Chapter 29: Monetary Policy in Canada Copyright © 2014 Pearson Canada Inc.

Chapter Outline/Learning Objectives Section Learning Objectives After studying this chapter, you will be able to 29.1How the Bank of Canada Implements Monetary Policy 1.explain why the Bank of Canada chooses to directly target interest rates rather than the money supply. 29.2Inflation Targeting2.understand why many central banks have adopted formal inflation targets. 3.explain how the Bank of Canada's policy of inflation targeting helps to stabilize the economy. 29.3Long and Variable Lags 4.describe why monetary policy affects real GDP and the price level only after long time lags. 29.4Thirty Years of Canadian Monetary Policy 5.discuss the main economic challenges that the Bank of Canada has faced over the past three decades. Copyright © 2014 Pearson Canada Inc. 2 Chapter 29, Slide

29.1How the Bank of Canada Implements Monetary Policy Money Supply Versus the Interest Rate For any given money demand curve, any central bank must choose between: targeting the money supply targeting the interest rate Both cannot be targeted independently. Copyright © 2014 Pearson Canada Inc. 3 Chapter 29, Slide

Fig Two Approaches to the Implementation of Money Policy 4 Copyright © 2014 Pearson Canada Inc. Chapter 29, Slide

Money Supply Versus the Interest Rate The Bank of Canada chooses to implement its monetary policy by targeting interest rates (rather than the money supply) because: 1.The Bank can influence an interest rate more easily than it can affect the money supply. 2.Instability of money demand. 3.Easier to communicate its policy through changes in interest rates. But which interest rate (of many) does the Bank target? 5 Copyright © 2014 Pearson Canada Inc. Chapter 29, Slide

The Bank of Canada and the Overnight Interest Rate The Bank can more or less control the overnight interest rate. It does this by: 1.Setting a target for the overnight interest rate 2.Establishing the bank rate 0.25% above this target 3.Establishing a borrowing rate 0.25% below target  keep actual overnight rate within 0.5% band 6 Copyright © 2014 Pearson Canada Inc. Chapter 29, Slide

Fig The Overnight Interest Rate: Target and Actual 7 Copyright © 2014 Pearson Canada Inc. Chapter 29, Slide

The Money Supply is Endogenous As the Bank changes its target for the overnight rate: other interest rates change bank lending changes banks' demand for currency changes  the Bank responds by supplying currency or buying currency from commercial banks  the need for open-market operations 8 Copyright © 2014 Pearson Canada Inc. Chapter 29, Slide

But these transactions are done passively by the Bank of Canada:  the money supply is endogenous 9 Copyright © 2014 Pearson Canada Inc. APPLYING ECONOMIC CONCEPTS 29-1 What Determines the Amount of Currency in Circulation? Chapter 29, Slide

Expansionary and Contractionary Monetary Policies An expansionary monetary policy occurs when the Bank of Canada reduces its target for the overnight interest rate.  eventually increases M S (or its growth rate) An expansionary monetary policy occurs when the Bank of Canada increases its target for the overnight interest rate.  eventually decreases M S (or its growth rate) 10 Copyright © 2014 Pearson Canada Inc. Chapter 29, Slide

Fig The Monetary Transmission Mechanism 11 Copyright © 2014 Pearson Canada Inc. Chapter 29, Slide

29.2Inflation Targeting Why Target Inflation? Over the past few decades, central banks have come to realize two things: 1.High inflation is costly for individuals and damaging for economies. 2.Inflation is the one variable on which monetary policy can have a systematic and sustained influence. Copyright © 2014 Pearson Canada Inc. 12 Chapter 29, Slide

Why Target Inflation? Recognition of these points has led many central banks to adopt formal inflation targets: New Zealand (1990) Canada (1991) Israel, U.K., Australia Finland, Spain, Sweden plus many others Canada has renewed its inflation targets several times since 1991: the current target of 2% lasts until Copyright © 2014 Pearson Canada Inc. Chapter 29, Slide

The Role of the Output Gap In the short run, when an output gap opens, the Bank has two choices: allow the adjustment process to operate intervene with monetary policy Since output gaps put pressure on inflation, the Bank monitors the output gap and may intervene in order to keep output near potential thereby keeping inflation within the target band 14 Copyright © 2014 Pearson Canada Inc. Chapter 29, Slide

15 Copyright © 2014 Pearson Canada Inc. Time 1% 3% Inflation Rate Inflation target band t1t1 t0t0 t2t2 t3t3 2% Output Gap 0 Time Bank's policy closes gap Positive shock opens gap Bank's policy closes gap Negative shock opens gap Chapter 29, Slide

Inflation Targeting as a Stabilizing Policy As the previous diagram suggests, inflation targeting tends to stabilize output: in response to a positive output shock, the Bank tightens policy in response to a negative output shock, the Bank loosens policy  policy tends to keep output close to Y* But this is not automatic stabilization—the Bank must actively change policy. 16 Copyright © 2014 Pearson Canada Inc. Chapter 29, Slide

Complications in Inflation Targeting Inflation targeting is complicated by two factors: 1.Volatile Food and Energy Prices prices of many goods included in CPI are determined in world markets these may change suddenly for reasons unrelated to Canadian output gaps  the Bank also monitors core inflation 17 Copyright © 2014 Pearson Canada Inc. Chapter 29, Slide

Fig. 29-4Canadian CPI and Core Inflation, 1992– Copyright © 2014 Pearson Canada Inc. Chapter 29, Slide

2.The Exchange Rate and Monetary Policy the Bank must identify the cause of any exchange rate change before determining the appropriate policy response consider an appreciation of the Canadian dollar caused by an increase in demand for exports or an appreciation of the Canadian dollar caused by an increase in demand for Canadian bonds 19 Copyright © 2014 Pearson Canada Inc. Chapter 29, Slide

Financial Crisis and Recession: 2007–Present The decline in U.S. house prices that began in early 2007 led to widespread losses in financial institutions. Central banks responded with quite expansionary (and also creative) monetary policies, designed to maintain the smooth functioning of credit markets. The losses and failures of many financial institutions created severe disruptions in the global credit markets. The subsequent recession led to both monetary and fiscal expansions in all of the G20 countries. 20 Copyright © 2014 Pearson Canada Inc. Chapter 29, Slide

By 2012, three years into a modest recovery, the Bank of Canada still had a historically low target for the overnight interest rate. The weakness of the U.S. and European economies at that time were offsetting the stronger economic performance within Canada. 21 Copyright © 2014 Pearson Canada Inc. Chapter 29, Slide

Review In practice, it is not possible for the Bank of Canada to control the money supply because A) it cannot control the process of deposit creation carried out by the commercial banks. B) the resulting effects on the value of the Canadian dollar are difficult to predict. C) it cannot control the amount of cash reserves that are injected into or withdrawn from the banking system. D)it does not have the legal power to do so. E)None of the abovethe Bank of Canada could control the money supply if it chose to do so. 22 © 2014 Pearson Education Canada Inc.

Refer to Figure If the Bank of Canada raises the target interest rate to 3%, as shown in part (i), then it must accommodate the resulting ________ in quantity of money demanded by ________ in financial markets. A) increase; selling government securities B)decrease; buying government securities C) decrease; selling government securities D) increase; buying government securities 23 © 2014 Pearson Education Canada Inc.

Review Suppose the Bank of Canada announces its target for the overnight interest rate at 2.5%. In that case, the Bank of Canada is willing to lend to commercial banks at ________% and is willing to pay ________% on deposits it receives from commercial banks. A) 2.5; 2.5 B) 3.5; 1.5 C) 2.75; 2.25 D) 2.5; 2.0 E) 2.25; © 2014 Pearson Education Canada Inc.