© 2003 McGraw-Hill Ryerson Limited. Monetary Policy and the Debate about Macro Policy Chapter 14

© 2003 McGraw-Hill Ryerson Limited.

Monetary Policy and Monetary Policy and the Debate about the Debate about

Macro PolicyMacro Policy

Chapter 14Chapter 14

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IntroductionIntroduction

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

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IntroductionIntroduction

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.

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Effect of Monetary Effect of Monetary Policy on the AS/AD Policy on the AS/AD ModelModel Expansionary monetary policy shifts the

AD curve to the right. Contractionary monetary policy shifts

the AD curve to the left.

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Effect of Monetary Effect of Monetary Policy on the AS/AD Policy on the AS/AD ModelModel 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.

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Effect of Monetary Effect of Monetary Policy on the AS/AD Policy on the AS/AD ModelModel The supply conditions of the economy

are central to the effect one believes monetary policy will have on the economy.

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Effect of Monetary Effect of Monetary Policy on the AS/AD Policy on the AS/AD ModelModel Its effect on real income depends on

how the price level responds.

% Real Income =

% Nominal Income - % Price Level

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Effect of Monetary Effect of Monetary Policy on the AS/AD Policy on the AS/AD ModelModel In Keynesian range, real income will

rise with expansionary monetary policy and decline with contractionary monetary policy.

The price level is unaffected.

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Effect of Monetary Effect of Monetary Policy on the AS/AD Policy on the AS/AD ModelModel In the Classical range, real income does

not change; the effect is on the price level and inflation.

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Monetary Policy When Monetary Policy When Prices are Fixed, Prices are Fixed, Fig. 14-1a, p Fig. 14-1a, p

339339

P0

SAS

Y2 Y0 Y1

AD0 AD1

Pricelevel

Real output

Expansionary monetary policy

Contractionary monetary policy

AD2

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P0

SAS0

AD0

AD1

Pricelevel

Real output

P1

SAS1

Y0

LRAS

Expansionary Monetary Expansionary Monetary Policy in the Classical Policy in the Classical Range, Range, Fig. 14-1b, p 339Fig. 14-1b, p 339

A

B

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Duties and Structure of Duties and Structure of the Bank of Canadathe 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.

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Duties and Structure of Duties and Structure of the Bank of Canadathe 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.

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Structure of the BankStructure 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.

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Structure of the BankStructure 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.

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Structure of the BankStructure 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.

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International International ConsiderationsConsiderations The design and implementation of

monetary policy is affected by international considerations.

Exchange rates play a critical role in the process.

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International International ConsiderationsConsiderations 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)

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International International ConsiderationsConsiderations 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.

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International International ConsiderationsConsiderations 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.

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Duties of the BankDuties of the Bank

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

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The Importance of The Importance of Monetary PolicyMonetary 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.

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The Importance of The Importance of Monetary PolicyMonetary Policy Actual decisions about monetary policy

are made by the Governor of the Bank of Canada, with consultation with senior staff.

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The Conduct of The Conduct of Monetary PolicyMonetary 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.

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The Conduct of The Conduct of Monetary PolicyMonetary Policy By controlling the monetary base, the

Bank can influence the amount of money in the economy and the activities of banks.

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The Conduct of The Conduct of Monetary PolicyMonetary 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.

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Tools of Monetary Tools of Monetary PolicyPolicy The tools of monetary policy include:

Changing the target range for the overnight financing rate.

Cash management operations.

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The Overnight The Overnight Financing RateFinancing 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.

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The Overnight The Overnight Financing RateFinancing 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.

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The Overnight The Overnight Financing RateFinancing Rate The overnight financing rate is the

rate of interest associated with these very short-term loans in the overnight market.

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The Overnight The Overnight Financing RateFinancing 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.

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The Overnight The Overnight Financing RateFinancing Rate Arbitrage – the buying and selling of

similar goods and services across different markets – provides the link between interest rates on dissimilar assets.

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The Overnight The Overnight Financing RateFinancing Rate The bank rate is the interest rate

charged on advances from the central bank.

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The Overnight The Overnight Financing RateFinancing 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).

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The Overnight The Overnight Financing RateFinancing 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.

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

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

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Cash Management Cash Management OperationsOperations 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.

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Cash Management Cash Management OperationsOperations 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.

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Open Market Open Market OperationsOperations 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.

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Open Market Open Market OperationsOperations 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.

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Open Market Open Market OperationsOperations 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.

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Government DepositsGovernment 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.

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Government DepositsGovernment 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.

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Open Market Open Market Operations, Operations, Fig. 14-3a, p 350Fig. 14-3a, p 350

Pri

ce o

f a b

on

d

Quantity of bonds

D0

Supply

a) An open market purchase

D1

A

B

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Open Market Open Market Operations, Operations, Fig. 14-3b, p 350Fig. 14-3b, p 350

Pri

ce o

f a b

on

d

Quantity of bonds

Demand

S0

b) An open market sale

S1

A

C

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Monetary Policy in the Monetary Policy in the AS/AD ModelAS/AD Model In AS/AD terms, monetary policy works

primarily through its effect on interest rates.

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Contractionary Contractionary Monetary PolicyMonetary 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.

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Contractionary Contractionary Monetary PolicyMonetary Policy The AD curve shifts to the left by a

multiple of the shift in investment. Income and output decrease.

M i I Y

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Expansionary Monetary Expansionary Monetary PolicyPolicy Expansionary monetary policy works in

the opposite direction.

M i I Y

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Contractionary Contractionary Monetary Policy When Monetary Policy When Prices are Fixed, Prices are Fixed, Fig. 14-4a, p Fig. 14-4a, p

351351M i I Y

AD1 AD0

Y1 Y0

P0

SAS

Price level

0 Real income

I Initial shift

Multiplier effect

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Expansionary Monetary Expansionary Monetary Policy When Prices are Policy When Prices are Fixed, Fixed, Fig. 14-4b, p 351Fig. 14-4b, p 351

M i I Y

AD0 AD1

Y0 Y1

P0

Aggregate supply

Price level

0 Real income

Multiplier effect

I Initial shift

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Monetary Policy in the Monetary Policy in the Circular FlowCircular Flow If monetary and fiscal policy are

needed, it is because the financial sector is in some ways clogged and is not correctly translating savings into investment.

Monetary policy works to unclog the financial sector.

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Keynesian Monetary Keynesian Monetary Policy in the Circular Policy in the Circular Flow, Flow, Fig. 14-5, p 352Fig. 14-5, p 352

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Emphasis on the Emphasis on the Interest RateInterest Rate A rising interest rate indicates a

tightening of monetary policy. A falling interest rate indicates a

loosening of monetary policy.

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Emphasis on the Emphasis on the Interest RateInterest Rate A natural conclusion is that the Bank

should target interest rates in setting monetary policy.

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Real and Nominal Real and Nominal Interest RatesInterest Rates There is a problem in using interest

rates to measure whether monetary policy is contractionary or expansionary.

That problem is the real/nominal interest rate problem.

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Real and Nominal Real and Nominal Interest RatesInterest Rates Nominal interest rates are those you

actually see and pay. Real interest rates are nominal interest

rates adjusted for expected inflation.

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Real and Nominal Real and Nominal Interest RatesInterest Rates The real interest rate cannot be

observed since it depends on expected inflation, which cannot be directly observed.

Nominal interest rate = Real interest rate + Expected inflation rate

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Real and Nominal Real and Nominal Interest Rates and Interest Rates and Monetary PolicyMonetary Policy Making a distinction between nominal

and real interest rates adds uncertainty to the effect on monetary policy.

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Real and Nominal Real and Nominal Interest Rates and Interest Rates and Monetary PolicyMonetary Policy If expansionary monetary policy leads to

expectations of increased inflation, nominal interest rates will go up, leaving real interest rates unchanged.

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Real and Nominal Real and Nominal Interest Rates and Interest Rates and Monetary PolicyMonetary Policy The possible effect of monetary policy

on expectations of inflation has led most economists to conclude that a monetary regime, not a monetary policy is the best approach to policy.

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Real and Nominal Real and Nominal Interest Rates and Interest Rates and Monetary PolicyMonetary Policy A monetary regime is a predetermined

statement of the policy that will be followed in various situations.

A monetary policy, in contrast, is a response to events which is chosen without a predetermined framework.

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Real and Nominal Real and Nominal Interest Rates and Interest Rates and Monetary PolicyMonetary Policy The monetary regime the Bank is

currently using involves feedback rules that center on the overnight financing rate.

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Real and Nominal Real and Nominal Interest Rates and Interest Rates and Monetary PolicyMonetary Policy If inflation is above its target the Bank

rises the target range, decreasing the money supply.

If inflation is below its target, and if economy is going into recession, the Bank lowers the target range, increasing the money supply.

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Real and Nominal Real and Nominal Interest Rates and Interest Rates and Monetary PolicyMonetary Policy If inflation is below its target and the

economy is sliding into a recession the Fed attempts to expand the economy.

The Fed lowers the Federal funds rate by buying bonds thereby increasing the money supply.

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Problems in the Problems in the Conduct of Monetary Conduct of Monetary PolicyPolicy Five problems of monetary policy are:

Knowing what policy to use. Understanding the policy you're

using. Lags in monetary policy. Political pressure. Conflicting international goals.

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Knowing What Policy to Knowing What Policy to UseUse The potential level of income must be

known. Otherwise you don’t know whether to

use expansionary or contractionary monetary policy.

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Understanding the Understanding the Policy You’re UsingPolicy You’re Using You must know whether the policy

being used is expansionary or contractionary in order to use monetary policy effectively.

The Bank only indirectly controls the monetary base.

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Understanding the Understanding the Policy You’re UsingPolicy You’re Using The money multiplier is influenced by

both the amount of cash people hold as well as the lending process at the bank.

Neither of these are stable numbers.

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Understanding the Understanding the Policy You’re UsingPolicy You’re Using Then there are interest rates. If interest rates rise, is it because of

expected inflation or is it that the real interest rate is going up?

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Lags in Monetary PolicyLags in Monetary Policy

Monetary policy, like fiscal policy, takes time to work.

Just because the Bank decreases interest rates, that does not necessarily mean that people will borrow money.

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Lags in Monetary PolicyLags in Monetary Policy

In the face of a contractionary monetary policy, banks have been creative in circumventing cuts in the money supply.

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Political PressurePolitical Pressure

The Bank is not totally insulated from political pressure.

Politicians place great pressure on the Bank to use expansionary monetary policy, especially during an election year.

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Conflicting Conflicting International GoalsInternational Goals Monetary policy is conducted in an

international arena. It must be coordinated with other

governments’ monetary policies.

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Monetary Policy and Monetary Policy and the Debate about the Debate about

Macro PolicyMacro Policy

End of Chapter 14End of Chapter 14