Chapter 12

Bank of Canada and Monetary Policy

Bank of Canada http://

bankofcanada.ca/en/video_corp/videos.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: 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 CanadaCanada’s “Biggie” Bank

Canada’s central bank, in operation since 1935 During great

depression Aimed to add

stability to system and prevent a run on chartered banks

The Bank of CanadaCanada’s “Biggie” Bank

Originally the bank was expected to: Regulate credit and

currency Control external

value of the Canadian Currency

Reduce fluctuations in production, trade, prices and inflation

Structure of the BofC 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 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

Interest rates take into account inflation Therefore interest rates have an inflation

premium built in

Interest rates Two components

Nominal Rate of interest Premium for risk of non repayment Premium for delayed consumptions

Inflation Premium Expected rate of inflation

Real Rate of interest Nominal – Inflation Premium

Inflation and interest rates 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 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 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 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 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 Prime rate: Rate offered by

commercial banks to their best customers (?) 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 Overnight rate

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 Rate1. Dollar goes down and Interest Rates

Drop

2. Increase in demand

3. Increase prices

4. Rate of inflation increased

STIMULATES THE ECONOMY

Increase in Overnight Rate1. Dollar goes up and Interest Rates

go up

2. Decrease in demand

3. Decrease prices

4. Rate of inflation decrease

SLOWS THE ECONOMY

Monetary Policy Easy Money: Increase the money

supply (expansionary) Tight Money: Restricts the money

supply (contractionary)

Tight Money Used when economic times are good

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 Used when economic times are bad

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

Easy Money

Tight Money

Bank Rates vs GDP

Classwork Read P 264-268 question 1-6

Easy Money Policy 4 stages

Stage 1: Bank shifts money to the chartered banks

to increase reserves and encourage lending

Stage 2: 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 Stage 3:

Increased borrowing = increased money supply resulting in increased output (GDP)

Stage 4: This increases aggregate demand and GDP

leading to full employment

Tight Money Policy 4 stages

Stage 1: 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: Higher interest rates =less borrowing Business responds by cutting back (stock,

equipment, expansion)

Stage 3: Less borrowing = less money supply

Stage 4: Decreased spending by consumers and

businesses shifts AD to the left This results in decreased prices (deflation)

Hardship Caused by Inflation 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

Pric

e le

vel

Real GDP (Output)

AS

AD

Aggregate Demand and Aggregate Supply Graph The AS curve goes vertical because

there is a limit (CP) to production

Pric

e le

vel

Real GDP (Output)

AS

AD

Aggregate Demand and Aggregate Supply Graph FE: Full employment. In Canada

approx 6-7% unemployment. 1-3% Inflation.

Pric

e le

vel

Real GDP (Output)

AS

AD

FE

Aggregate Demand and Aggregate Supply Graph If AD < FE then there is a recession.

Low inflation/deflation. High Unemployment

Pric

e le

vel

Real GDP (Output)

AS

FE

AD

Aggregate Demand and Aggregate Supply Graph If AD > FE then there is a boom.

High inflation. Low unemployment

Pric

e le

vel

Real GDP (Output)

AS

FE

AD

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. 1. Consumers spend on big ticket items goods

2. Businesses spend on capital goods (equipment)

3. Borrowing and spending by increases money supply. Which triggers more borrowing and spending

Monetary Policy (Easy Money)4. Increased spending shifts AD1 to

AD2 thus reaching FE

Pric

e le

vel

Real GDP (Output)

AS

AD2

FE

AD1

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.

1. Consumers delay on big ticket items goods

2. Businesses delay on capital goods (equipment)

3. Less borrowing and spending decreases money supply. Which triggers less borrowing and spending

Monetary Policy (Easy Money)4. Decrease spending shifts AD1 to

AD2 thus ending high inflation

Pric

e le

vel

Real GDP (Output)

AS

AD2

FE

AD1

Homework P268 1-6 P273 4 and 5 P276 1, 2 3 P279 2

P268 question 1-61. The bank of Canada insists on the right

to issue currency in order to meet its function of controlling inflation

2. Accounts at the Bank of Canada1. Chartered Banks: Settle debts among

themselves. Location for short term loans2. Federal Government:

1. Allows monetary policy2. Deposit the proceeds of bond payments3. Paying interest on bonds4. Holding foreign reserves

P268 question 1-63. 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

4. Spending and Creating money are kept separate in order to resist the temptation to print money to pay for spending

P268 question 1-65. The Minister of finance is

accountable to the voters and the PMO. The Governor of the BofC is accountable to the Minister

6. 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 Real = Nominal - Expected A) Nominal interest rate: 7% B) Real interest rate : 4% C) Real interest rate: 3%

P273 5 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 31. 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 Easy money pressures interest rates

down Tight money pressures interest rates

up