Post on 28-Apr-2015
Monetary PolicyAP Macroeconomics 12
Expansionary vs. Restrictive
Monetary Policy
Government Policy
Monetary
Expansionary Restrictive
Fiscal
Expansionary Contractionary
Interest RatesMoney Supply
TaxSpending
Expansionary Monetary Policy
Real GDP
Time for Bank of Canada to …
Initiate Expansionary Monetary Policy (Easy money policy)
Definition:
Policies designed by Bank of Canada that increase the money supply to lower interest rates and expand real GDP
The ultimate goal
Steps
• Bank of Canada will announce a lower target for the overnight loans rate
Lower overnight lending
rate
• Bank of Canada buys bonds from banks and the public
• Result--- increase in the reserves in the banking system
Open market
operation
Results of greater reserves
1. Supply of reserves in the overnight market increase, lowering the overnight rate to the new targeted rate
2. A multiple expansion of the nation’s money supply
a) What is the economic problem this country is facing?
b) What monetary policy should the government take?
c) How would the policy help this country to achieve its goals?
Example 1:Year Ago Quarter Last Quarter Estimate for Quarter
Now Ending
Real GDP $3049 $2678 $2588
Consumer Price Index
287 253 232
Unemployment Rate
6% 11% 15%
The economy is in a Recession
Expansionary Monetary Policy
The increase in money supply results decrease in interest rate; thus, investment would increase, causing real GDP to increase and bring the economy to equilibrium.
Prime interest rate
• It is a reference point for determining other interest rates charged on business and individuals. Ex. mortgage rate
• Higher than overnight lending rate• Fluctuates with overnight lending
rate and bank rate
Definition: the interest rate banks charge their most creditworthy borrowers.
In recession, business become…
Restrictive Monetary Policy
Oh no! Now it’s inflation!
We have to increase
the interest rate!
The busy Bank of Canada now…
Initiate Restrictive Monetary Policy (Tight money policy)
Definition:
Policies designed by Bank of Canada that restrict the growth of the nation’s money supply to reduce or eliminate inflation
The ultimate goal
Steps
• Bank of Canada will announce a higher target for the overnight loans rate
Higher overnight lending
rate
• Bank of Canada sells bonds from banks and the public
• Result--- decrease in the reserves in the banking system
Open market
operation
Results of smaller reserves
1. Supply of reserves in the overnight market decrease, increasing the overnight rate to the new targeted rate
2. A multiple contraction of the nation’s money supply. Other interest rate like prime interest rate will increase.
a) What is the economic problem this country is facing?
b) What monetary policy should the government take?
c) How would the policy help this country to achieve its goals?
Example 2:Year Ago Quarter Last Quarter Estimate for Quarter
Now Ending
Real GDP $2560 $2742 $2985
Consumer Price Index
230 250 270
Unemployment Rate
12% 9% 7%
This country is in a heavy inflation
Restrictive monetary policy
By decreasing the money supply in reserves, the interest rate increases and results decrease in investment and consumption, and ultimately reduce inflation.
The Taylor Rule--by John Taylor
The Taylor rule stipulates exactly how much a central bank should change interest rates to meet target real GDP and rate of inflation
situation Bank of Canada action
Real GDP increase 1% above target of 2%
Raise overnight lending rate by 0.5%
Inflation increase 1% above target of 2%
Raise overnight lending rate by 0.5%
Real GDP is equal to potential GDP, inflation is equal to the target of 2%
Overnight rate should remain at about 4%, and real interest rate at 2%
The Transmission Mechanism
Effects of Monetary Policy
Expansionary Monetary Policy
Unemployment &
recession
Central bank buys bonds
Excess reserves increases
Overnight rate falls
Money supply rises
Interest rate falls
Investment spending increases
Aggregate demand increases
Real GDP rises
Restrictive Monetary Policy
Inflation
Central bank sells bonds
Excess reserves
decreases
Overnight rate rises
Money supply falls
Interest rate rises
Investment spending decreases
Aggregate demand
decreases
Inflation declines
Advantage of Monetary Policy
Monetary Policy Fiscal Policy
Speedy & flexible
Political pressure
Practice Question:
1. If the economy is experiencing a sharp recession trend, what changes would you suggest to do? How would the policy affect the money supply and chartered bank cash reserves?
Suggesting Expansionary Monetary Policy.
As government buying bonds from banks, money from Central Bank is going to the chartered banks, as a result, increase banks’ reserves and money supply. The increase in money supply would lower the interest rate, causing investment increase, thus, the real GDP would also increase.
2. What would the government do if the economy is in a sharp inflation? What policy is used? What happens to the bank reserves and money supply?
The government would SELL bonds to banks and publics.
Restrictive Monetary policy is used, resulting decrease in money supply and bank reserves. Because of the decrease in money supply, the interest rate would increase, thus, decrease in investment and reduce inflation.
Summary
Expansionary Monetary Policy Used in a recessionGovernment buys bonds from chartered banks Money supply↑= Interest rate↓= Investment↑ = AD↑ = Real GDP↑
Restrictive Monetary Policy Used in a sharp inflationGovernment sells bonds from chartered banks Money supply↑= Interest rate↓= Investment↑ = AD↑ = Real GDP↑
THANK YOU FOR LISTENING!