1. Copyright © 2006 Pearson Education Canada Monetary Policy 28 CHAPTER

2. Copyright © 2006 Pearson Education Canada Objectives After studying this chapter, you will able to  Describe Canada’s monetary policy objectives and the framework for setting and achieving them  Explain how the Bank of Canada makes its interest rate decision and achieves it interest rate target  Explain the transmission channels through which the Bank of Canada influences the inflation rate  Explain and compare alternative monetary policy strategies

3. Copyright © 2006 Pearson Education Canada Fiddling with the Knobs On eight pre-set dates a year, the Bank of Canada announces whether the interest rate will rise, fall, or remain constant until the next decision date. How does the Bank make its interest rate decision? What does the Bank do to keep interest rates where it wants them? Do the Bank’s interest rate changes influence the economy in the way the Bank wants? Can the Bank speed up economic growth by lowering interest rates and keep inflation in check by raising them?

4. Copyright © 2006 Pearson Education Canada Monetary Policy Objective and Framework Canada’s monetary policy objective and the framework for setting and achieving that objective stems from the relationship between the Bank of Canada and the government of Canada.

5. Copyright © 2006 Pearson Education Canada Monetary Policy Objective and Framework Monetary Policy Objective The objective of monetary policy stems from the mandate of the Bank that is set out in the Bank of Canada Act. The preamble to the Bank of Canada Act of 1935 states the Bank’s objective as being to regulate credit and currency in the best interests of the economic life of the nation... and to mitigate by its influence fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action…

6. Copyright © 2006 Pearson Education Canada Monetary Policy Objective and Framework These words have come to mean that the Bank’s job is to control the quantity of money and interest rates in order to avoid inflation and, when possible, prevent excessive swings in real GDP growth and unemployment.

7. Copyright © 2006 Pearson Education Canada Monetary Policy Objective and Framework Joint Statement of the Government and the Bank In 2001, the government of Canada and the Bank of Canada agreed that 1. The inflation control target range will be 1 to 3 percent a year 2. Policy will aim at keeping the trend of inflation at the 2 percent target midpoint 3. The agreement will run for five years and be reviewed before the end of 2006. The Bank believes that the core inflation rate provides a better measure of the underlying inflation trend and a better prediction of future CPI inflation.

8. Copyright © 2006 Pearson Education Canada Monetary Policy Objective and Framework Interpretation of the Agreement The inflation control target uses the Consumer Price Index (or CPI) as the measure of inflation. So it is the CPI inflation rate that the Bank has agreed to keep on a 2 percent target trend. The Bank also pays close attention to core inflation, the CPI excluding the eight most volatile prices and indirect taxes. The Bank believes that the core inflation rate provides a better measure of the underlying inflation trend and a better prediction of future CPI inflation.

9. Copyright © 2006 Pearson Education Canada Monetary Policy Objective and Framework Actual Inflation Figure 28.1 shows that the Bank of Canada has kept the inflation rate close to target. In part (a), you can see that the actual inflation rate has rarely gone outside the target range of 1 to 3 percent a year.

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11. Monetary Policy Objective and Framework In part (b), you can see the trend of inflation at the 2 percent target midpoint.

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13. Monetary Policy Objective and Framework Rationale for an Inflation-Control Target Two main benefits flow from adopting an inflation-control target: 1. Fewer surprises and mistakes on the part of savers and investors. 2. Anchors expectations about future inflation.

14. Copyright © 2006 Pearson Education Canada Monetary Policy Objective and Framework Controversy About the Inflation-Control Target Critics of inflation targeting fear that 1. Reigning in aggregate demand might push the economy into recession. 2. The Bank might make the dollar rise on the foreign exchange market and make exports suffer.

15. Copyright © 2006 Pearson Education Canada Monetary Policy Objective and Framework Supporters of inflation targeting respond: 1. Keeping inflation low and stable is the best way to achieve full employment and sustained economic growth. 2. The Bank’s record is good. The last time the Bank created a recession was at the beginning of the 1990s when it was faced with double-digit inflation.

16. Copyright © 2006 Pearson Education Canada Monetary Policy Objective and Framework Responsibility for Monetary Policy The Bank of Canada’s Governing Council is responsible for the conduct of monetary policy. The Governor and the Minister of Finance must consult regularly. If the Governor and the Minister disagree in a profound way, the Minister may direct the Bank in writing to follow a specified course and the Bank would be obliged to accept the directive.

17. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy Choosing a Policy Instrument As the sole issuer of Canadian money, the Bank of Canada can decide to control 1. The quantity of money (the monetary base), or 2. The price of Canadian money on the foreign exchange market (the exchange rate), or 3. The opportunity cost of holding money (the short-term interest rate). The Bank of Canada can set only one of these must decide which of these three instruments to use.

18. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy The Overnight Rate The Bank of Canada’s choice of policy instrument (which is the same choice as that made by most other major central banks) is a short-term interest rate. Given this choice, the exchange rate and the quantity of money to find their own equilibrium values. The specific interest rate that the Bank of Canada targets is the overnight loans rate, which is the interest rate on overnight loans that members of the LVTS (the big banks) make to each other.

19. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy Figure 28.2 shows the overnight loans rate. The overnight loans rate was  raised to 8 percent a year in 1995 and 6 percent a year on two occasions when inflation was a concern.  and lowered to about 2 percent a year to avoid recession.

20. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy Since late 2000, the Bank has set eight fixed dates on which it announces its overnight rate target for the coming six weeks. Before 2000, the Bank announced changes in the overnight loans rate whenever it thought a change was required.

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22. The Conduct of Monetary Policy Although the Bank can change the overnight rate by any (reasonable) amount that it chooses, it normally changes the rate by only a quarter of a percentage point. How does the Bank the appropriate level for the overnight rate? And how, having made that decision, does the Bank get the overnight rate to move to the target level?

23. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy The Bank’s Decision-Making Process The Bank of Canada could adopt either  An instrument rule  A targeting rule

24. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy Instrument Rule An instrument rule sets the policy instrument at a level based on the current state of the economy. The best known instrument rule is the Taylor rule: Set the interest rate at a level that depends on the deviation of the inflation rate from target and the size and direction of the output gap.

25. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy Targeting Rule A targeting rule sets the policy instrument at a level that makes the forecast of the ultimate policy target equal to the target. Where the ultimate policy target is the inflation rate and the instrument is the overnight rate, the targeting rule sets the overnight rate at a level that makes the forecast of the inflation rate equal to the target for the inflation rate.

26. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy To implement such a targeting rule, a central bank must gather and process a large amount of information about the economy, the way it responds to shocks, and the way it responds to policy. It must then process all this data and come to a judgement about the best level for the policy instrument. The Bank of Canada (along with most other central banks) follows a process that uses a targeting rule.

27. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy Hitting the Overnight Rate Target Once an interest rate decision is made, the Bank of Canada achieves its target by using two tools:  Operating band  Open market operations

28. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy Operating Band The operating band is the target overnight rate plus or minus 0.25 percentage points. So the operating band is 0.5 percentage points wide. The Bank creates the operating band by setting two other interest rates: bank rate and the settlement balances rate. 1. Bank rate, the interest rate that the Bank charges big banks on loans, is set at the target overnight rate plus 0.25 percentage points. 2. Settlement balances rate, the interest rate the Bank pays on reserves, is set at the target overnight rate minus 0.25 percentage point.

29. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy Open Market Operations An open market operation is the purchase or sale of government of Canada securities—Treasury bills and government bonds—by the Bank of Canada from or to a chartered bank or the public. When the Bank of Canada buys securities, it increases bank reserves. When the Bank of Canada sells securities, it decreases bank reserves.

30. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy Figure 28.3 shows the effects of an open market purchase on the balance sheets of the Bank of Canada and the CIBC. The open market purchase increases bank reserves.

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32. The Conduct of Monetary Policy Figure 28.4 shows the effects of an open market sale on the balance sheets of the Bank of Canada and CIBC. The open market sale decreases bank reserves.

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34. The Conduct of Monetary Policy Equilibrium in the Market for Reserves Figure 28.5 illustrates the market for reserves. The x-axis measures the quantity of reserves held. The y-axis measures the overnight rate.

35. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy Bank rate is set at target overnight loans rate + 0.25 percentage points. Settlement balances rate is set at target overnight loans rate  0.25 percentage points. The blue bar is the Bank’s operating band for the actual overnight loans rate.

36. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy The overnight rate cannot exceed bank rate because, if it did, a bank could earn a profit by borrowing from the Bank of Canada and lending to another bank. But all banks can borrow from the Bank of Canada at bank rate, so no bank is willing to pay more than bank rate to borrow reserves.

37. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy The overnight rate cannot fall below the settlement balances rate because, if it did, a bank could earn a profit by borrowing from another bank and increasing its reserves at the Bank of Canada. But all banks can earn the settlement balances rate at the Bank of Canada, so no bank will lend reserves at a rate below that level.

38. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy The banks’ demand for reserves is the curve RD. If the overnight rate equals bank rate, banks are indifferent between borrowing reserves and lending reserves. The demand curve is horizontal at bank rate.

39. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy If the overnight rate equals the settlement balances rate, banks are indifferent between holding reserves and lending reserves. The demand curve is horizontal at the settlement balances rate.

40. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy If the overnight rate lies between bank rate and the settlement balances rate, banks are willing to borrow and lend reserves to one another at the overnight rate. But the overnight rate is the opportunity cost of holding reserves, so the higher the overnight rate, the fewer are the reserves demanded.

41. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy The Bank’s open market operations determine the actual quantity of reserves in banking system. Equilibrium in the market for reserves —where the quantity of reserves demanded equals the quantity supplied— determines the overnight rate.

42. Copyright © 2006 Pearson Education Canada The Conduct of Monetary Policy So the Bank uses open market operations to keep the overnight loans rate on target.

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44. Monetary Policy Transmission Quick Overview When the Bank of Canada lowers the overnight rate: 1. Other interest rates and the exchange rate fall. 2. The quantities of money, credit, and loans increase. 3. The lower interest rate increases consumption expenditure and investment. 4. The lower exchange rate increases net exports. 5. Easier bank credit reinforces the effects of lower interest rates on consumption expenditure and investment.

45. Copyright © 2006 Pearson Education Canada Monetary Policy Transmission 6. Aggregate demand decreases. 7. Real GDP decreases and the price level falls relative to what they would have been. 8. Real GDP growth and inflation slow down. Figure 28.6 provides a schematic summary of these ripple effects, which stretch out over a period of between one and two years.

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48. Monetary Policy Transmission Interest Rate Fluctuations Figure 28.7 shows the fluctuations in four interest rates:  The overnight loans rate  The 3-month Treasury bill rate  The 10-year government bond rate  The long-term corporate bond rate.

49. Copyright © 2006 Pearson Education Canada Monetary Policy Transmission Short-term rates move closely together and follow the overnight rate. Long-term rates move in the same direction as the overnight loans rate but are only loosely connected to the overnight rate.

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51. Monetary Policy Transmission Exchange Rate Fluctuations The exchange rate responds to changes in the interest rate in Canada relative to the interest rates in other countries. But other factors are also at work, which make the exchange rate hard to predict.

52. Copyright © 2006 Pearson Education Canada Monetary Policy Transmission The red line in Fig. 28.8 shows the gap between the Canadian and U.S. overnight loans rates—the Canadian-U.S. interest rate differential. The blue line shows the exchange rate of the Canadian dollar against the U.S. dollar. Most of the time, the relationship is weak.

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54. Monetary Policy Transmission Money and Loans When the Bank of Canada lowers the overnight loans rate, the quantity of money and the quantity of loans increase.

55. Copyright © 2006 Pearson Education Canada Monetary Policy Transmission The Interest Rate and Expenditure Plans The real interest rate influences people’s spending. Nominal Interest and Real Interest The nominal interest rate is the percentage return on an asset such as a bond expressed in terms of money. It is the interest rate that is quoted in everyday transactions and news reports. The real interest rate is the percentage return on an asset expressed in terms of what money will buy. It is the nominal interest rate adjusted for inflation.

56. Copyright © 2006 Pearson Education Canada Monetary Policy Transmission The nominal interest rate is approximately equal to the nominal interest rate minus the inflation rate. Interest Rate and Opportunity Cost The nominal interest rate is the opportunity cost of holding money. The real interest rate is the opportunity cost of spending. A change in the real interest rate changes the opportunity cost of two components of aggregate expenditure:  Consumption expenditure  Investment

57. Copyright © 2006 Pearson Education Canada Monetary Policy Transmission Consumption Expenditure Other things remaining the same, the lower the real interest rate, the greater is the amount of consumption expenditure and the smaller is the amount of saving. The interest rate effect on consumption expenditure influences autonomous consumption expenditure.

58. Copyright © 2006 Pearson Education Canada Monetary Policy Transmission Investment Other things remaining the same, the lower the real interest rate, the greater is the amount of investment. The funds used to finance investment might be borrowed or the firm’s own (retained earnings). Either way, the real interest rate is the opportunity cost of those funds. Firms invest only if the expected rate of return on a project exceeds the real interest rate.

59. Copyright © 2006 Pearson Education Canada Monetary Policy Transmission Net Exports and the Interest Rate Net exports change when the real interest rate changes because  A change in the interest rate changes the exchange rate—other things remaining the same, the higher the interest rate, the higher is the exchange rate.  A change in the exchange rate changes net exports— other things remaining the same, the higher the exchange rate, the smaller are net exports.

60. Copyright © 2006 Pearson Education Canada Monetary Policy Transmission Interest-Sensitive Expenditure Curve The interest-sensitive expenditure curve (the IE curve) shows the relationship between aggregate planned expenditure and the real interest rate when all other influences on expenditure plans remain the same. Figure 25.9 on the next slide shows the components of interest-sensitive expenditure, autonomous consumption expenditure, investment, and net exports and illustrates how changes in the real interest rate change interest- sensitive expenditure along the IE curve.

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62. Copyright © 2006 Pearson Education Canada Monetary Policy Transmission Loose Link from Overnight Rate to Spending Long-term interest rates that influence spending plans are linked loosely to the overnight rate. The response of the real long-term interest rate to a change in the nominal rate depends on how inflation expectations change. The response of expenditure plans to changes in the real interest rate depends on many factors that make the response hard to predict.

63. Copyright © 2006 Pearson Education Canada Monetary Policy Transmission The Change in Aggregate Demand, Real GDP, and the Price Level Figure 28.10 shows the final link in the transmission chain when the Bank of Canada believes the inflation rate is near the bottom of the target band and lowers the overnight rate. Eventually, aggregate demand increases and the inflation rate returns to the middle of the target band.

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65. Monetary Policy Transmission Figure 28.11 shows the final link in the transmission chain when the Bank believes that the inflation rate is increasing and is near the top of the target band. The Bank raises the overnight rate. Eventually, aggregate demand decreases and the inflation rate is lowered to the middle of the target band.

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67. Monetary Policy Transmission Time Lags in the Adjustment Process Figure 28.12 shows that monetary policy actions have a powerful influence on real GDP growth. When the Bank pushes the overnight rate above the long-term bond rate, the real GDP growth rate slows in the following year.

68. Copyright © 2006 Pearson Education Canada Monetary Policy Transmission When the Bank lowers the overnight rate below the long-term bond rate, the real GDP growth rate speeds up in the next year. The inflation increases and decreases in sympathy with these fluctuations in the real GDP growth rate. But the effects on inflation rate take even longer.

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70. Alternative Monetary Policy Strategies The Bank of Canada might have chosen any of four alternative monetary policy strategies: Two of them are instrument rules and two are alternative targeting rules. The four alternatives are  Overnight rate instrument rule  Monetary base instrument rule  Exchange rate targeting rule  Money targeting rule

71. Copyright © 2006 Pearson Education Canada Alternative Monetary Policy Strategies Overnight Rate Instrument Rule Calling the overnight rate R, the neutral real overnight rate R*, the inflation rate , the target inflation rate  *, and the output gap (as a percentage of potential GDP), G, the Taylor rule says, set the overnight rate to equal R = R* + p + 0.5(  –  *) + 0.5G.

72. Copyright © 2006 Pearson Education Canada Alternative Monetary Policy Strategies Taylor suggests a neutral real overnight rate of 2 percent a year, so if inflation is on target and the output gap is zero (full employment), with a 2 percent inflation target, the overnight rate will be 4 percent. If the Bank of Canada moves the interest rate up and down by less than the Taylor rule moves it. The Bank believes that because it uses much more information than just the current inflation rate and the output gap, it is able to set the overnight rate more intelligently than any simple rule can set.

73. Copyright © 2006 Pearson Education Canada Alternative Monetary Policy Strategies Monetary Base Instrument Rule The McCallum rule makes the growth rate of the monetary base respond to the long-term average growth rate of real GDP and medium-term changes in the velocity of circulation of the monetary base. The rule is based on the quantity theory of money. The McCallum rule does not need an estimate of either the neutral real overnight rate or the output gap. The McCallum rule relies on the velocity of circulation being reasonably stable. The Bank believes that velocity is too unstable to make a McCallum rule work well.

74. Copyright © 2006 Pearson Education Canada Alternative Monetary Policy Strategies Exchange Rate Targeting Rule With a fixed exchange rate, a country has no control over its inflation rate. Money Targeting Rule Friedman’s k-percent rule makes the quantity of money grow at a rate of k percent a year, where k equals the growth rate of potential GDP. Friedman’s idea was tried but abandoned during the 1970s and 1980s. The Bank believes that the demand for money is too unstable to make the use of monetary targeting reliable.

75. Copyright © 2006 Pearson Education Canada Alternative Monetary Policy Strategies Why Rules? Why do all the monetary policy strategies involve rules? Why doesn’t the Bank of Canada use discretion? The answer is that monetary policy is about managing inflation expectations. A well-understood monetary policy rule helps to create an environment in which inflation is easier to forecast and manage.

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