernight rate is a tool
the *an$ o' Canada (ses to signi'y itsmonetary policy intentionsDhen the *an$ o' Canada changes its target
band 'or the o"ernight rate it also a(tomaticallyad&(sts the ban$ rate since this rate is at thetop end o' the target band
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Changes in the .arget %"ernight
Rate /b! rise in the target o"ernight rate signi4es a
contractionary policy in the near '(t(rewhile a 'all in the target o"ernight ratesigni4es an e+pansionary policy
' the change in the target o"ernight rate iss(bstantial9 then deposit-ta$ers also ad&(sttheir prime rate9 which is the lowestpossible rate charged on loans to deposit-ta$ers best corporate c(stomers
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.he *ene4ts and =rawbac$s o'
Monetary olicyMonetary policy has two main bene4ts)t is separated 'rom day-to-day politics
=ecisions regarding monetary policy can be made5(ic$ly
Monetary policy has two main drawbac$s)t is less e,ecti"e as an e+pansionary tool than as
a contractionary tool
t cannot be 'oc(sed on partic(lar regions
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.ypes o' nation .here are two main types o' ination)=emand-p(ll ination occ(rs as rightward shi'ts
in the != c(r"e p(ll (p prices
Cost-p(sh ination occ(rs as le'tward shi'ts inthe !6 c(r"e p(sh (p prices
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=emand-(ll nation8ig(re 13>9 age 3#3
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3 r i c e
L e ! e l ' G 3 d
e & l a t o r 4
2 0 0 2 5 1 0 0 )
Real G3 '2002 ( billions)
6/0 6600
10
1/0
AD0
AD1
AS
b
a
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.he hillips C(r"e /a .he hillips c(r"e is a graph showing the
ass(med in"erse relationship between(nemployment and ination8rom 1@#0 to 1@?2 the Canadian hillips c(r"e
was relati"ely stable
8rom 1@?3 to 1@:2 the Canadian hillips c(r"eshi'ted rightward res(lting in stagation
8rom 1@:3 to 2010 stagation was re"ersed b(tno constant hillips c(r"e emerged
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.he hillips C(r"e8ig(re 13#9 age 3#3
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:nemployment Rate ',)
+ n & l a t i o n R a t e
' , )
0 2 8 10
2
8
10
b
c
a
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Cost-(sh nation8ig(re 13:9 age 3#>
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Real G3 '2002 ( billions)
3 r i c
e L e ! e l ' G 3 d e & l a t o r 4
2 0 0 2 5 1 0 0 )
6/0 660
10
0
1/0
AD
AS0
AS1
c
d
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.he 6el'-6tabili;ing
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.he 6el'-6tabili;ing
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Money Matters /aMilton 8riedman was a leading s(pporter o'
monetarism9 which stresses the in(ence o'money in the economyCentral to monetarism is the "elocity o' money
/E9 which is the n(mber o' times money is spenton 4nal goods and ser"ices d(ring a gi"en year
E is 'o(nd by di"iding nominal G= by the money
s(pply /M
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Money Matters /b .hese calc(lations lead to the e5(ation o'
e+change9 M + E F + 9 where is the pricele"el and is the le"el o' real o(tp(t
!ccording to the 5(antity theory o' money9accepted by monetarists9 both E and arerelati"ely stable9 which means thatad&(stments in are d(e to changes in M
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Money Matters /c*ased on 8riedmans theories9 monetarists
consider "ariations in the money s(pply to bethe most signi4cant 'actor in the economy9
with changes in M translating immediatelyinto changes in nominal G= and the pricele"el
!ccording to monetarists9 central ban$ssho(ld not (se discretionary policy9 b(t adopta set monetary r(le instead
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! Crisis .oo 8ar /%LC
.he 200: Meltdown .he credit meltdown o' 200: was the most
serio(s 4nancial crisis since the 1@2@ crash n6eptember) .wo 6 p(blic-sponsored mortgage pro"iders
8reddie Mac and 8annie Mae were nationali;ed
Lehman *rothers 'aced ban$r(ptcy9 and the 6go"ernment too$ o"er mega-ins(rer !G
n %ctober9 stoc$ mar$ets t(mbled worldwide9and the ban$ing systems in se"eral co(ntrieswere on the "erge o' collapse
Go"ernments responded with emergencymeas(res
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.he Meltdowns Ca(ses
/a! spec(lati"e b(bble in real estate began in
many co(ntries in the 1@@0s9 dri"en by ane+tended period o' low interest ratesn the 69 the b(bble was worsened d(e to the
a"ailability o' s(bprime mortgages geared toborrowers with wea$ credit ratings9 partlythan$s to the bac$ing o' 8reddie Mac and
8annie Mae
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.he Meltdowns Ca(ses
/bCollaterali;ed debt obligations /C=%s are
collections o' a certain class o' sec(rity sold inpac$ages %riginally meant to help manage
ris$9 they began to be (sed in spec(lati"e waysI eg the pac$aging o' C=%s based onmortgages9 especially o' the s(bprime "ariety
Credit de'a(lt swaps /C=6s gi"e holders a
g(arantee that the s(pplier will pay the '(ll"al(e o' the swaps (nderlying 4nancial sec(rityi' the (nderlying sec(rity de'a(lts
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.he Meltdowns Ca(ses
/cn the early 2000s9 C=6s began to be (sed as a
'orm o' ins(rance on 4nancial sec(rities9 withthe 4rms iss(ing them liable to ma$e h(ge
payments in the case o' e+tensi"e de'a(lts onthe (nderlying sec(rities
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! Crisis .oo 8ar /%LC
.he Meltdowns mpact%nce the credit meltdown hit9 4rms and
go"ernment agencies with large holdings o'C=%s9 as well as iss(ers o' C=6s9 'acedcrippling losses
.he res(lt has been a new consens(s that
comple+ 4nancial instr(ments re5(ires newmethods o' 4nancial reg(lation
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Understanding Economics
Chapter 13The End
Copyright © 2012 by McGraw-Hill Ryerson Limited !ll rights reser"ed
#th editionby Mar$ Lo"ewell