Interest Rate vs Money Supply Monetary Policy Interest Rate vs Money Supply

Recall monetary transmission mechanism It is the interest rate that influences consumption/investment/net export Recall the liquidity preference theory of interest Money supply + money demand determine equilibrium interest rate Add some details, and this will become more complicated Central bank can influence money supply Print money Open-market operations Cannot influence money demand that much And does not even know that well what the money demand is at the moment Can influence interest rate And let money supply adjust

A summary of can and can’t for a central bank: Money supply: Deposit creation cannot be controlled MD is not know, just roughly estimated. And changing. Slope Position Money Demand – out of consideration Interest rate Central bank controls overnight interest rate Don’t need to know the curves in order to establish Can easily be communicated

The Bank of Canada controls overnight interest rate Rate the commercial banks borrow from each other and from Bank of Canada for short period To adjust reserves The Bank of Canada uses target overnight rate to conduct policy It is called the Bank of Canada’s policy instrument The target is midpoint of 0.5% range Target range Announced at 8 FADs a year Upper end of the range Called the bank rate Can borrow from the Bank of Canada as much as you want Lower end of the range Can deposit with the Bank of Canada as much as you want And earn that rate It is controlled very tightly Banks would not borrow/lend outside the range All other interest rates adjust

So suppose the Bank of Canada set the overnight rate The commercial banks will then adjust their loans to reflect the new rate To do that they will need to adjust their reserves Lower interest rate Increased loans Lags, takes time More reserves are desired by commercial banks The banks sell securities (government bonds) The Bank of Canada buys securities through open-market operations There’s more money in circulation More deposits created Money supply increases Money supply is endogenous The Bank of Canada passively expands money supply

Back to monetary transmission mechanism Bank of Canada: set the rate (say lower) Other interest rates adjust Consumption up Big ticket items Investment up More projects undertaken Net export up Capital outflow Exchange rate Relative prices Positive AD shock New (higher) P and Y Because interest rate, not money supply is the instrument, a policy is contractionary if it increases interest rate, and expansionary if it lowers interest rate Not contractionary if it decreases money supply, and expansionary if it increases money supply Although, it does

High inflation is not good Inflation Targeting: High inflation is not good Arbitrary income redistribution Volatility => uncertainty Bank of Canada targets inflation 2% target these days It does targeting by closely watching output gaps and reacting if the gaps are going to cause inflation outside inflation target band This is hard The developments are hard to predict And there are conflicting objectives But committing to the target is a stabilizing policy Public/businesses know that the Bank will respond in predictable manner

Complications for inflation targeting Volatile food and energy prices Core inflation vs CPI inflation Exchange rate Need to know where changes come from Monetary policy has lags, just as fiscal policy does Read “30 years of Canadian Monetary Policy”