Transcript Monetary Policy in Practice, continued* What the Bank of Canada

Monetary Policy In Action:
The Bank of Canada’s Monetary
Tools
• Good economic times stimulate Canadians (consumers, businesses)
to borrow more
• Banks willing to lend more to credit-worthy borrowers
• Result: money supply expands
: more bank deposit $ created to supply
desire to spend more
BUT…
• Expansionary growth comes with higher prices for goods as
inflation creeps in – consumers & producers could fuel demand so
much that prices rise throughout entire economy (severe inflation)
Bank of Canada responds…
• Bank plays “party pooper”
• Raises interest rates to restrain borrowing/ slow down
growth of money supply
BUT
• Too much restraint, badly timed, could throw economy into
recession
• Bank’s goal is to slow growth, not end it
• Also works in reverse when economic growth shows signs
of slowing down
“Easy” vs. “Tight” Money
• “Easy money”:
– policy of low interest rates, easier credit, growth
of money supply
– used to curb recessions, stimulate econ. growth
• “Tight money”:
– Higher interest rates, more difficult credit,
decrease of money supply
– used to restrain growth, curb inflation
“Tight Money” to
reduce inflation
“Easy money” to
stimulate economy
Canada’s Inflation Target
• Canadian government attempts to keep
inflation rate between 1% and 3%
• “Sweet spot” is thus a rate of 2%
• When inflation begins to move too far away
from 2% target, government will “step in” with
monetary policy tools to re-balance inflation
rate
Interest Rates: The Main Tool of
Monetary Policy
• Interest: the price paid for a loan
• Demand for loanable funds comes from:
consumers, businesses, governments
• Rates affect (and are affected by) the laws of
supply and demand (ie. shifting curves)
Importance and Impact of
Interest Rates
• Affect consumer decisions about both borrowing and
saving money; ex. the higher the rate, the less we borrow
• Affect business decisions to invest in expanding, buying
new machinery
• Affect the value of the Canadian dollar internationally –
higher interest rates attract more foreign investors,
increasing demand for Canadian $
• Affects gov’t budgets – the more $ necessary to pay for
interest on gov’t debts, the less $ for spending on social
programs
Types of Rates
1. Prime rate:
• lowest rate offered by a bank to its best
customers (ex. large firms)
• benchmark for loans to other customers (ex.
“prime plus ____%”), depending on creditworthiness
Types of Rates, cont’d…
2. Bank rate:
• interest rate the Bank of Canada charges the
chartered banks for loans
• when Bank rate rises, chartered banks
respond by raising their customers’ rates;
when Bank rate falls, chartered banks’ rates
fall
Types of Rates, cont’d…
3. Nominal Interest rate:
• Rate that builds in a premium (extra %) to cover
inflation + allowance for risk
• Ex. 4% (Bank rate) + 3% premium
= 7% nominal rate
VS.
4. Real rate of interest:
Nominal rate – expected rate of inflation
= real rate of interest
Types of Rates, finis…
5. the “Overnight rate”:
• Interest rate charged by banks for short-term
(“overnight”) loans between them
• rate is controlled (“set”) by Bank of Canada
• Bank uses overnight rate target to signal chartered
banks which direction it wants monetary policy to
move
• Ex. overnight rate rises; gov’t signals it’s worried about
inflation;
• Result: chartered banks raise their interest rates; rate
of inflation drops as borrowing (& consumption) by
consumers, businesses decreases
One other tool… Bonds
• Bond: an IOU issued by a borrower to repay
borrowed $ by a fixed date
• Gov’t of Canada sells bonds to Bank of Canada
(gov’t is borrower)
• Gov’t uses the $ borrowed from bond sales to
increase the money supply, and stimulate the
economy
• Gov’t repays the bond (and interest) from
increased tax revenues collected from a
rejuventated economy (theoretically…)
READ & DO !!!!
• Theoretical Dynamics of Interest Rates:
a) READ p. 269-271 b) DO Qu.#1-3 on p. 273
• What the Bank of Canada tries to do:
a) READ p. 276-278
b) DO make notes (with diagrams to illustrate) the
STAGES that occur when central banks adopt a
“tight money” monetary policy or an “easy
money” monetary policy