Monetary Policy and the Debate about Macro Policy

1. Monetary Policy and the Debate about Macro Policy Chapter 14

2. Introduction • Monetary policy influences the economy through changes in the financial system’s reserves that influence the money supply and credit availability in the economy.

3. Introduction • Monetary policy is one of the two main traditional macroeconomic tools to control the aggregate economy. • While fiscal policy is controlled by the government directly, monetary policy is controlled by the central bank in Canada.

4. Effect of Monetary Policy on the AS/AD Model • Expansionary monetary policy shifts the AD curve to the right. • Contractionary monetary policy shifts the AD curve to the left.

5. Effect of Monetary Policy on the AS/AD Model • The effect of monetary policy on equilibrium income and the price level depends on whether inflationary pressures are set in motion. • That in turn depends on how close the economy is to its potential income.

6. Effect of Monetary Policy on the AS/AD Model • The supply conditions of the economy are central to the effect one believes monetary policy will have on the economy.

7. Effect of Monetary Policy on the AS/AD Model • Its effect on real income depends on how the price level responds. % Real Income = % Nominal Income - % Price Level

8. Effect of Monetary Policy on the AS/AD Model • In Keynesian range, real income will rise with expansionary monetary policy and decline with contractionary monetary policy. • The price level is unaffected.

9. Effect of Monetary Policy on the AS/AD Model • In the Classical range, real income does not change; the effect is on the price level and inflation.

10. Price level SAS P0 AD2 AD0 AD1 Y2 Y0 Y1 Real output Monetary Policy When Prices are Fixed, Fig. 14-1a, p 339 Expansionary monetary policy Contractionary monetary policy

11. LRAS SAS1 Price level SAS0 AD1 AD0 Real output Y0 Expansionary Monetary Policy in the Classical Range, Fig. 14-1b, p 339 B P1 A P0

12. Duties and Structure of the Bank of Canada • A central bank is a type of bankers’ bank. • A central bank conducts monetary policy and acts as financial adviser to the government.

13. Duties and Structure of the Bank of Canada • In some countries the central bank is a part of the government. • In Canada the central bank is not part of the government – it is a Crown corporation, not under direct day-to-day control of the federal government.

14. Structure of the Bank • The head of the Bank of Canada is the Governor of the Bank. • So far the Bank of Canada has had seven governors.

15. Structure of the Bank • Monetary policy is set by the governor with the advice of his senior advisers. • The Bank has a Board of Directors made up of 12 non-specialists in monetary policy.

16. Structure of the Bank • Price stability has often been the goal of monetary policy. • Price stability is interpreted to mean a low and stable rate of inflation.

17. International Considerations • The design and implementation of monetary policy is affected by international considerations. • Exchange rates play a critical role in the process.

18. International Considerations • An exchange rate expresses the value of one currency in terms of the value of another. • Exchange rate can be expressed in two ways – it tells us how many units of one currency is needed to buy one unit of another. • For example, it takes Can$1.54 to buy US$1 (or, US$0.65 to buy Can$1)

19. International Considerations • Exchange rates matter because international trade is an important part of every economy. • Monetary policy is important because it will affect international trade through changes in the money supply.

20. International Considerations • The exchange rate as the relative price of one nation’s currency depends on how much of that currency is in circulation. • Therefore, monetary policy cannot be set without consideration of international issues.

21. Duties of the Bank • The bank of Canada is responsible for: • Conducting monetary policy • Providing Central banking services • Issuing bank notes • Administering public debt.

22. The Importance of Monetary Policy • Monetary policy is the Bank’s most important function, and the most-used policy in macroeconomics. • In practice,the Bank of Canada conducts monetary policy and controls it, whereas fiscal policy is conducted directly by the government.

23. The Importance of Monetary Policy • Actual decisions about monetary policy are made by the Governor of the Bank of Canada, with consultation with senior staff.

24. The Conduct of Monetary Policy • Bank reserves are IOUs of the Bank of Canada. • Bank reserves – either vault cash or deposits at the Bank. • The monetary base is currency in circulation plus deposits at the Bank.

25. The Conduct of Monetary Policy • By controlling the monetary base, the Bank can influence the amount of money in the economy and the activities of banks.

26. The Conduct of Monetary Policy • The tools of monetary policy will affect the amount of reserves in the system. • The amount of reserves will affect interest rates. • Other things being equal, as reserves decline, interest rates will rise. • As reserves increase, interest rates will fall.

27. Tools of Monetary Policy • The tools of monetary policy include: • Changing the target range for the overnight financing rate. • Cash management operations.

28. The Overnight Financing Rate • All chartered banks are members of the Canadian Payments Association. • Among other things, this association runs an electronic funds transfer system called the Large Value Transfer system (LVTS), where payments clear and settle daily.

29. The Overnight Financing Rate • If financial institutions have surplus balances resulting from the clearing process at the LVTS, they can loan them on a very short term basis to those members who are in deficit position. • These loans occur in the overnight market.

30. The Overnight Financing Rate • The overnight financing rate is the rate of interest associated with these very short-term loans in the overnight market.

31. The Overnight Financing Rate • Changes in the overnight financing rate influence all other rates through the term structure of interest rates – the structure of yields on financial instruments with similar characteristics, but different terms to maturity.

32. The Overnight Financing Rate • Arbitrage – the buying and selling of similar goods and services across different markets – provides the link between interest rates on dissimilar assets.

33. The Overnight Financing Rate • The bank rate is the interest rate charged on advances from the central bank.

34. The Overnight Financing Rate • The Bank of Canada has a target range for the overnight financing rate – it falls between the bank rate (maximum) and the rate at which the Bank will pay the LVTS participants who want to leave their surplus funds with the Bank of Canada (minimum).

35. The Overnight Financing Rate • The main tool of monetary policy in Canada is the target range for the overnight financing rate. • The AD will decline if the target range for the overnight financing rate is increased. • By decreasing the target range, the AD will increase.

36. Relationship Among Interest Rates, Fig. 14-2a, p 348

37. Relationship Among Interest Rates, Fig. 14-2b, p 348

38. Cash Management Operations • Cash management is the second major tool of monetary policy in Canada. • Cash management operations are the main techniques for implementing monetary policy in Canada.

39. Cash Management Operations • Cash management techniques include various open market operations - buying and selling of government bonds and bills. • Cash management techniques also include the transfer of government deposits between chartered banks (and others) and the Bank of Canada.

40. Open Market Operations • Open market operations involve the purchase or sale of federal government securities. • When the Bank of Canada buys bonds, the money supply rises. Thus, an open market purchase is an example of expansionary monetary policy.

41. Open Market Operations • An open market sale has the opposite effect: • When the Bank of Canada sells bonds, the money supply declines. Thus, an open market sale is an example of contractionary monetary policy.

42. Open Market Operations • Open market purchase (expansionary monetary policy) increases the money supply, decreasing the interest rates. • Open market sale (contractionary monetary policy) reduces the money supply, increasing interest rates.

43. Government Deposits • A transfer of government deposits from the chartered banks and other financial institutions to the Bank of Canada reduces the liquidity in the banking system. • This puts an upward pressure on interest rates.

44. Government Deposits • A transfer of government deposits from the Bank of Canada to the chartered banks and other financial institutions increases the liquidity in the banking system. • This puts a downward pressure on interest rates.

45. Supply B Price of a bond A D1 D0 Quantity of bonds Open Market Operations, Fig. 14-3a, p 350 a) An open market purchase

46. S0 S1 A Price of a bond C Demand Quantity of bonds Open Market Operations, Fig. 14-3b, p 350 b) An open market sale

47. Monetary Policy in the AS/AD Model • In AS/AD terms, monetary policy works primarily through its effect on interest rates.

48. Contractionary Monetary Policy • The Bank decreases the money supply. • The interest rates go up. • As interest rates go up, the quantity of investment goes down, decreasing income and output.

49. Contractionary Monetary Policy • The AD curve shifts to the left by a multiple of the shift in investment. • Income and output decrease. M iIY

50. Expansionary Monetary Policy • Expansionary monetary policy works in the opposite direction. MiIY