CHAPTER 13

Interest Rates and Monetary Policy

1

Slides prepared by Bruno Fullone, George Brown College

© 2010 McGraw-Hill Ryerson Limited

PART 4: MONEY, BANKING, AND

MONETARY POLICY

Chapter 13 2

• Learning Objective 13.1: How the equilibrium interest rate is determined in the market for money

• Learning Objective 13.2: The main functions of the Bank of Canada

• Learning Objective 13.3: The goals and tools of monetary policy

• Learning Objective 13.4: About the overnight lending rate and how the Bank of Canada controls it

• Learning Objective 13.5: The mechanisms by which monetary policy affects GDP and the price level

• Learning Objective 13.6: The effectiveness of monetary policy and its shortcomings

• Learning Objective 13.7: About the effects of the international economy on the operation of monetary policy

In This Chapter You Will Learn:

LO13.1 3

• The Demand for Money

• Transactions Demand, Dt

– demand for money as a medium of exchange

– varies directly with GDP

• Asset Demand, Da

– demand for money as a store of value

– varies inversely with the interest rate

13.1 The Market for Money and the

Determination of Interest Rates

LO13.1 4

Transactions

Demand, Dt + In

tere

st

Ra

te

Amount of money

demanded (billions

of dollars)

Dt

10

7.5

5

2.5

0 0 50 100 150 200 250 300

i%

Figure 13-1

The Demand for Money

LO13.1 5

Transactions

Demand, Dt

Asset

Demand, Da + =

Amount of money

demanded (billions

of dollars)

10

7.5

5

2.5

0

Da

0 50 100 150 200 250 300

Amount of money

demanded (billions

of dollars)

Dt

10

7.5

5

2.5

0 0 50 100 150 200 250 300

i% i%

Inte

res

t R

ate

Figure 13-1

The Demand for Money

LO13.1 6

Transactions

Demand, Dt

Asset

Demand, Da

Total demand

for money, Dm + = 10

7.5

5

2.5

0

Amount of money

demanded (billions

of dollars)

10

7.5

5

2.5

0

Da

0 50 100 150 200 250 300

Amount of money

demanded (billions

of dollars)

Dt

10

7.5

5

2.5

0 0 50 100 150 200 250 300

Amount of money

demanded (billions

of dollars)

0 50 100 150 200 250 300

Dm

i% i% i%

100 + 100 = 200

Inte

res

t R

ate

Figure 13-1

The Demand for Money

LO13.1 7

• Demand for money combined with supply of money determine the equilibrium rate of interest

• Add the supply of money…

Equilibrium Interest Rate

LO13.1 8

• When the interest rate increases, bond prices fall; and vice versa.

• Example

– A $1,000 bond pays $50 annual interest. Interest yield on this bond is ___

$50/$1000 = 5%

– Interest rate rises to 7.5%, bond price will fall to ____

$50/7.5% = $667

– Interest rate falls to 2.5%, bond price will rise to ____

$50/2.5% = $2000

Interest Rates and Bond Prices

LO13.2 9

- Acting as the “Bankers’ Bank”

- Issuing Currency

- Acting As Fiscal Agent

- Supervising the Chartered Banks

- Regulating the Supply of Money

13.2 Functions of the Bank of

Canada

LO13.2 10

• Controversial

• Voters hold Parliament responsible

• Bank must be protected from political pressures

Bank of Canada Independence

LO13.2 11

Table 13-1 Bank of Canada Statement of Assets &

Liabilities, December 31, 2008

LO13.1 12

Transactions

Demand, Dt

Asset

Demand, Da

Total demand

for money, Dm + = 10

7.5

5

2.5

0

Amount of money

demanded (billions

of dollars)

10

7.5

5

2.5

0

Da

0 50 100 150 200 250 300

Amount of money

demanded (billions

of dollars)

Dt

10

7.5

5

2.5

0 0 50 100 150 200 250 300

Amount of money

demanded (billions

of dollars)

0 50 100 150 200 250 300

i% i% i% Sm

ie

Inte

res

t R

ate

Figure 13-1

Dm

The Demand for Money

Equilibrium Interest Rate

LO13.3 13

• To keep inflation low, stable & predictable, to moderate the business cycle, & help the economy achieve full employment & sustained growth

• By altering the money supply to influence interest rates

• Inflation target range of 1—3% annually

13.3 Goals of Monetary Policy

Global Perspective 13.1:Central

Banks

Reserve Bank of Australia (RBA)

Bank of Canada

European Central Bank (ECB)

Bank of Japan (BOJ)

Banco de Mexico (Mex Bank)

Central Bank of Russia

Sveriges Riksbank

Bank of England

Federal Reserve System (the “Fed”)

(12 Regional Federal Reserve Banks)

Australia:

Canada:

Euro Zone:

Japan:

Mexico:

Russia

Sweden:

United Kingdom:

United States:

Selected Nations

33-14

LO13.3 15

• The Objective of the Bank of Canada’s Monetary Policy

• Tools of Monetary Policy:

– Open-Market Operations

– Bank Rate

Goals and Tools of Monetary

Policy

LO13.3 16

• Bank of Canada BUYS bonds

From the chartered banks… – Chartered bank gives up bonds

– Bank of Canada pays chartered bank by increasing chartered bank’s reserves

Open-Market Operations

LO13.3 17

Bank Of Canada BUYS $1000

Of Securities From The Chartered Banks

Bank of Canada

Assets Liabilities

Chartered Banks

Assets Liabilities

Open Market Operations

LO13.3 18

Bank of Canada

Assets Liabilities

Chartered Banks

Assets Liabilities

Bank Of Canada BUYS $1000 of

Securities From The Chartered Banks

+ Securities - Securities

Open Market Operations

LO13.3 19

Bank of Canada

Assets Liabilities

Chartered Banks

Assets Liabilities

+ Securities - Securities + Reserves

of

chartered

banks

+ Reserves

Bank Of Canada BUYS $1000 of

Securities From The Chartered Banks

Open Market Operations

LO13.3 20

• Bank of Canada BUYS bonds

From the chartered banks… – Chartered bank gives up bonds

– Bank of Canada pays chartered bank by increasing chartered bank’s reserves

From the public…

– Public gives up bonds for cheque

– Cheque is deposited in chartered bank

– Chartered bank’s reserves increase

Open Market Operations

LO13.3 21

+ Reserves

of

chartered

banks

Bank of Canada

Assets Liabilities

Chartered Banks

Assets Liabilities

+ Securities + Reserves +Deposits

some reserves must be kept on

hand against this deposit

Bank Of Canada BUYS $1,000 Of

Securities From The Public

Open-Market Operations

LO13.3 22

D=E X m

= $1000 X 1/.20

=$1000 X 5

New reserves

$1000

Excess

reserves

$5,000

Chartered bank system lending

Total increase in money supply ($5,000)

Purchase of a

$1000 bond

from a

chartered

bank....

Figure 13-2

Bank of Canada Bond Purchase

LO13.3 23

Total increase in money supply ($5,000)

Purchase of a

$1000 bond

from the

public....

$4000

Chartered bank system lending

$1000

Initial

deposit

Figure 13-2

D=E X m

= $800 X 1/.20

=$800 X 5

$200

Desired

reserves

New reserves

$800

Excess

reserves

Bank of Canada Bond Purchase

LO13.3 24

Bank of Canada BUYS bonds

– Chartered bank’s reserves increase

– Banks increase lending

– Money supply increases

Bank of Canada SELLS bonds

– Chartered bank’s reserves decrease

– Banks decrease lending

– Money supply decreases

Open-Market Operations

LO13.3 25

• The bank rate is the interest rate the Bank of Canada charges on the loans to the chartered banks

• Bank rate is set at the upper end of the Bank of Canada’s operating band for the overnight lending rate

• Bank has a publicized target for the overnight lending rate

The Bank Rate and the Overnight

Lending Rate

LO13.3 26

• Of the two policy instruments, buying & selling securities in the open market is by far the most important

• Bank rate is a signalling device

Relative Importance

LO13.4 27

Qf1

Quantity of Reserves

Ov

ern

igh

t L

end

ing

Rat

e

4.0 Sf1

Demand curve is downward slopping

Df

Supply is horizontal at the target rate

Bank targets 4% rate

13.4 Targeting the Overnight

Lending Rate

LO13.4 28

Qf1 Qf2

Quantity of Reserves

Ov

ern

igh

t L

end

ing

Rat

e

4.0

3.5

Sf1

Sf2

Bank will - buy securities - switch government deposits to chartered banks - reduce the bank rate

Suppose that the economy faces recession and unemployment

Expansionary Monetary Policy

LO13.4 29

Qf3 Qf1

Quantity of Reserves

Ov

ern

igh

t L

end

ing

Rat

e 4.5

4.0

3.5

Sf3

Sf1

Bank will - sell securities - lower reserves - increase the bank rate

Suppose that the economy faces rising inflation

Expansionary Monetary Policy

LO13.4 30

Figure 13-4 The Prime Interest Rate, the Bank Rate,

the Overnight Target Rate, and the Overnight Lending

Rate in Canada

LO13.4 31

• If real GDP rises by 1% above potential GDP, the Bank should raise the overnight rate by 1.5 percentage point

• If inflation rises by 1% above its target of 2 percent, the bank should raise the overnight lending rate by 1.5%

• When real GDP is equal to potential GDP and inflation is equal to its target, the overnight rate should remain about 4%, implying a real interest rate of 2%.

The Taylor Rule

LO13.5 32

Cause-Effect Chain: The Transmission Mechanism

• Money supply impacts interest rates

• Interest rates affect investment

• Investment is a component of AD

• Equilibrium GDP is changed

13.5 Monetary Policy, Real GDP &

the Price Level

LO13.5 33

LO13.5 34

Problem: Unemployment and Recession

Bank of Canada buys bonds, and lowers the bank rate

Money supply rises

Excess reserves increase, overnight rate falls

Interest rate falls

Investment spending increases

Aggregate demand increases

Real GDP rises

Table 13-2

LO13.5 35

Problem: Inflation

Bank of Canada sells bonds and raises the bank rate

Money supply falls

Excess Reserves decrease, overnight rate rises

Interest rate rises

Investment spending decreases

Aggregate demand decreases

Inflation declines

Table 13-2

LO13.5 36

• Dominant component of Canadian national stabilization policy

• Two key advantages over fiscal policy:

– speed & flexibility

– isolation from political pressure

Monetary Policy: Evaluation and

Issues

LO13.5 37

• Early 1990s: restrictive monetary policy after the recession of 1991-2 made growth slow

• Easing encouraged growth in the second half of the 1990s

• Vigorous economy & stock market bubble led to tightening at the end of the 1990s

• Economy slowed at the end of 2000, so Bank cut interest rates in 2001

• Expansion in 2002 led to increased rates • Reduced rate to stimulate the economy in

2004 • Interest rate hikes from 2005 – 2007 • Started dropping again in 2008 to an all time

low of 0.25% in 2009!

Recent Monetary Policy

• Monetary policy has certain limitations and faces real-world complications:

• Lags

- recognition lag

-operational lag

• Cyclical Asymmetry

• Inflation Targeting

– has increased transparency of monetary policy & accountability

– critics say inflation targeting is too narrow

LO13.6 38

13.6 Problems and Complications

LO13.7 39

• Net exports effects reinforce monetary policy

13.7 Monetary Policy & the

International Economy

LO13.7 40

Problem: recession, slow growth

Expansionary monetary policy

(lower interest rate)

Decreased foreign demand for dollars

Dollar depreciates

Net exports increase

Aggregate demand increases

Monetary policy is reinforced

Table 13-3

LO13.7 41

Problem: inflation

Restrictive monetary policy

(higher interest rate)

Increased foreign demand for dollars

Dollar appreciates

Net exports decrease

Aggregate demand decreases

Monetary policy is reinforced

Table 13-3

LO13.7 42

Macroeconomic Stability & the Trade Balance

• The easy money policy that is appropriate for the alleviation of unemployment & sluggish growth is compatible with the goal of correcting a balance-of-trade deficit

• The tight money policy used to alleviate inflation conflicts with the goal of correcting a balance-of-trade deficit

Monetary Policy and the International

Economy

The Last Word: The Mortgage Debt

Crisis: The Fed Responds

• Home mortgage default 2007

• Banks write off bad loans

• Reserves reduced

• Fed as lender of last resort

• Term auction facility

• Fed lowered federal funds rate • Mortgage backed securities as a new innovation

– Bad incentives

LO13.7 43

Chapter 13 44

13.1: The market for money and the determination of interest rates

13.2 : Functions of the Bank of Canada

13.3: Goals and tools of monetary policy

13.4: Targeting the overnight lending rate

13.5 : Monetary policy, real GDP, and price level

13.6: Problems and complications

13.7: Monetary policy and the international economy

Chapter 13 Summary