1. Monetary Policy in Canada
Chapter 29
Monetary Policy in Canada
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2. In this chapter you will learn
1. why the Bank of Canada chooses to set interest rates rather than directly influence the money supply.
2. how changes in the Bank of Canada’s target for the overnight interest rate affect longer-term interest rates.
3. why many central banks have adopted formal inflation targets.
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3. In this chapter you will learn
4. how the Bank of Canada’s policy of inflation targeting helps to stabilize the economy.
5. why monetary policy affects real GDP and the price level only after long time lags.
6. about the main economic challenges that the Bank of Canada has faced over the past three decades.
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4. 29.1 HOW 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:
- setting the money supply
- setting the interest rate
Both cannot be set independently.
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6. How could the Bank of Canada actually try to increase the MS?
1. Simply lend reserves to commercial banks
Open Market Operations
1. B of C buys G of C bonds in the open market
2. B of C pays for the bonds by writing a cheque cashable at the B of C
3. Seller of G of C bonds deposits the cheque in her commercial bank account
4. Her commercial bank deposits the cheque at the B of C – commercial bank reserves have just increased
How to decrease the MS? Do the reverse
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7. 2. the instability of money demand.
Actually, the Bank of Canada chooses to implement its monetary policy by setting interest rates because:
1. the Bank can influence an interest rate more easily than it can affect the money supply.
2. the instability of money demand.
3. it is easier to communicate its policy through changes in interest rates.
Trying to control the money supply turns out to be too imprecise in practice.
But which interest rate (of many) does the Bank influence?
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8. the Overnight Interest Rate
The Bank of Canada and
the Overnight Interest Rate
The Overnight Interest Rate
Commercial banks borrow and lend reserves to each other overnight.
The Overnight Interest Rate is the interest rate in this overnight market.
You can think of this rate as the cost of reserves to commercial banks.
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9. 1. Setting a target for the overnight interest rate
The Bank of Canada 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
B of C will lend any amount of reserves at this rate
3. Establishing a borrowing rate 0.25% below target
B of C will borrow any amount of reserves at this rate
 keep actual overnight rate within 0.5% band
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10. Setting the Overnight Rate
B of C will lend any amount of reserves at the Bank Rate,
so the Overnight Rate should never go above the Bank Rate
Overnight Rate
B of C will borrow any amount of reserves at the Target Rate less 0.25%,
so the Overnight Rate should never go below the Bank Rate RS
excess supply
Bank Rate
Target rate •
B of C covers any excess supply of or excess demand for reserves.
Can it really do this? Yes.
TR-0.25% RD
excess demand
Quantity of Reserves
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11. Copyright © 2011 Pearson Canada Inc.
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Copyright © 2011 Pearson Canada Inc.

12. The Money Supply Is Endogenous
As the Bank of Canada changes its target for the overnight rate:
- other interest rates change (very quickly)
- bank lending changes (more slowly)
- banks’ demand for currency changes (as lending changes)
 the Bank of Canada responds by supplying currency or buying currency from commercial banks
 the need for open-market operations
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13. What Determines the Amount of Currency in Circulation?
But these transactions are done passively by the Bank of Canada:
 the money supply is endogenous
APPLYING ECONOMIC CONCEPTS 29-1
What Determines the Amount of Currency in Circulation?
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14. 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 MS (or its growth rate)
A contractionary monetary policy occurs when the Bank of Canada increases its target for the overnight interest rate
 eventually decreases MS (or its growth rate)
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15. Why Target Inflation? 29.2 INFLATION TARGETING
Over the past few decades, central banks have come to realize two things:
1. High inflation is costly for individuals and damaging for economies.
- affects those on incomes fixed in nominal terms
- high inflation is associated with volatility in inflation (unexpected inflation) results in real income reallocation – borrowers/lenders, workers/firms, etc.
- distorts our ability to perceive relative price changes
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16. Why Target Inflation?
Over the past few decades, central banks have come to realize two things:
2. Inflation is the one variable on which monetary policy can have a systematic and sustained influence.
exogenous AD and AS shocks can cause isolated periods of inflation but only accommodating monetary policy can cause sustained inflations.
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17. Monetary policy can have short-run real effects and
Price Level
AS0
Monetary policy can have
short-run real effects and
is useful in helping end
recessions. • P1 E1
AD1 P0 • E0
AD0 Y0 Y*
Real GDP
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18. Monetary policy can have short-run real effects and
is useful in helping end
inflationary booms
but it cannot directly affect Y*
Price Level
AS0 E0 • P0 P1 • E1
AD0
AD1 Y* Y0
Real GDP
How does the B of C know that a positive or negative output gap exists?
It monitors the rate of inflation
Why not output or employment/unemployment?
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19. Canada has renewed its inflation targets several times since 1991:
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 1% lasts until December 2011
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20. 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
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21. Output Gap Time 3% Inflation Rate Inflation target band 2% 1% Time
Positive shock opens gap
Bank’s policy closes gap
Output Gap
Time
Bank’s policy closes gap
Negative shock opens gap 3%
Inflation Rate
Inflation target band 2% 1% t0 t1 t2 t3
Time
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22. 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.
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23. 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
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24. Copyright © 2011 Pearson Canada Inc.24
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Copyright © 2011 Pearson Canada Inc.

25. 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
(contractionary monetary policy)
- or an appreciation of the Canadian dollar caused by an increase in demand for Canadian bonds
(expansionary monetary policy)
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26. The appropriate response by the Bank would be different in these two cases.
For a more detailed discussion of how movements in the
exchange rate complicate the implementation of monetary
policy, look for “Monetary Policy and the Exchange Rate
in Canada” in the Additional Topics section of this book’s
MyEconLab.
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27. Not in Text 3. Asset price bubbles
What if the money supply is increased and interest rates fall but the lower interest rates and increased credit do not lead to an increase in the demand for current output?
What if the lower interest rates and increased credit lead for an increase in the demand for existing assets (houses, real estate, ‘dot com’ stocks, equities, gold, etc).
If the central bank is targeting inflation it will largely miss this asset price inflation – it could easily start a price bubble for a class of assets. People buying the asset whose price is rising with borrowed money (speculating) – the price bubble burst, the asset price falls and they default on their borrowings. (money is credit) The banking system is in now trouble. Sound familiar?
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28. What Are the Lags in Monetary Policy?
LONG AND VARIABLE LAGS
What Are the Lags in Monetary Policy?
Monetary policy operates with a time lag that is long and variable for two main reasons:
changes in expenditure take time
the multiplier process takes time
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29. Two Views on the Role of Money in the Great Depression
LESSONS FROM HISTORY 29-1
Two Views on the Role of Money in the Great Depression
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30. Destabilizing Policy?
Long and variable lags  some monetarists argued that central banks should not try to stabilize national income.
They argued that attempts to stabilize will more likely be destabilizing
- they advocate the use of a monetary rule
- increase bank reserves at a constant rate
Most economists now agree that monetary policy can lead to more economic stability. ????
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31. Bank of Canada’s target inflation band
Political Difficulties
Rate of Inflation 3%
Actual Inflation
Bank of Canada’s target inflation band A • 1%
Inflation Forecast
Current Period
Time
Monetary policy must be forward-looking.
 often creates difficulties when policy is tightened now because of expected future inflation
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32. 29.4 30 YEARS OF CANADIAN MONETARY POLICY OPTIONAL Early 1980s:
- inflation reached 12 percent as a result of OPEC oil shocks in the mid and late 1970s
- the Bank embarked on a strict policy of monetary restraint
- but unanticipated surge in money demand led to a much tighter monetary policy than intended
 the most serious recession since the 1930s
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33. OPTIONAL
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34. Economic Recovery: 1983-1987 Rising Inflation: 1987-1990 OPTIONAL
The main challenge was creating sufficient liquidity to accommodate the recovery without triggering a return to the high inflation rates.
Rising Inflation:
Inflation crept upwards throughout the late 1980s.
Many economists argued the need for tightening monetary policy.
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35. Disinflation: 1990-1992 OPTIONAL
The Bank of Canada embarked on its stated policy of “price stability.”
When the tight monetary policy took effect:
- interest rates increased
- the Canadian dollar appreciated
- inflation fell suddenly
The economy entered a significant recession in the early 1990s.
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36. Inflation Targeting I: 1991-2000
OPTIONAL
The ensuing economic recovery was quite gradual:
- excessive stimulation could have led to a return of inflation
- insufficient stimulation could have caused the economy to stall
Beginning in 1996, the recovery was more robust and inflation remained well within the 1 to 3 percent target band.
By 2000, Canadian GDP was near its potential level and inflation was just below 2 percent and quite stable.
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37. Two issues complicated monetary policy in the late 1990s: OPTIONAL
1. The Asian Crisis
This presented a (confusing) combination of aggregate demand and aggregate supply shocks.
2. The Stock Market
The “bull market” of the late 1990s presented some challenges — how should monetary policy respond?
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38. Inflation Targeting II: 2001-Present
OPTIONAL
The terrorist attacks of 9/11 presented substantial challenges for monetary policy:
- the U.S. economy was already slowing down
- policy interest rates were dramatically reduced
The period presented other challenges:
- commodity prices were rising sharply
- U.S. dollar was weakening against most currencies
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39. OPTIONAL With the success of many central banks in maintaining
low and stable inflation, some economists have raised
the concern that inflation may now be “too low,” and that
the economy may actually function more smoothly with
slightly higher inflation. For more details about this
contentious debate, look for “Can Inflation Be Too Low?”
in the Additional Topics section of this book’s MyEconLab.
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