CHAP 13

• Monetary Policy Implementation Approaches

  • Target the money supply
  • Target the interest rate

  
• For a given MD curve, both money supply and interest rate cannot be targeted independently

  
• Overnight interest rate


  The interest rate that commercial banks charge one another for overnight loans
• The Bank of Canada targets the interest rate because it can control it
• Uncertainty about the slope and position of the MD curve does not prevent the Bank of Canada from establishing its desired interest rate
• The Bank of Canada can easily communicate its interest-rate policy to the public
• The Bank of Canada influences the overnight interest rate


  It also influences the longer-term interest rates that are more relevant for determining aggregate consumption and investment expenditure
• The Bank establishes a target for the overnight interest rate and announces this target 8 times per year
• The Bank announces the bank rate, which isan interest rate that is 0.25 percentage points above the target rate
• The Bank promises to lend at the bank rate any amount that commercial banks want to borrow
• The actual overnight interest rate stays within the 0.5-percentage-point range centred around the target rate

  
• When the Bank of Canada changes its target for the overnight rate, the change in the actual overnight rate happens almost instantly
• Changes in other market interest rates also happen very quickly
• As the demand for new loans gradually adjusts to the new lower interest rate, commercial banks often find themselves in need of more cash reserves
• Open-market operations

  1. Sell government securities for cash

  2. Extend new loans with cash
• The money supply is the sum of bank deposits and currency in circulation - its endogenous
• The amount of bank deposits is not directly controlled by the Bank of Canada. But instead is determined by the economic decisions of households, firms, and commercial banks.

  They're passive in their decisions
• The Bank of Canada conducts its open-market operations to accommodate the changing demand for currency
• Reducing the overnight interest rate is an expansionary monetary policy - stimulate AD
• Raising the overnight interest rate is a contractionary monetary policy - reduce AD
• Monetary policy influences aggregate demand

  Through the monetary transmission mechanism
• The Bank of Canada monitors the output gap to keep inflation close to its formal 2 percent target
• Persistent output gaps generally create pressure for the rate of inflation to change
• Positive shocks to the economy that create an inflationary gap will be met by contractionary monetary policy
• Negative shocks to the economy that create a recessionary gap will be met with expansionary monetary policy
• "Divine coincidence" - Inflation targeting tends to stabilize the rate of inflation around its target and stabilize real GDP around potential output
• The volatility of food and energy prices is often unrelated to the level of the output gap in Canada
• Changes in the exchange rate can signal the need for changes in the stance of monetary policy
• Monetary policy operates with a time lag that is long and variable
• Reasons for long and variable lags in monetary policy

  • Changes in expenditure take time
  • The multiplier process takes time
• The Bank of Canada must design its policy for what is expected to occur in the future rather than what's been observed
• The extensive time lags in the effectiveness of monetary policy increase the difficulty of stabilizing the economy
• Monetary policy may have a destabilizing effect
• Time lags in monetary policy require that decisions be forward-looking
• Inflation reached 12% as a result of OPEC oil shocks


  Early 1980s
• The Bank embarked on a strict policy of monetary restraint in the early 1980s
• Unexpected increases in money demand led to a sharper increase in interest rates than intended by the Bank in the early 1980s
• The main challenge during the economic recovery from 1983 to 1987 was creating enough liquidity to accommodate the recovery without triggering high inflation rates
• Inflation crept upwards throughout the late 1980s
• Governor John Crow announced that monetary policy would be guided more by the goal of long-term price stability in the late 1980s