1. Lecture notes Prepared by Anton Ljutic

2. © 2004 McGraw–Hill Ryerson Limited Monetary Policy CHAPTER TWELVE

3. © 2004 McGraw–Hill Ryerson Limited This Chapter Will Enable You To: Describe the various functions of Canada’s central bank - the Bank of Canada Understand the role of monetary policy and how the Bank of Canada influences interest rates Clearly understand why monetary policy is needed Describe the arguments for and against –the activist approach to monetary policy –the non-activist approach to monetary policy Realize why some argue that other direct controls are needed as alternatives to both fiscal and monetary policy

4. © 2004 McGraw–Hill Ryerson Limited Functions of the Bank of Canada The issuer of currency The government’s bank and manager of foreign currency reserves The bankers’ bank and lender of last resort The auditor and inspector of commercial banks The regulator of the money supply

5. © 2004 McGraw–Hill Ryerson Limited Monetary Policy Monetary policy is designed to change or influence the economy through changes in the money supply The Bank of Canada sees the role of monetary policy as a means of providing a healthy economic environment that will assist the economy in achieving the goals of low inflation and low unemployment

6. © 2004 McGraw–Hill Ryerson Limited Types of Monetary Policy Expansionary monetary policy –A policy that aims to increase the amount of money in the economy and make credit cheaper and more easily available Contractionary monetary policy –A policy in which the amount of money in the economy is decreased and credit becomes harder to obtain and more expensive

7. © 2004 McGraw–Hill Ryerson Limited Tools of Monetary Policy (I) Open-market operations –The buying and selling of securities by the Bank of Canada in the open (to the public) market Switching government deposits –The government keeps deposits with commercial banks and the Bank of Canada. By switching deposits between these two accounts, it can influence the money supply Moral suasion –The Bank of Canada informs the financial community of the direction it would like to take

8. © 2004 McGraw–Hill Ryerson Limited Tools Of Monetary Policy (II) Setting the bank rate –Bank rate The rate of interest payable by the commercial banks on loans from the Bank of Canada –Prime Rate The rate that commercial banks charge their best customers

9. © 2004 McGraw–Hill Ryerson Limited Is Monetary Policy Needed? If the money supply is increased too much, the result will be inflation If the money supply is not increased sufficiently, the result will be a recession and low economic growth The economic health of an economy depends on the money supply growing but not too quickly nor too slowly

10. © 2004 McGraw–Hill Ryerson Limited The Activist Approach to Monetary Policy Keynesian monetary policy is used to assist in achieving four goals: –Steady growth in real GDP –An exchange rate that ensures a viable balance of trade –Stable prices –Full employment

11. © 2004 McGraw–Hill Ryerson Limited The Effect of Contractionary Monetary Policy Contractionary monetary policy reduces AD 1 to AD 2 the inflationary gap (Y E – Y FE ) is thereby closed Contractionary monetary policy reduces AD 1 to AD 2 the inflationary gap (Y E – Y FE ) is thereby closed Potential GDP AS AD 1 AD 2 Y FE YEYE P Figure 12.1

12. © 2004 McGraw–Hill Ryerson Limited The Effect of Expansionary Monetary Policy Expansionary monetary policy Increases AD 1 to AD 2 the recessionary gap (Y FE - Y E ) is thereby closed Expansionary monetary policy Increases AD 1 to AD 2 the recessionary gap (Y FE - Y E ) is thereby closed Potential GDP AS AD 1 AD 2 Y FE YEYE P Figure 12.2

13. © 2004 McGraw–Hill Ryerson Limited Criticisms of Keynesian Monetary Policy The twin goals of full employment and stable prices are incompatible and it may not be possible to achieve them together The best that a central bank can do is achieve a delicate balance between the two without ever attaining either goal

14. © 2004 McGraw–Hill Ryerson Limited Anti-Inflationary Monetary Policy (I) The Bank of Canada now sees its role as preserving both the internal and external value of the currency. Controlling inflation is done by keeping the pace of monetary expansion in line with economic growth and, occasionally, by using contractionary monetary policy

15. © 2004 McGraw–Hill Ryerson Limited Anti-Inflationary Monetary Policy (II) This results in higher interest rates, which encourages foreigners to hold Canadian securities, which increases the demand for the Canadian dollar, causes a rise in the Canadian dollar and leads to a decrease in net exports With fixed exchange rates, monetary policy cannot be used to bring about the change in the domestic economy

16. © 2004 McGraw–Hill Ryerson Limited Anti-Inflationary Monetary Policy (III) Tight money Higher r Lower I Lower AD Low inflation Higher D for CA$ Higher ER of CA$ Lower netX

17. © 2004 McGraw–Hill Ryerson Limited Criticisms of Anti-Inflationary Monetary Policy Because the Bank of Canada is overly concerned about controlling inflation, it will lose sight of other equally valid goals such as economic growth and low unemployment Raises the question of lags –It takes time for for the effect of monetary policy to be felt in the economy Monetary changes have an uncontrollable impact on the economy

18. © 2004 McGraw–Hill Ryerson Limited The Non-Activist School (I) The focus is on ensuring that the quantity of money supplied is kept equal to the quantity of money demanded. This would imply a constant interest rate They believe that not only should interest rates be held constant, but that target should be announced to the world

19. © 2004 McGraw–Hill Ryerson Limited The Non-Activist School (II) A variation to the same approach would be for the central bank to maintain a constant, pre-announced pace of monetary expansion and have the interest rate adjust to maintain the balance between quantities of money demanded and quantities of money supplied

20. © 2004 McGraw–Hill Ryerson Limited Criticisms of the Non-Activist School While the objective is stability in the money markets, the result may be instability in the economy The reason for this is that fixing the growth in the money supply is not of much use if you cannot also control the demand for money A changing demand for money will cause interest rates to change unpredictably

21. © 2004 McGraw–Hill Ryerson Limited Beyond Fiscal and Monetary Policy Stagflation –The simultaneous occurrence of high inflation and unemployment –It is caused by a decrease in the short-run aggregate supply, which could be caused by a significant increase in the price of imported resources such as oil

22. © 2004 McGraw–Hill Ryerson Limited The Cause of Stagflation Y2Y2 Y1Y1 Potential GDP AS 2 AS 1 AD P1P1 P2P2 A leftward shift in AS will result in: lower GDP higher P A leftward shift in AS will result in: lower GDP higher P Figure 12.4

23. © 2004 McGraw–Hill Ryerson Limited Aggregate Demand and Stagflation Potential GDP A leftward shift in AD will result in lower P, but also lower GDP A rightward shift in AD will result in higher GDP, but also higher P. A leftward shift in AD will result in lower P, but also lower GDP A rightward shift in AD will result in higher GDP, but also higher P. Figure 12.5 Y2Y2 Y1Y1 AS AD 1 P1P1 P2P2 AD 2 AD 3 Y3Y3 P3P3

24. © 2004 McGraw–Hill Ryerson Limited Direct Controls (I) They take the form of specific laws, rules, and regulations designed to modify the way people behave They usually affect the supply side of the economy

25. © 2004 McGraw–Hill Ryerson Limited Direct Controls (II) They include: –Tax incentive programs Tax changes that help stimulate people’s incentive to work and save, and businesses to invest more –Pro-competition policies These are aimed at loosening the power of big corporations and trade unions in order to make the marketplace more competitive and enable it to more easily adjust to the changing pattern of demand and technology –Employment policies These include policies designed to increase the amount of employment and to reduce the natural rate of unemployment

26. © 2004 McGraw–Hill Ryerson Limited the various functions of Canada’s central bank - the Bank of Canada the role of monetary policy and how the Bank of Canada influences interest rates why monetary policy is needed the arguments for and against –the activist approach to monetary policy –the non-activist approach to monetary policy why some argue that other direct controls are needed as alternatives to both fiscal and monetary policy Chapter Summary: What to Study and Remember