Chapter 12 Bank of Canada and Monetary Policy

Bank of Canada  deos.html deos.html

Monetary Policy  A process by which the government affects the economy by influencing the expansion of money and credit

Central Banks  A public authority charged with regulating and controlling a country’s monetary and financial institutions and markets  Two Models: Independence: complete autonomy to determine nation’s monetary policy Subservience: in the event of a difference of opinion, the Government has the final say

The Bank of Canada Canada’s “Biggie” Bank  Canada’s central bank, in operation since 1935 During great depression  Aimed to add stability to system and prevent a run on chartered banks

The Bank of Canada Canada’s “Biggie” Bank  Originally the bank was expected to: Regulate credit and currency Control external value of the Canadian Currency Reduce fluctuations in production, trade, prices and inflation

Structure of the BofC  The Governor (Mark Carney – 7 year term)  Board of Directors (meet once a month)  Senior Staff (economists and central bankers with considerable national and international experience) Please let the economy recover

Key roles of BofC  To control the amount of money circulating in the economy  Deciding and implementing monetary policy  Issuing paper currency  affecting the activities of chartered banks to adjust the interest rate and the supply of money

Inflation  Inflation Premium  Interest rates take into account inflation  Therefore interest rates have an inflation premium built in

Interest rates  Two components Nominal Rate of interest  Premium for risk of non repayment  Premium for delayed consumptions Inflation Premium  Expected rate of inflation  Real Rate of interest Nominal – Inflation Premium

Inflation and interest rates  A dollar tomorrow is worth less than dollar today  Ex you borrow $1000 (interest free)  Inflation is 4% per annum  You repay $1000 in a year  In terms of purchasing power you have paid back $960 = ($1000 – ($1000 x 4%)  Inflation hurts lenders (why?)

Interest rates  Inflation premium is key component of any interest rate  An interest rate should be at least be equal to the rate of inflation to protect the purchasing power of the money

Interest rates  How do interest rates affect purchases?  What type of purchases should you finance with debt?  What effect do interest rates have on the dollar?  How do interest rates effect government spending?

Interest rates How do they affect demand?  When rates rise major purchases become more expensive  When rates rise investments become less attractive Rate of Return = 7% Interest Rate = 3% Rate of Return = 7% Interest Rate = 7%  When rates rise governments (tax payers) pay more for borrowed money

Interest rates How do they affect supply for money?  When rates increase savings rates increases increases amount available for banks to loan Decreases amount in circulation (spend less)  When rates increase banks want to lend more

Types of interest rate  Prime rate: Rate offered by commercial banks to their best customers (?) Prime plus “x”  Bank rate: Rate charged by bank of Canada to chartered banks  Overnight Rate: The main tool used by the BofC. Key way of indicating monetary policy

Overnight Rate  Overnight rate Tool of monetary policy The rate that large financial institutions borrow money from each other Operating band – difference between Bank of Canada’s loan rate (bank rate) 4% and their interest rate 3.5% Therefore the overnight rate is somewhere between 3.5% and 4% Overnight rate is less than the bank rate so it encourages banks to lend to one another rather than from the BOC.  What happens if the Bank of Canada increases the bank rate?

Decrease in Overnight Rate 1. Dollar goes down and Interest Rates Drop 2. Increase in demand 3. Increase prices 4. Rate of inflation increased STIMULATES THE ECONOMY

Increase in Overnight Rate 1. Dollar goes up and Interest Rates go up 2. Decrease in demand 3. Decrease prices 4. Rate of inflation decrease SLOWS THE ECONOMY

Monetary Policy  Easy Money: Increase the money supply (expansionary)  Tight Money: Restricts the money supply (contractionary)

Tight Money  Used when economic times are good Sales are up Employment is up Investment is up  Commercial banks are willing to lend money  Too much money in the economy will cause inflation  Limiting the money supply will slow the economy down

Easy Money  Used when economic times are bad Sales are down Employment is down Investment is down  Commercial banks are scared to lend money  Too little money in the economy will cause deflation  Increasing the money supply will jump start the economy

When to apply monetary policy Easy Money Tight Money

Bank Rates vs GDP

Classwork  Read P question 1-6

Easy Money Policy  4 stages Stage 1:  Bank shifts money to the chartered banks to increase reserves and encourage lending Stage 2:  Lower interest rates to encourage more borrowing for large purchases (homes, car, education, business, etc.). Business then responds by investing and borrowing more.

Easy Money Policy Stage 3:  Increased borrowing = increased money supply resulting in increased output (GDP) Stage 4:  This increases aggregate demand and GDP leading to full employment

Tight Money Policy  4 stages Stage 1: Banks takes it’s deposits from chartered banks back to the BOC This means less money for banks to lend This leads to decreased money supply resulting in increased interest rates Stage 2: Higher interest rates =less borrowing Business responds by cutting back (stock, equipment, expansion)

Stage 3: Less borrowing = less money supply Stage 4: Decreased spending by consumers and businesses shifts AD to the left This results in decreased prices (deflation)

Hardship Caused by Inflation  Pressure  Sadness Not enough  Fear  Divorce  Marriages of convenience  Bankruptcy  Lay offs  Welfare  Raise Taxes  Resentful  Affected everyone

Mark Carney and the 3 bears I want the Economy … Not too Hot (Inflation) Not too cold (Unemployment) Just Right! (Full Employment) I hate Bear markets!

Aggregate Demand and Aggregate Supply Graph  AD AS curve shows the Total amount of supply and demand for economy Price level Real GDP (Output) AS AD

Aggregate Demand and Aggregate Supply Graph  The AS curve goes vertical because there is a limit (CP) to production Price level Real GDP (Output) AS AD

Aggregate Demand and Aggregate Supply Graph  FE: Full employment. In Canada approx 6-7% unemployment. 1-3% Inflation. Price level Real GDP (Output) AS AD FE

Aggregate Demand and Aggregate Supply Graph  If AD < FE then there is a recession. Low inflation/deflation. High Unemployment Price level Real GDP (Output) AS FE AD

Aggregate Demand and Aggregate Supply Graph  If AD > FE then there is a boom. High inflation. Low unemployment Price level Real GDP (Output) AS FE AD

Monetary Policy (Easy Money) P Bank shifts government deposits to chartered banks. Increasing their reserves. Banks able to lend more. 2. Lower interest rates. Encourages borrowing. 1. Consumers spend on big ticket items goods 2. Businesses spend on capital goods (equipment) 3. Borrowing and spending by increases money supply. Which triggers more borrowing and spending

Monetary Policy (Easy Money) 4. Increased spending shifts AD1 to AD2 thus reaching FE Price level Real GDP (Output) AS AD2 FE AD1

Monetary Policy (Tight Money) P Bank shifts government deposits from chartered banks. Decreasing their reserves. Banks lend less. 2. Increase interest rates. Discourage borrowing. 1. Consumers delay on big ticket items goods 2. Businesses delay on capital goods (equipment) 3. Less borrowing and spending decreases money supply. Which triggers less borrowing and spending

Monetary Policy (Easy Money) 4. Decrease spending shifts AD1 to AD2 thus ending high inflation Price level Real GDP (Output) AS AD2 FE AD1

Homework  P  P273 4 and 5  P276 1, 2 3  P279 2

P268 question The bank of Canada insists on the right to issue currency in order to meet its function of controlling inflation 2. Accounts at the Bank of Canada 1. Chartered Banks: Settle debts among themselves. Location for short term loans 2. Federal Government: 1. Allows monetary policy 2. Deposit the proceeds of bond payments 3. Paying interest on bonds 4. Holding foreign reserves

P268 question The BofC provides confidence to the financial system. In the case of a run on the bank the central bank could “bail out” a bank 4. Spending and Creating money are kept separate in order to resist the temptation to print money to pay for spending

P268 question The Minister of finance is accountable to the voters and the PMO. The Governor of the BofC is accountable to the Minister 6. A directive would show a lack of confidence in the BofC.

Beware of the Ninja!

N o I Ncome No J Ab Loan

P273 4  Real = Nominal - Expected  A) Nominal interest rate: 7%  B) Real interest rate : 4%  C) Real interest rate: 3%

P273 5  Because they want to ensure that the funds when paid back have at least the same purchasing power as when they were loaned

P276 1, The main tool to control inflation is interest rates. Price stability is key to healthy long term growth 2. Operating Band: Difference between the bank rate (what banks pay BofC) and the rate that BofC pays on deposits. Overnight rate sits in the middle 3. Bonds = assets / Deposits of the Chartered Bank = Liabilities

P  Easy money pressures interest rates down  Tight money pressures interest rates up