monetary policy and the debate about macro policy
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Monetary Policy and the Debate about Macro Policy. Chapter 14. Introduction. Monetary policy influences the economy through changes in the financial system’s reserves that influence the money supply and credit availability in the economy. Introduction. - PowerPoint PPT PresentationTRANSCRIPT
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Monetary Policy and Monetary Policy and the Debate about the Debate about
Macro PolicyMacro Policy
Chapter 14Chapter 14
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IntroductionIntroduction Monetary policy influences the
economy through changes in the financial system’s reserves that influence the money supply and credit availability in the economy.
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IntroductionIntroduction Monetary policy is one of the two main
traditional macroeconomic tools to control the aggregate economy.
While fiscal policy is controlled by the government directly, monetary policy is controlled by the central bank in Canada.
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Effect of Monetary Effect of Monetary Policy on the AS/AD Policy on the AS/AD ModelModel Expansionary monetary policy shifts the
AD curve to the right. Contractionary monetary policy shifts
the AD curve to the left.
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Effect of Monetary Effect of Monetary Policy on the AS/AD Policy on the AS/AD ModelModel The effect of monetary policy on
equilibrium income and the price level depends on whether inflationary pressures are set in motion.
That in turn depends on how close the economy is to its potential income.
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Effect of Monetary Effect of Monetary Policy on the AS/AD Policy on the AS/AD ModelModel The supply conditions of the economy
are central to the effect one believes monetary policy will have on the economy.
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Effect of Monetary Effect of Monetary Policy on the AS/AD Policy on the AS/AD ModelModel Its effect on real income depends on
how the price level responds.
% Real Income = % Nominal Income - % Price Level
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Effect of Monetary Effect of Monetary Policy on the AS/AD Policy on the AS/AD ModelModel In Keynesian range, real income will
rise with expansionary monetary policy and decline with contractionary monetary policy.
The price level is unaffected.
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Effect of Monetary Effect of Monetary Policy on the AS/AD Policy on the AS/AD ModelModel In the Classical range, real income does
not change; the effect is on the price level and inflation.
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Monetary Policy When Monetary Policy When Prices are Fixed, Prices are Fixed, Fig. 14-1a, p Fig. 14-1a, p 339339
P0SAS
Y2 Y0 Y1
AD0 AD1
Pricelevel
Real output
Expansionary monetary policy
Contractionary monetary policy
AD2
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P0
SAS0
AD0
AD1
Pricelevel
Real output
P1
SAS1
Y0
LRAS
Expansionary Monetary Expansionary Monetary Policy in the Classical Policy in the Classical Range, Range, Fig. 14-1b, p 339Fig. 14-1b, p 339
A
B
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Duties and Structure of Duties and Structure of the Bank of Canadathe Bank of Canada A central bank is a type of bankers’
bank. A central bank conducts monetary
policy and acts as financial adviser to the government.
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Duties and Structure of Duties and Structure of the Bank of Canadathe Bank of Canada In some countries the central bank is a
part of the government. In Canada the central bank is not part of the
government – it is a Crown corporation, not under direct day-to-day control of the federal government.
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Structure of the BankStructure of the Bank The head of the Bank of Canada is the
Governor of the Bank. So far the Bank of Canada has had
seven governors.
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Structure of the BankStructure of the Bank Monetary policy is set by the governor
with the advice of his senior advisers. The Bank has a Board of Directors
made up of 12 non-specialists in monetary policy.
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Structure of the BankStructure of the Bank Price stability has often been the goal of
monetary policy. Price stability is interpreted to mean a
low and stable rate of inflation.
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International International ConsiderationsConsiderations The design and implementation of
monetary policy is affected by international considerations.
Exchange rates play a critical role in the process.
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International International ConsiderationsConsiderations An exchange rate expresses the value
of one currency in terms of the value of another.
Exchange rate can be expressed in two ways – it tells us how many units of one currency is needed to buy one unit of another. For example, it takes Can$1.54 to buy
US$1 (or, US$0.65 to buy Can$1)
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International International ConsiderationsConsiderations Exchange rates matter because
international trade is an important part of every economy.
Monetary policy is important because it will affect international trade through changes in the money supply.
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International International ConsiderationsConsiderations The exchange rate as the relative price
of one nation’s currency depends on how much of that currency is in circulation.
Therefore, monetary policy cannot be set without consideration of international issues.
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Duties of the BankDuties of the Bank The bank of Canada is responsible for:
Conducting monetary policy Providing Central banking services Issuing bank notes Administering public debt.
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The Importance of The Importance of Monetary PolicyMonetary Policy Monetary policy is the Bank’s most
important function, and the most-used policy in macroeconomics.
In practice,the Bank of Canada conducts monetary policy and controls it, whereas fiscal policy is conducted directly by the government.
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The Importance of The Importance of Monetary PolicyMonetary Policy Actual decisions about monetary policy
are made by the Governor of the Bank of Canada, with consultation with senior staff.
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The Conduct of The Conduct of Monetary PolicyMonetary Policy Bank reserves are IOUs of the Bank of
Canada. Bank reserves – either vault cash or
deposits at the Bank. The monetary base is currency in
circulation plus deposits at the Bank.
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The Conduct of The Conduct of Monetary PolicyMonetary Policy By controlling the monetary base, the
Bank can influence the amount of money in the economy and the activities of banks.
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The Conduct of The Conduct of Monetary PolicyMonetary Policy The tools of monetary policy will affect
the amount of reserves in the system. The amount of reserves will affect
interest rates. Other things being equal, as reserves
decline, interest rates will rise. As reserves increase, interest rates will fall.
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Tools of Monetary Tools of Monetary PolicyPolicy The tools of monetary policy include:
Changing the target range for the overnight financing rate.
Cash management operations.
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The Overnight The Overnight Financing RateFinancing Rate All chartered banks are members of the
Canadian Payments Association. Among other things, this association
runs an electronic funds transfer system called the Large Value Transfer system (LVTS), where payments clear and settle daily.
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The Overnight The Overnight Financing RateFinancing Rate If financial institutions have surplus
balances resulting from the clearing process at the LVTS, they can loan them on a very short term basis to those members who are in deficit position.
These loans occur in the overnight market.
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The Overnight The Overnight Financing RateFinancing Rate The overnight financing rate is the
rate of interest associated with these very short-term loans in the overnight market.
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The Overnight The Overnight Financing RateFinancing Rate Changes in the overnight financing rate
influence all other rates through the term structure of interest rates – the structure of yields on financial instruments with similar characteristics, but different terms to maturity.
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The Overnight The Overnight Financing RateFinancing Rate Arbitrage – the buying and selling of
similar goods and services across different markets – provides the link between interest rates on dissimilar assets.
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The Overnight The Overnight Financing RateFinancing Rate The bank rate is the interest rate
charged on advances from the central bank.
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The Overnight The Overnight Financing RateFinancing Rate The Bank of Canada has a target range
for the overnight financing rate – it falls between the bank rate (maximum) and the rate at which the Bank will pay the LVTS participants who want to leave their surplus funds with the Bank of Canada (minimum).
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The Overnight The Overnight Financing RateFinancing Rate The main tool of monetary policy in
Canada is the target range for the overnight financing rate. The AD will decline if the target range
for the overnight financing rate is increased.
By decreasing the target range, the AD will increase.
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Relationship Among Relationship Among Interest Rates, Interest Rates, Fig. 14-2a, p 348Fig. 14-2a, p 348
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Relationship Among Relationship Among Interest Rates, Interest Rates, Fig. 14-2b, p 348Fig. 14-2b, p 348
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Cash Management Cash Management OperationsOperations Cash management is the second major
tool of monetary policy in Canada. Cash management operations are the
main techniques for implementing monetary policy in Canada.
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Cash Management Cash Management OperationsOperations Cash management techniques include
various open market operations - buying and selling of government bonds and bills.
Cash management techniques also include the transfer of government deposits between chartered banks (and others) and the Bank of Canada.
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Open Market Open Market OperationsOperations Open market operations involve the
purchase or sale of federal government securities. When the Bank of Canada buys
bonds, the money supply rises. Thus, an open market purchase is an example of expansionary monetary policy.
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Open Market Open Market OperationsOperations An open market sale has the opposite
effect:
When the Bank of Canada sells bonds, the money supply declines. Thus, an open market sale is an example of contractionary monetary policy.
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Open Market Open Market OperationsOperations Open market purchase (expansionary
monetary policy) increases the money supply, decreasing the interest rates.
Open market sale (contractionary monetary policy) reduces the money supply, increasing interest rates.
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Government DepositsGovernment Deposits A transfer of government deposits from
the chartered banks and other financial institutions to the Bank of Canada reduces the liquidity in the banking system.
This puts an upward pressure on interest rates.
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Government DepositsGovernment Deposits A transfer of government deposits from
the Bank of Canada to the chartered banks and other financial institutions increases the liquidity in the banking system.
This puts a downward pressure on interest rates.
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Open Market Open Market Operations, Operations, Fig. 14-3a, p 350Fig. 14-3a, p 350
Price
of a
bo n
d
Quantity of bonds
D0
Supply
a) An open market purchase
D1
A
B
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Open Market Open Market Operations, Operations, Fig. 14-3b, p 350Fig. 14-3b, p 350
Price
of a
bo n
d
Quantity of bonds
Demand
S0
b) An open market sale
S1
AC
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Monetary Policy in the Monetary Policy in the AS/AD ModelAS/AD Model In AS/AD terms, monetary policy works
primarily through its effect on interest rates.
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Contractionary Contractionary Monetary PolicyMonetary Policy The Bank decreases the money supply. The interest rates go up. As interest rates go up, the quantity of
investment goes down, decreasing income and output.
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Contractionary Contractionary Monetary PolicyMonetary Policy The AD curve shifts to the left by a
multiple of the shift in investment. Income and output decrease.
M i I Y
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Expansionary Monetary Expansionary Monetary PolicyPolicy Expansionary monetary policy works in
the opposite direction.
M i I Y
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Contractionary Contractionary Monetary Policy When Monetary Policy When Prices are Fixed, Prices are Fixed, Fig. 14-4a, p Fig. 14-4a, p 351351 M i I Y
AD1 AD0
Y1 Y0
P0SAS
Price level
0 Real income
I Initial shift
Multiplier effect
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Expansionary Monetary Expansionary Monetary Policy When Prices are Policy When Prices are Fixed, Fixed, Fig. 14-4b, p 351Fig. 14-4b, p 351
M i I Y
AD0 AD1
Y0 Y1
P0Aggregate supply
Price level
0 Real income
Multiplier effect
I Initial shift
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Monetary Policy in the Monetary Policy in the Circular FlowCircular Flow If monetary and fiscal policy are
needed, it is because the financial sector is in some ways clogged and is not correctly translating savings into investment.
Monetary policy works to unclog the financial sector.
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Keynesian Monetary Keynesian Monetary Policy in the Circular Policy in the Circular Flow, Flow, Fig. 14-5, p 352Fig. 14-5, p 352
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Emphasis on the Emphasis on the Interest RateInterest Rate A rising interest rate indicates a
tightening of monetary policy. A falling interest rate indicates a
loosening of monetary policy.
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Emphasis on the Emphasis on the Interest RateInterest Rate A natural conclusion is that the Bank
should target interest rates in setting monetary policy.
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Real and Nominal Real and Nominal Interest RatesInterest Rates There is a problem in using interest
rates to measure whether monetary policy is contractionary or expansionary.
That problem is the real/nominal interest rate problem.
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Real and Nominal Real and Nominal Interest RatesInterest Rates Nominal interest rates are those you
actually see and pay. Real interest rates are nominal interest
rates adjusted for expected inflation.
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Real and Nominal Real and Nominal Interest RatesInterest Rates The real interest rate cannot be
observed since it depends on expected inflation, which cannot be directly observed.
Nominal interest rate = Real interest rate + Expected inflation rate
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Real and Nominal Real and Nominal Interest Rates and Interest Rates and Monetary PolicyMonetary Policy Making a distinction between nominal
and real interest rates adds uncertainty to the effect on monetary policy.
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Real and Nominal Real and Nominal Interest Rates and Interest Rates and Monetary PolicyMonetary Policy If expansionary monetary policy leads to
expectations of increased inflation, nominal interest rates will go up, leaving real interest rates unchanged.
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Real and Nominal Real and Nominal Interest Rates and Interest Rates and Monetary PolicyMonetary Policy The possible effect of monetary policy
on expectations of inflation has led most economists to conclude that a monetary regime, not a monetary policy is the best approach to policy.
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Real and Nominal Real and Nominal Interest Rates and Interest Rates and Monetary PolicyMonetary Policy A monetary regime is a predetermined
statement of the policy that will be followed in various situations.
A monetary policy, in contrast, is a response to events which is chosen without a predetermined framework.
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Real and Nominal Real and Nominal Interest Rates and Interest Rates and Monetary PolicyMonetary Policy The monetary regime the Bank is
currently using involves feedback rules that center on the overnight financing rate.
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Real and Nominal Real and Nominal Interest Rates and Interest Rates and Monetary PolicyMonetary Policy If inflation is above its target the Bank
rises the target range, decreasing the money supply.
If inflation is below its target, and if economy is going into recession, the Bank lowers the target range, increasing the money supply.
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Real and Nominal Real and Nominal Interest Rates and Interest Rates and Monetary PolicyMonetary Policy If inflation is below its target and the
economy is sliding into a recession the Fed attempts to expand the economy.
The Fed lowers the Federal funds rate by buying bonds thereby increasing the money supply.
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Problems in the Problems in the Conduct of Monetary Conduct of Monetary PolicyPolicy Five problems of monetary policy are:
Knowing what policy to use. Understanding the policy you're
using. Lags in monetary policy. Political pressure. Conflicting international goals.
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Knowing What Policy to Knowing What Policy to UseUse The potential level of income must be
known. Otherwise you don’t know whether to
use expansionary or contractionary monetary policy.
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Understanding the Understanding the Policy You’re UsingPolicy You’re Using You must know whether the policy
being used is expansionary or contractionary in order to use monetary policy effectively.
The Bank only indirectly controls the monetary base.
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Understanding the Understanding the Policy You’re UsingPolicy You’re Using The money multiplier is influenced by
both the amount of cash people hold as well as the lending process at the bank.
Neither of these are stable numbers.
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Understanding the Understanding the Policy You’re UsingPolicy You’re Using Then there are interest rates. If interest rates rise, is it because of
expected inflation or is it that the real interest rate is going up?
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Lags in Monetary PolicyLags in Monetary Policy Monetary policy, like fiscal policy, takes
time to work. Just because the Bank decreases
interest rates, that does not necessarily mean that people will borrow money.
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Lags in Monetary PolicyLags in Monetary Policy In the face of a contractionary monetary
policy, banks have been creative in circumventing cuts in the money supply.
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Political PressurePolitical Pressure The Bank is not totally insulated from
political pressure. Politicians place great pressure on the
Bank to use expansionary monetary policy, especially during an election year.
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Conflicting Conflicting International GoalsInternational Goals Monetary policy is conducted in an
international arena. It must be coordinated with other
governments’ monetary policies.
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Monetary Policy and Monetary Policy and the Debate about the Debate about
Macro PolicyMacro Policy
End of Chapter 14End of Chapter 14