Transcript Chapter 13 The Bank of Canada and Monetary Policy

The Bank of Canada
and
Monetary Policy
SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
1
In this chapter you will learn
13.1 The main functions of the Bank of
Canada
13.2 The goals and tools of monetary policy
13.3 The mechanism by which monetary
policy affects GDP and the price level
13.4 The effectiveness of monetary policy
and its shortcomings
13.5 About the effects of the international
economy on the operation of monetary
policy
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
2
Chapter 13 Topics
13.1 Functions of the Bank of Canada
13.2 Goals & Tools of Monetary Policy
13.3 Monetary Policy, Real GDP, &
Price Level
13.4 Problems & Complications
13.5 Monetary Policy & the
International Economy
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
3
Functions of the Bank of
Canada
1.
2.
3.
4.
5.
Acting as the “Bankers’ Bank”
Issuing Currency
Acting As Fiscal Agent
Supervising the Chartered Banks
Regulating the Supply of Money
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
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Bank of Canada Independence
controversial
 voters hold Parliament responsible
 Bank must be protected from
political pressures

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Macroeconomics, Chapter 13
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Balance Sheet Of
The Bank Of Canada
Table 13-1
ASSETS
LIABILITIES AND
NET WORTH
Advances to chartered
banks
Treasury bills of Canada
Other government
securities
Foreign currency deposits
Other assets
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Macroeconomics, Chapter 13
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Balance Sheet Of
The Bank Of Canada
Table 13-1
ASSETS
LIABILITIES AND
NET WORTH
Advances to chartered
banks
Notes in circulation
Treasury bills of Canada
Gov’t of Canada deposits
Other government
securities
Chartered bank deposits
Foreign currency deposits
Other deposits
Other assets
Other liabilities
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
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Balance Sheet Of
The Bank Of Canada
Table 13-1
ASSETS
LIABILITIES AND
NET WORTH
Advances to chartered
banks
Notes in circulation
Treasury bills of Canada
Gov’t of Canada deposits
Other government
securities
Chartered bank deposits
Foreign currency deposits
Other deposits
Securities are bought & sold to
Other liabilities
Other assets
influence chartered bank reserves
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
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Balance Sheet Of
The Bank Of Canada
Table 13-1
ASSETS
LIABILITIES AND
NET WORTH
Advances to chartered
banks
Notes in circulation
Treasury bills of Canada
Gov’t of Canada deposits
Other government
securities
Chartered bank deposits
Chartered banksOther
can deposits
increase
reserves
by borrowing
from
the Bank
Other
liabilities
Other
assets
of Canada
Foreign currency deposits
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
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Balance Sheet Of
The Bank Of Canada
Table 13-1
ASSETS
LIABILITIES AND
NET WORTH
Advances to chartered
banks
Notes in circulation
Treasury bills of Canada
Gov’t of Canada deposits
Other government
securities
Chartered bank deposits
Other deposits
These deposits necessary
for cheque
clearing; they areOther
partliabilities
of banks’
Other assets
reserves
Foreign currency deposits
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
10
Balance Sheet Of
The Bank Of Canada
Table 13-1
ASSETS
LIABILITIES AND
NET WORTH
Advances to chartered
banks
Notes in circulation
Treasury bills of Canada
Gov’t of Canada deposits
Other government
securities
Chartered bank deposits
Foreign currency deposits
Other deposits
Assets to the federal government,
Other liabilities
Other assets
liabilities to the Bank of Canada
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
11
Balance Sheet Of
The Bank Of Canada
Table 13-1
ASSETS
LIABILITIES AND
NET WORTH
Advances to chartered
banks
Notes in circulation
Treasury bills of Canada
Gov’t of Canada deposits
Other government
securities
Chartered bank deposits
Foreign currency deposits
Other deposits
Paper money in circulation is claim
Other liabilities
Other assets
against the Bank of Canada
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
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Chapter 13 Topics
13.1 Functions of the Bank of Canada
13.2 Goals & Tools of Monetary Policy
13.3 Monetary Policy, Real GDP, &
Price Level
13.4 Problems & Complications
13.5 Monetary Policy & the
International Economy
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
13
Goals of Monetary Policy



to keep inflation low, stable & predictable,
to moderate the business cycle, & help the
economy achieve full employment &
sustained growth
by altering the money supply to influence
interest rates
inflation target range of 1—3% annually
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
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Tools of Monetary Policy
Three instruments:
 Open-Market Operations
 Government Deposit Shifting
 Bank Rate
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Macroeconomics, Chapter 13
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Open-Market Operations

Bank of Canada’s buying bonds from
& selling them to chartered banks &
the general public
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Macroeconomics, Chapter 13
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Open-Market Operations

Bank of Canada BUYS bonds
From the chartered banks…
– Chartered bank gives up bonds
– Bank of Canada pays chartered bank by
increasing chartered bank’s reserves
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
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Open Market Operations
Bank Of Canada BUYS $1,000 Of
Securities From The Chartered Banks
Bank of Canada
Assets Liabilities
© 2005 McGraw-Hill Ryerson Ltd.
Chartered Banks
Assets Liabilities
Macroeconomics, Chapter 13
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Open Market Operations
Bank Of Canada BUYS $1,000 Of
Securities From The Chartered Banks
Bank of Canada
Assets Liabilities
Chartered Banks
Assets Liabilities
+ Securities
- Securities
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
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Open Market Operations
Bank Of Canada BUYS $1,000 Of
Securities From The Chartered Banks
Bank of Canada
Assets Liabilities
+ Securities
+ Reserves
of
chartered
banks
© 2005 McGraw-Hill Ryerson Ltd.
Chartered Banks
Assets Liabilities
- Securities
+ Reserves
Macroeconomics, Chapter 13
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Open-Market Operations

Bank of Canada BUYS bonds
From the chartered banks…
– Chartered bank gives up bonds
– Bank of Canada pays chartered bank by
increasing chartered bank’s reserves
From the public…
– Public gives up bonds for cheque
– Cheque is deposited in chartered bank
– Chartered bank’s reserves increase
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
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Open Market Operations
Bank Of Canada BUYS $1,000 Of
Securities From The Public
Bank of Canada
Assets Liabilities
© 2005 McGraw-Hill Ryerson Ltd.
Chartered Banks
Assets Liabilities
Macroeconomics, Chapter 13
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Open Market Operations
Bank Of Canada BUYS $1,000 Of
Securities From The Public
Bank of Canada
Assets Liabilities
+ Securities
© 2005 McGraw-Hill Ryerson Ltd.
Chartered Banks
Assets Liabilities
+Deposits
Macroeconomics, Chapter 13
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Open Market Operations
Bank Of Canada BUYS $1,000 Of
Securities From The Public
Bank of Canada
Assets Liabilities
+ Securities
+ Reserves
of
chartered
banks
Chartered Banks
Assets Liabilities
+ Reserves
+Deposits
some reserves must be kept on
hand against this deposit
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
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Bank Of Canada Bond Purchase
Purchase of a
$1000 bond
from a
chartered
bank....
Figure 13-1
New reserves
$1000
Excess
reserves
D=E X m
= $1000 X 1/.20
=$1000 X 5
$5,000
Chartered bank system lending
Total increase in money supply ($5,000)
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
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Bank Of Canada Bond Purchase
Purchase of a
$1000 bond
from the
public....
Figure 13-1
New reserves
$800
Excess
reserves
$200
Desired
reserves
D=E X m
= $800 X 1/.20
=$800 X 5
$1000
$4000
Initial
Chartered bank system lending deposit
Total increase in money supply ($5,000)
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
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Open-Market Operations
Bank of Canada BUYS bonds
– Chartered bank’s reserves increase
– Banks increase lending
– Money supply increases
Bank of Canada SELLS bonds
– Chartered bank’s reserves decrease
– Banks decrease lending
– Money supply decreases
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
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Switching Government of
Canada Deposits
Bank of Canada is the federal
government’s bank
 Switching deposits FROM the
chartered banks to the Bank of
Canada reduces deposits & reserves
 Switching deposits TO the chartered
banks from the Bank of Canada
increases deposits & reserves

© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
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The Bank Rate & the Overnight
Loans Rate
Bank rate is the interest rate the
Bank of Canada charges on the loans
to the chartered banks
 Bank rate is set at the upper end of
the Bank of Canada’s operating band
for the overnight lending rate
 Bank has a publicized target for the
overnight lending rate

© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
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Easy Money & Tight Money
Recession & unemployment
easy money policy

 buy securities, or
 switch government deposits to
chartered banks, or
 reduce the bank rate
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
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Easy Money & Tight Money
Inflation
tight money policy

 sell securities, or
 switch government deposits from
chartered banks, or
 increase the bank rate
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
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Relative Importance
of the three policy instruments,
buying & selling securities in the
open market is by far the most
important
 switching government deposits used
occasionally, but on a small scale
 bank rate is a signalling device

© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
32
Chapter 13 Topics
13.1 Functions of the Bank of Canada
13.2 Goals & Tools of Monetary Policy
13.3 Monetary Policy, Real GDP, &
Price Level
13.4 Problems & Complications
13.5 Monetary Policy & the
International Economy
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
33
Monetary Policy, Real GDP &
the Price Level
Cause-Effect Chain: The Transmission
Mechanism
 Money supply impacts interest rates
 Interest rates affect investment
 Investment is a component of AD
 Equilibrium GDP is changed
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
34
Real rate of interest, i
Monetary Policy and Equilibrium GDP- Fig.13-2
i%
i%
Sm0
10
10
8
8
6
6
Dm
0
$billions
$125
Investment
Demand
0
$15
$billions
Price level
potential
AS
GDP
P1
AD0
GDP0
If the money supply
increases to
stimulate the
economy....
Real GDP
35
Real rate of interest, i
Monetary Policy and Equilibrium GDP- Fig.13-2
i%
i%
Sm0 Sm1
10
10
8
8
6
6
Dm
0
$125 $150
$billions
Investment
Demand
0
$15
$billions
Price level
potential
AS
GDP
P1
AD0
GDP0
Real GDP
36
Real rate of interest, i
Monetary Policy and Equilibrium GDP- Fig.13-2
i%
i%
Sm0 Sm1
10
10
8
8
6
6
Dm
0
$125 $150
$billions
Investment
Demand
0
$15
$billions
Price level
potential
AS
GDP
P1
AD0
GDP0
Interest rates fall as
people work off
excess money by
buying bonds
Real GDP
37
Real rate of interest, i
Monetary Policy and Equilibrium GDP- Fig.13-2
i%
i%
Sm0 Sm1
10
10
8
8
6
6
Dm
0
$125 $150
$billions
Investment
Demand
0
$15
$20
$billions
Price level
potential
AS
GDP
Investment increases
in response to lower
interest costs
P1
AD0
GDP0
Real GDP
38
Real rate of interest, i
Monetary Policy and Equilibrium GDP- Fig.13-2
i%
i%
Sm0 Sm1
10
10
8
8
6
6
Dm
0
$125 $150
$billions
Investment
Demand
0
$15
$20
$billions
Price level
potential
AS
GDP
Investment increase
 increase in AD
(multiplier effect)
P1
AD0
GDP0
AD1
Real GDP
39
Real rate of interest, i
Monetary Policy and Equilibrium GDP- Fig.13-2
i%
i%
Sm0 Sm1
10
10
8
8
6
6
Dm
0
$125 $150
$billions
Investment
Demand
0
$15
$20
$billions
Price level
potential
AS
GDP
Increase in GDP and
price level
P2
P1
AD0
GDP0
GDPf
AD1
Real GDP
40
Real rate of interest, i
Monetary Policy and Equilibrium GDP- Fig.13-2
i%
i%
Sm0 Sm1
10
10
8
8
6
6
Dm
0
$125 $150
$billions
Investment
Demand
0
$15
$20
$billions
Price level
potential
AS
GDP
If the money supply
increases again...
P2
P1
AD0
GDP0
GDPf
AD1
Real GDP
41
Real rate of interest, i
Monetary Policy and Equilibrium GDP- Fig.13-2
i%
i%
Sm0 Sm1 Sm3
10
10
8
8
6
6
0
Dm
$125 $150 $175 $billions
Price level
potential
AS
GDP
P3
P2
P1
AD0
GDP0
AD1
GDPf GDP1
AD2
Investment
Demand
0
$15
$20 $25 $billions
GDP doesn’t
increase as much-multiplier effect
weaker because of
shape of AS
Real GDP
42
Table 13-2
Problem: Recessionary Gap
Bank of Canada buys bonds, switches deposits to chartered
banks, or lowers the bank rate
Reserves increase
Money supply rises
Interest rate falls
Investment spending increases
Aggregate demand increases
Real GDP rises by a multiple of the increase in investment
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
43
Table 13-2
Problem: Inflationary Gap
Bank of Canada sells bonds, switches deposits from
chartered banks, or both
Reserves decrease
Money supply falls
Interest rate rises
Investment spending decreases
Aggregate demand decreases
Inflation declines
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
44
Monetary Policy in Action
dominant component of Canadian
national stabilization policy
 two key advantages over fiscal
policy:

– speed & flexibility
– isolation from political pressure
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
45
Focus on the Overnight Lending
Rate

Bank of Canada communicates
changes in monetary policy by
announcing changes in the upper
limit for the operating band for the
overnight lending rate
– increase in upper limit signals tighter
monetary policy
– decrease in upper limit signals easier
monetary policy
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
46
Changes in the prime interest rate generally
track changes in the bank rate
Figure 13-3
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
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Focus on the Overnight Lending
Rate

Bank of Canada does not set the overnight
lending rate or the prime rate
– each is set by the interaction of borrowers &
lenders


Bank achieves desired interest rate by
changing reserves
Banks uses special purchase & resale
agreements (SPRA) & sale & repurchase
agreements (SRA) to reinforce target
overnight rate
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
48
Recent Monetary Policy





early 1990s: restrictive monetary policy
after the recession of 1991-2 made growth
slow
easing encouraged growth in the second
half of the 1990s
vigorous economy & stock market bubble
led to tightening at the end of the 1990s
economy slowed at the end of 2000, so
Bank cut interest rates in 2001
expansion in 2002 led to increased rates
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
49
Chapter 13 Topics
13.1 Functions of the Bank of Canada
13.2 Goals & Tools of Monetary Policy
13.3 Monetary Policy, Real GDP, &
Price Level
13.4 Problems & Complications
13.5 Monetary Policy & the
International Economy
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
50
Problems & Complications

monetary policy has certain limitations
– lags
– changes in velocity
– cyclical asymmetry

inflation targeting
– has increased transparency of monetary policy
& accountability
– critics say inflation targeting is too narrow
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
51
Chapter 13 Topics
13.1 Functions of the Bank of Canada
13.2 Goals & Tools of Monetary Policy
13.3 Monetary Policy, Real GDP, &
Price Level
13.4 Problems & Complications
13.5 Monetary Policy & the
International Economy
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
52
Monetary Policy & the
International Economy

Net exports effects reinforce
monetary policy
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
53
Table 13-3
Problem: recession, slow growth
Easy money policy
(lower interest rate)
Decreased foreign demand for dollars
Dollar depreciates
Net exports increase
Aggregate demand increases
Monetary policy is reinforced
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
54
Table 13-3
Problem: inflation
Tight money policy
(higher interest rate)
Increased foreign demand for dollars
Dollar appreciates
Net exports decrease
Aggregate demand decreases
Monetary policy is reinforced
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
55
Monetary Policy & the
International Economy
Macro Stability & the Trade Balance
 The easy money policy that is appropriate
for the alleviation of unemployment &
sluggish growth is compatible with the
goal of correcting a balance-of-trade
deficit
 The tight money policy used to alleviate
inflation conflicts with the goal of
correcting a balance-of-trade deficit
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
56
The Big Picture

Key graph 13-4 (see the text)
integrates the various components of
macroeconomic theory &
stabilization policy
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
57
Chapter 13 Topics
13.1 Functions of the Bank of Canada
13.2 Goals & Tools of Monetary Policy
13.3 Monetary Policy, Real GDP, &
Price Level
13.4 Problems & Complications
13.5 Monetary Policy & the
International Economy
© 2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 13
58