1. Interest Rate vs Money Supply
Monetary Policy
Interest Rate vs Money Supply

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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”