1 of 33 Chapter 29 Monetary Policy in

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2 of 33 In this chapter you will learn 1. why the Bank of Canada chooses to set interest rates rather than directly influence the money supply. 2. how changes in the Bank of Canada’s target for the overnight interest rate affect longer-term interest rates. 3. why many central banks have adopted formal inflation targets. 11/23/10 Copyright © 2008 Pearson Education Canada

3 of 33 In this chapter you will learn 4. how the Bank of Canada’s policy of inflation targeting helps to stabilize the economy. 5. why monetary policy affects real GDP and the price level only after long time lags. 6. about the main economic challenges that the Bank of Canada has faced over the past three decades. 11/23/10 Copyright © 2008 Pearson Education Canada

4 of 33 29. 1 HOW THE BANK OF CANADA IMPLEMENTS MONETARY POLICY Money Supply Versus the Interest Rate For any given money demand curve, any central bank must choose between: - setting the money supply - setting the interest rate Both cannot be set independently. 11/23/10 Copyright © 2008 Pearson Education Canada

6 of 33 How could the Bank of Canada actually try to increase the MS? 1. Simply lend reserves to commercial banks 2. Open Market Operations 1. B of C buys G of C bonds in the open market 2. B of C pays for the bonds by writing a cheque cashable at the B of C 3. Seller of G of C bonds deposits the cheque in her commercial bank account 4. Her commercial bank deposits the cheque at the B of C – commercial bank reserves have just increased How to decrease the MS? Do the reverse 11/23/10 MFC 2007, MFC 2007 MFC 2007 Copyright © 2008 Pearson Education Canada

7 of 33 Actually, the Bank of Canada chooses to implement its monetary policy by setting interest rates because: 1. the Bank can influence an interest rate more easily than it can affect the money supply. 2. the instability of money demand. 3. it is easier to communicate its policy through changes in interest rates. Trying to control the money supply turns out to be too imprecise in practice. But which interest rate (of many) does the Bank influence? 11/23/10 MFC 2007, MFC 2007 MFC 2007 Copyright © 2008 Pearson Education Canada

8 of 33 The Bank of Canada and the Overnight Interest Rate The Overnight Interest Rate Commercial banks borrow and lend reserves to each other overnight. The Overnight Interest Rate is the interest rate in this overnight market. You can think of this rate as the cost of reserves to commercial banks. 11/23/10 MFC 2007, MFC 2007 MFC 2007 Copyright © 2008 Pearson Education Canada

9 of 33 The Bank of Canada can more-or-less control the overnight interest rate. It does this by: 1. Setting a target for the overnight interest rate 2. Establishing the Bank Rate 0. 25% above this target B of C will lend any amount of reserves at this rate 3. Establishing a borrowing rate 0. 25% below target B of C will borrow any amount of reserves at this rate keep actual overnight rate within 0. 5% band 11/23/10 Copyright © 2008 Pearson Education Canada

10 of 33 Overnight Rate Setting the Overnight Rate B of C will lend any amount of reserves at the Bank Rate, so the Overnight Rate should never go above the Bank Rate excess supply RS Bank Rate Target rate • TR-0. 25% excess demand RD B of C will borrow any amount of reserves at the Target Rate less 0. 25%, so the Overnight Rate should never go below the Bank Rate B of C covers any excess supply of or excess demand for reserves. Can it really do this? Yes. Quantity of Reserves 11/23/10 MFC 2007, MFC 2007 MFC 2007 Copyright © 2008 Pearson Education Canada

12 of 33 The Money Supply Is Endogenous As the Bank of Canada changes its target for the overnight rate: - other interest rates change (very quickly) - bank lending changes (more slowly) - banks’ demand for currency changes (as lending changes) the Bank of Canada responds by supplying currency or buying currency from commercial banks the need for open-market operations 11/23/10 Copyright © 2008 Pearson Education Canada

13 of 33 But these transactions are done passively by the Bank of Canada: the money supply is endogenous APPLYING ECONOMIC CONCEPTS 29 -1 What Determines the Amount of Currency in Circulation? 11/23/10 Copyright © 2008 Pearson Education Canada

14 of 33 Expansionary and Contractionary Monetary Policies An expansionary monetary policy occurs when the Bank of Canada reduces its target for the overnight interest rate eventually increases MS (or its growth rate) A contractionary monetary policy occurs when the Bank of Canada increases its target for the overnight interest rate eventually decreases MS (or its growth rate) 11/23/10 MFC 2007, MFC 2007 MFC 2007 Copyright © 2008 Pearson Education Canada

15 of 33 29. 2 INFLATION TARGETING Why Target Inflation? Over the past few decades, central banks have come to realize two things: 1. High inflation is costly for individuals and damaging for economies. - affects those on incomes fixed in nominal terms - high inflation is associated with volatility in inflation (unexpected inflation) results in real income reallocation – borrowers/lenders, workers/firms, etc. - distorts our ability to perceive relative price changes 11/23/10 MFC 2007, MFC 2007 MFC 2007 Copyright © 2008 Pearson Education Canada

16 of 33 Why Target Inflation? Over the past few decades, central banks have come to realize two things: 2. Inflation is the one variable on which monetary policy can have a systematic and sustained influence. exogenous AD and AS shocks can cause isolated periods of inflation but only accommodating monetary policy can cause sustained inflations. 11/23/10 MFC 2007, MFC 2007 MFC 2007 Copyright © 2008 Pearson Education Canada

Price Level 17 of 33 P 1 P 0 AS 0 • • E 0 E 1 AD 1 Monetary policy can have short-run real effects and is useful in helping end recessions. AD 0 Y* Real GDP 11/23/10 MFC 2007, MFC 2007 MFC 2007 Copyright © 2008 Pearson Education Canada

Price Level 18 of 33 AS 0 • E 0 P 1 • Monetary policy can have short-run real effects and is useful in helping end inflationary booms but it cannot directly affect Y* E 1 AD 0 Y* Y 0 Real GDP How does the B of C know that a positive or negative output gap exists? It monitors the rate of inflation Why not output or employment/unemployment? 11/23/10 MFC 2007, MFC 2007 MFC 2007 Copyright © 2008 Pearson Education Canada

19 of 33 Recognition of these points has led many central banks to adopt formal inflation targets: - New Zealand (1990) - Canada (1991) - Israel, U. K. , Australia - Finland, Spain, Sweden - plus many others Canada has renewed its inflation targets several times since 1991: - the current target of 1% lasts until December 2011 11/23/10 Copyright © 2008 Pearson Education Canada

20 of 33 The Role of the Output Gap In the short run, when an output gap opens, the Bank has two choices: - allow the adjustment process to operate - intervene with monetary policy Since output gaps put pressure on inflation, the Bank monitors the output gap and may intervene in order to keep output near potential - thereby keeping inflation within the target band 11/23/10 Copyright © 2008 Pearson Education Canada

21 of 33 Inflation Rate Output Gap Positive shock opens gap 11/23/10 Bank’s policy closes gap Time 0 Bank’s policy closes gap Negative shock opens gap 3% Inflation target band 2% 1% t 0 t 1 t 2 t 3 Copyright © 2008 Pearson Education Canada Time

22 of 33 Inflation Targeting as a Stabilizing Policy As the previous diagram suggests, inflation targeting tends to stabilize output: - in response to a positive output shock, the Bank tightens policy - in response to a negative output shock, the Bank loosens policy tends to keep output close to Y* But this is not automatic stabilization — the Bank must actively change policy. 11/23/10 Copyright © 2008 Pearson Education Canada

23 of 33 Complications in Inflation Targeting Inflation targeting is complicated by two factors: 1. Volatile Food and Energy Prices - prices of many goods included in CPI are determined in world markets - these may change suddenly for reasons unrelated to Canadian output gaps the Bank also monitors core inflation 11/23/10 Copyright © 2008 Pearson Education Canada

25 of 33 2. The Exchange Rate and Monetary Policy - the Bank must identify the cause of any exchange rate change before determining the appropriate policy response - consider an appreciation of the Canadian dollar caused by an increase in demand for exports (contractionary monetary policy) - or an appreciation of the Canadian dollar caused by an increase in demand for Canadian bonds (expansionary monetary policy) 11/23/10 Copyright © 2008 Pearson Education Canada

26 of 33 The appropriate response by the Bank would be different in these two cases. For a more detailed discussion of how movements in the exchange rate complicate the implementation of monetary policy, look for “Monetary Policy and the Exchange Rate in Canada” in the Additional Topics section of this book’s My. Econ. Lab. www. myeconlab. com 11/23/10 Copyright © 2008 Pearson Education Canada

27 of 33 Not in Text 3. Asset price bubbles What if the money supply is increased and interest rates fall but the lower interest rates and increased credit do not lead to an increase in the demand for current output? What if the lower interest rates and increased credit lead for an increase in the demand for existing assets (houses, real estate, ‘dot com’ stocks, equities, gold, etc). If the central bank is targeting inflation it will largely miss this asset price inflation – it could easily start a price bubble for a class of assets. People buying the asset whose price is rising with borrowed money (speculating) – the price bubble burst, the asset price falls and they default on their borrowings. (money is credit) The banking system is in now trouble. Sound familiar? 11/23/10 MFC 2007, MFC 2007 MFC 2007 Copyright © 2008 Pearson Education Canada

28 of 33 29. 3 LONG AND VARIABLE LAGS What Are the Lags in Monetary Policy? Monetary policy operates with a time lag that is long and variable for two main reasons: • changes in expenditure take time • the multiplier process takes time 11/23/10 Copyright © 2008 Pearson Education Canada

30 of 33 Destabilizing Policy? Long and variable lags some monetarists argued that central banks should not try to stabilize national income. They argued that attempts to stabilize will more likely be destabilizing - they advocate the use of a monetary rule - increase bank reserves at a constant rate Most economists now agree that monetary policy can lead to more economic stability. ? ? 11/23/10 MFC 2007, MFC 2007 MFC 2007 Copyright © 2008 Pearson Education Canada

31 of 33 Rate of Inflation Political Difficulties 3% Actual Inflation 1% Bank of Canada’s target inflation band A • Inflation Forecast Current Period Time Monetary policy must be forward-looking. often creates difficulties when policy is tightened now because of expected future inflation 11/23/10 Copyright © 2008 Pearson Education Canada

32 of 33 29. 4 30 YEARS OF CANADIAN OPTIONAL MONETARY POLICY Early 1980 s: - inflation reached 12 percent as a result of OPEC oil shocks in the mid and late 1970 s - the Bank embarked on a strict policy of monetary restraint - but unanticipated surge in money demand led to a much tighter monetary policy than intended the most serious recession since the 1930 s 11/23/10 Copyright © 2008 Pearson Education Canada

34 of 33 Economic Recovery: 1983 -1987 OPTIONAL The main challenge was creating sufficient liquidity to accommodate the recovery without triggering a return to the high inflation rates. Rising Inflation: 1987 -1990 Inflation crept upwards throughout the late 1980 s. Many economists argued the need for tightening monetary policy. 11/23/10 Copyright © 2008 Pearson Education Canada

35 of 33 Disinflation: 1990 -1992 OPTIONAL The Bank of Canada embarked on its stated policy of “price stability. ” When the tight monetary policy took effect: - interest rates increased - the Canadian dollar appreciated - inflation fell suddenly The economy entered a significant recession in the early 1990 s. 11/23/10 Copyright © 2008 Pearson Education Canada

36 of 33 Inflation Targeting I: 1991 -2000 OPTIONAL The ensuing economic recovery was quite gradual: - excessive stimulation could have led to a return of inflation - insufficient stimulation could have caused the economy to stall Beginning in 1996, the recovery was more robust and inflation remained well within the 1 to 3 percent target band. By 2000, Canadian GDP was near its potential level and inflation was just below 2 percent and quite stable. 11/23/10 Copyright © 2008 Pearson Education Canada

37 of 33 Two issues complicated monetary policy in the late 1990 s: OPTIONAL 1. The Asian Crisis This presented a (confusing) combination of aggregate demand aggregate supply shocks. 2. The Stock Market The “bull market” of the late 1990 s presented some challenges — how should monetary policy respond? 11/23/10 Copyright © 2008 Pearson Education Canada

38 of 33 Inflation Targeting II: 2001 -Present OPTIONAL The terrorist attacks of 9/11 presented substantial challenges for monetary policy: - the U. S. economy was already slowing down - policy interest rates were dramatically reduced The 2002 -2006 period presented other challenges: - commodity prices were rising sharply - U. S. dollar was weakening against most currencies 11/23/10 Copyright © 2008 Pearson Education Canada

39 of 33 OPTIONAL With the success of many central banks in maintaining low and stable inflation, some economists have raised the concern that inflation may now be “too low, ” and that the economy may actually function more smoothly with slightly higher inflation. For more details about this contentious debate, look for “Can Inflation Be Too Low? ” in the Additional Topics section of this book’s My. Econ. Lab. www. myeconlab. com 11/23/10 Copyright © 2008 Pearson Education Canada