Monetary Policy In Action: The Bank of Canada’s Monetary Tools

Good economic times stimulate Canadians (consumers, businesses) to borrow more Banks willing to lend more to credit-worthy borrowers Result: money supply expands : more bank deposit $ created to supply desire to spend more BUT… Expansionary growth comes with higher prices for goods as inflation creeps in – consumers & producers could fuel demand so much that prices rise throughout entire economy (severe inflation)

Bank of Canada responds… Bank plays “party pooper” Raises interest rates to restrain borrowing/ slow down growth of money supply BUT Too much restraint, badly timed, could throw economy into recession Bank’s goal is to slow growth, not end it Also works in reverse when economic growth shows signs of slowing down

“Easy” vs. “Tight” Money “Easy money”: – policy of low interest rates, easier credit, growth of money supply – used to curb recessions, stimulate econ. growth “Tight money”: – Higher interest rates, more difficult credit, decrease of money supply – used to restrain growth, curb inflation

“Tight Money” to reduce inflation “Easy money” to stimulate economy

Canada’s Inflation Target Canadian government attempts to keep inflation rate between 1% and 3% “Sweet spot” is thus a rate of 2% When inflation begins to move too far away from 2% target, government will “step in” with monetary policy tools to re-balance inflation rate

Interest Rates: The Main Tool of Monetary Policy Interest:the price paid for a loan Demand for loanable funds comes from: consumers, businesses, governments Rates affect (and are affected by) the laws of supply and demand (ie. shifting curves)

Importance and Impact of Interest Rates Affect consumer decisions about both borrowing and saving money; ex. the higher the rate, the less we borrow Affect business decisions to invest in expanding, buying new machinery Affect the value of the Canadian dollar internationally – higher interest rates attract more foreign investors, increasing demand for Canadian $ Affects gov’t budgets – the more $ necessary to pay for interest on gov’t debts, the less $ for spending on social programs

Types of Rates 1. Prime rate: lowest rate offered by a bank to its best customers (ex. large firms) benchmark for loans to other customers (ex. “prime plus ____%”), depending on credit- worthiness

Types of Rates, cont’d… 2. Bank rate: interest rate the Bank of Canada charges the chartered banks for loans when Bank rate rises, chartered banks respond by raising their customers’ rates; when Bank rate falls, chartered banks’ rates fall

Types of Rates, cont’d… 3. Nominal Interest rate: Rate that builds in a premium (extra %) to cover inflation + allowance for risk Ex. 4% (Bank rate) + 3% premium = 7% nominal rate VS. 4. Real rate of interest: Nominal rate – expected rate of inflation = real rate of interest

Types of Rates, finis… 5. the “Overnight rate”: Interest rate charged by banks for short-term (“overnight”) loans between them rate is controlled (“set”) by Bank of Canada Bank uses overnight rate target to signal chartered banks which direction it wants monetary policy to move Ex. overnight rate rises; gov’t signals it’s worried about inflation; Result: chartered banks raise their interest rates; rate of inflation drops as borrowing (& consumption) by consumers, businesses decreases

One other tool… Bonds Bond: an IOU issued by a borrower to repay borrowed $ by a fixed date Gov’t of Canada sells bonds to Bank of Canada (gov’t is borrower) Gov’t uses the $ borrowed from bond sales to increase the money supply, and stimulate the economy Gov’t repays the bond (and interest) from increased tax revenues collected from a rejuventated economy (theoretically…)

READ & DO !!!! Theoretical Dynamics of Interest Rates: a)READ p b) DO Qu.#1-3 on p. 273 What the Bank of Canada tries to do: a)READ p b)DO make notes (with diagrams to illustrate) the STAGES that occur when central banks adopt a “tight money” monetary policy or an “easy money” monetary policy