Transcript document

Chapter 12
Bank of Canada and
Monetary Policy
Bank of Canada

http://bankofcanada.ca/en/video_corp/vi
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:
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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
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Canada’s central bank,
in operation since 1935
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During great depression
Aimed to add stability
to system and prevent
a run on chartered
banks
The Bank of Canada
Canada’s “Biggie” Bank
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Originally the bank was
expected to:
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Regulate credit and
currency
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Control external value
of the Canadian
Currency

Reduce fluctuations in
production, trade,
prices and inflation
Structure of the BofC
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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
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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
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Interest rates take into account inflation
Therefore interest rates have an inflation
premium built in
Interest rates
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Two components
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Nominal Rate of interest
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Inflation Premium
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Premium for risk of non repayment
Premium for delayed consumptions
Expected rate of inflation
Real Rate of interest
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Nominal – Inflation Premium
Inflation and interest rates
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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
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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
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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
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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
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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
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Prime rate: Rate offered by commercial
banks to their best customers (?)
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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
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Overnight rate
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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.
2.
3.
4.
Dollar goes down and Interest Rates
Drop
Increase in demand
Increase prices
Rate of inflation increased
STIMULATES THE ECONOMY
Increase in Overnight Rate
1.
2.
3.
4.
Dollar goes up and Interest Rates go up
Decrease in demand
Decrease prices
Rate of inflation decrease
SLOWS THE ECONOMY
Monetary Policy
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Easy Money: Increase the money supply
(expansionary)
Tight Money: Restricts the money supply
(contractionary)
Tight Money
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Used when economic times are good
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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
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Used when economic times are bad
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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
Tight Money
Easy Money
Bank Rates vs GDP
Classwork
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Read P 264-268 question 1-6
Easy Money Policy
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4 stages
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Stage 1:
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Bank shifts money to the chartered banks to
increase reserves and encourage lending
Stage 2:
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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
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Stage 3:
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Increased borrowing = increased money supply
resulting in increased output (GDP)
Stage 4:
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This increases aggregate demand and GDP
leading to full employment
Tight Money Policy
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4 stages
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Stage 1:
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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:
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Higher interest rates =less borrowing
Business responds by cutting back (stock, equipment,
expansion)
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Stage 3:
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Less borrowing = less money supply
Stage 4:
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Decreased spending by consumers and businesses
shifts AD to the left
This results in decreased prices (deflation)
Hardship Caused by Inflation
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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
AS
AD
Price level

Real GDP (Output)
Aggregate Demand and
Aggregate Supply Graph
The AS curve goes vertical because there
is a limit (CP) to production
AS
AD
Price level
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Real GDP (Output)
Aggregate Demand and
Aggregate Supply Graph
FE: Full employment. In Canada approx
6-7% unemployment. 1-3% Inflation.
AS
AD
Price level
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Real GDP (Output)
FE
Aggregate Demand and
Aggregate Supply Graph
If AD < FE then there is a recession. Low
inflation/deflation. High Unemployment
AS
AD
Price level
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Real GDP (Output)
FE
Aggregate Demand and
Aggregate Supply Graph
If AD > FE then there is a boom. High
inflation. Low unemployment
AD
AS
Price level

Real GDP (Output)
FE
Monetary Policy (Easy Money) P277
1.
Bank shifts government deposits to chartered
banks. Increasing their reserves. Banks able to
lend more.
2.
Lower interest rates. Encourages borrowing.
3.
1.
Consumers spend on big ticket items goods
2.
Businesses spend on capital goods (equipment)
Borrowing and spending by increases money
supply. Which triggers more borrowing and
spending
Monetary Policy (Easy Money)
Increased spending shifts AD1 to AD2
thus reaching FE
AS
AD1
AD2
Price level
4.
Real GDP (Output)
FE
Monetary Policy (Tight Money) P277
1.
Bank shifts government deposits from
chartered banks. Decreasing their reserves.
Banks lend less.
2.
Increase interest rates. Discourage borrowing.
3.
1.
Consumers delay on big ticket items goods
2.
Businesses delay on capital goods (equipment)
Less borrowing and spending decreases money
supply. Which triggers less borrowing and
spending
Monetary Policy (Easy Money)
Decrease spending shifts AD1 to AD2
thus ending high inflation
AD1
AS
AD2
Price level
4.
Real GDP (Output)
FE
Homework
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P268
P273
P276
P279
1-6
4 and 5
1, 2 3
2
P268 question 1-6
1.
2.
The bank of Canada insists on the right to
issue currency in order to meet its
function of controlling inflation
Accounts at the Bank of Canada
1.
2.
Chartered Banks: Settle debts among
themselves. Location for short term loans
Federal Government:
1.
2.
3.
4.
Allows monetary policy
Deposit the proceeds of bond payments
Paying interest on bonds
Holding foreign reserves
P268 question 1-6
3.
4.
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
Spending and Creating money are kept
separate in order to resist the temptation
to print money to pay for spending
P268 question 1-6
5.
6.
The Minister of finance is accountable to
the voters and the PMO. The Governor of
the BofC is accountable to the Minister
A directive would show a lack of
confidence in the BofC.
Beware of the Ninja!
Beware of the Ninja!
No INcome No JAb Loan
P273 4
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Real = Nominal - Expected
A) Nominal interest rate: 7%
B) Real interest rate : 4%
C) Real interest rate: 3%
P273 5
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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, 2 3
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 279 2
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Easy money pressures interest rates
down
Tight money pressures interest rates up