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Chapter 11 (Lecture Notes and Textbook Notes)

Tuesday, March 28, 2023
Birdget O’Shaughnessy
ECON 1BB3 C02

Lecture Notes (Tuesday, March 28, 2023)

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Textbook Notes (pg 328– 370)

11.1 What is Monetary Policy?
 Actions BOC takes to manage money supply and interest rates to pursue macro policy
goals/objectives

The gaols of monetary policy

1. Price stability
 Rising prices reduce usefulness of money as medium of exchange and store of value
 Inflation targeting = conducting monetary policy so as to commit central bank to
achieving publicly announced level of inflation
 Symmetric inflation targeting = conducting monetary policy based on equal concern
about inflation rising above target about inflation falling below its target
 Flexible inflation targeting = conducting monetary policy that doesn't rely on mechanical
rules to achieve its inflation target, but tries to meet inflation target over some time
horizon
2. High employment
 Unemployed workers and underused factories and office buildings reduce GDP below
potential level
 Goal of high employment extends beyond BOC to other branches of federal govt
3. Stability of financial markets and institutions
 Financial firms subject to liquidity problems b/c borrow short term and invest funds in
long-term securities
4. Economic growth
 Policymakers aim to encourage stable economic growth, to accurately plan and
encourages firms to engage in investment needed to sustain growth
 Govt better able to increase saving and investment than BOC

11.2 The Money Market and the Bank of Canada's Choice of Monetary
Policy Targets
 Policy intended to achieve one monetary policy goal may make more difficult to achieve another
policy goal

Monetary policy targets

 Used to affect variables
 Main monetary policy targets are money supply and interest rate

The demand for money

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 Money demand curve slopes downward b/c lower interest rates cause households and firms to
switch from financial assets
 Households and firms have choice b/t holding money and holding other financial assets
 Take into account different factors
1. Has one partially desirable characteristic: use to buy goods, services, or financial
assets
2. Has on undesirable characteristic: earns 0 interest rate or very low interest rate
 Interest rate is opportunity cost of holding money
 Interest rates on financial assets low, opportunity cost of holding money low, so quantity of
money demanded high
 Interest rates high, opportunity cost of holding money high, so quantity of money demanded
low

Shifts in the money demand curve

 Changes in variables other than price cause demand curve to shift
 Demand curve for money drawn holding constant all variables affect willingness of households
and firms to hold money
 Changes in most important variables that cause money demand curve shift
1. Real GDP
2. Price level
3. Technology
 Additional buying and selling increases demand for money as medium of exchange shifting
money demand curve right
 Increase in price level increases quantity of money demanded at each interest rate, shifting
money demand curve right
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How the Bank of Canada manages the money supply: a quick review
 Equilibrium in the money market
 Occurs where money demand curve crosses money supply curve
 If BOC increases money supply, money supply curve shift right, and equilibrium interest
rate fall

 When BOC increases money supply, short-term interest rate fall until reaches level at which
households and firms willing to hold additional money
 Rising short-term interest rates increase opp cost of holding money, causing movement up
money demand curve
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Tale of two interest rates

1. Loanable funds model
 Concerned w long-term real rate of interest
 Interest rate relevant when savers consider purchasing long-term financial security
 Interest rate relevant to firms when borrowing to finance long-term investment projects
2. Money market model
 Concerned w short-term nominal rate of interest
 Economists focus on short-term nominal interest rate b/c interest rate affected by BOC
policy

Choosing a monetary policy target

 BOC targeted interest rate known as overnight interest rate
 Importance of the overnight interest rate
 Interest rate banks charge each other for overnight loans
 Very short-term loans
 BOC operates under system where announces target for overnight interest rate on 8
“fixed” dates throughout year
 Operating band = BOC's 50-basis-point range for overnight interest rate
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 Interest rate not directly relevant for households

 Changes in overnight interest rate result in changes in interest rates on other assets

11.3 Monetary Policy and Economic Activity

 Open market buyback operations = agreements where BOC purchases securities w
understanding that seller repurchase them in short period of time, usually < week
 Ability of BOC to use monetary policy to affect economic variables depends on ability to affect
long-term real interest rates

How interest rates affect aggregate demand

 Consumption
 Lower interest payments on loans ↑ household spending on consumer durables and ↓
return to saving
 Higher interest rates ↓ household spending on consumer durables and ↑ return to
saving
 Investment
 Firms borrow in financial markets either by issuing corporate bonds or by obtaining
loans from banks
 Higher interest rates ↓ investment projects and ↑ investment spending
 Lower interest rates ↑ investment projects
 ↑ demand for stock raises prices so acquire funds need
 Net exports
 = spending by foreign households/firms on goods/services produced in Canada -
spending by Canadian households/firms on goods/services produced in other countries
 $ value ↑, households/firms in other countries pay more for goods/services, but
Canadians pay less for goods/services produced elsewhere
 Export less and import more = NE ↓

Effect of monetary policy on real GDP and price level

 Expansionary monetary policy = BOC's decreasing interest rate to increase real GDP
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 BOC use monetary policy to affect price level and, in short run, level of real GDP, allowing it to
attain policy goals of high employment and price stability

Can Bank of Canada eliminate recessions?

 Must recognize need for change in monetary policy
 Typically lag b/t policy change and effect on economic variables
 Takes time for interest rates that affect firm and household behaviour to also decline

 Summary of how monetary policy works

 Expansionary monetary policy sometimes called loose policy, or easy policy
 Contractionary monetary policy sometimes called tight policy

11.4 Monetary Policy in the Dynamic Aggregate Demand and

Aggregate Supply Model
 Aggregate expenditure usually increases for three key reasons:
1. As population grows and incomes rise, consumption increase over time
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2. As economy grows, firms expand capacity, and new firms est, increasing investment
spending
3. Expanding population and economy require increased govt services, so govt purchases
expand

Effect of monetary policy on real GDP and the price level: a more complete account
 During certain periods, AD not increase enough during year to keep economy at potential GDP

 Economists at BOC monitor economy and update forecasts of future levels of real GDP and
prices
 When economists anticipate aggregate demand not growing fast enough to allow economy to
remain at full employment, present findings to BOC’s governing council
 Governing council = council w 6 member responsible for management of BOC

Using monetary policy to fight inflation

 BOC use contractionary monetary policy to keep aggregate demand from expanding rapidly that
inflation rate begins to increase above upper limit of inflation rate target band of 3%

11.5 A Closer Look at the Bank of Canada's Setting of Policy Targets

Should the Bank of Canada target the money supply?
 Some economists argued that BOC should use money supply
 Belong to a school of thought known as monetarism
 Monetary growth rule = plan for increasing quantity of money at fixed rate that doesn't respond
to changes in economic conditions
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 Proposed monetary growth rule of increasing money supply every year at rate equal to long-run
growth rate of real GDP (3%)

Why doesn't the Bank of Canada target both the money supply and the interest rate?
 Economists believe interest rate best monetary policy target

 BOC controls money supply, but not money demand

 Money demand determined by decisions of households/firms weighing trade-off b/t
convenience of money and low interest rate
 BOC choose b/t targeting interest rate and targeting money supply

The Taylor rule

 Rule developed by John Taylor linking central bank's target for overnight interest rate to
economic variables
 Begins w estimate of value of equilibrium real overnight interest rate
 BOC set target for overnight interest rate so that = sum of inflation rate, equilibrium real
overnight interest rate, and 2 additional terms
1. Inflation gap = difference b/t current inflation and target rate
2. Output gap = % difference b/t real GDP and potential GDP

 Includes expressions for inflation gap and output gap b/c BOC concerned about inflation and
fluctuations in real GDP
 Taylor demonstrated that if equilibrium real overnight interest rate is 2% and target rate of
inflation is 2%

 Coefficient on inflation gap > 0

 When inflation rate increases by 1% point, central bank increases overnight interest rate
by >1% point so real interest rate also rises
 Taylor principle = principle that central bank should raise nominal interest rate by more than
increase in inflation rate so that real interest rate also increases
 Economists view rule as convenient tool for analyzing overnight funds target

Inflation targeting
 Conducting monetary policy to commit central bank to achieving publicly announced level of
inflation
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 Central bank respond to periods of recession or other economic problems without following
inflexible rule
 Arguments supporting central bank’s use of inflation target focus on following points
1. Draws public’s attention to what central bank can achieve in practice
2. Provides anchor for inflationary expectations
3. Promote accountability for central bank by providing yardstick against which
performance measured
 Some economists and policymakers critical of monetary policy strategies designed to target
inflation rate
1. Targets for inflation diminish flexibility of monetary policy to address other policy goals
2. Requires central bank use forecasts of future inflation, which may turn out to be
inaccurate
3. Holding central bank accountable for goal of low inflation make more difficult for
elected officials to monitor central bank’s support for good economic policy
4. Inflation targets increase uncertainty over whether central bank take prompt action to
return economy to full employment following recession

11.6 Central Bank Policies During the 2007-2009 Global Financial

Crisis
 Central bank’s traditional response to recession is to lower target for overnight interest rate

The inflation and deflation of the housing market bubble in the United States
 Many economists believe stock market bubble can form when prices of stocks rise above levels
that can be justified by the profitability of firms issuing stocks
 End when enough investors decide stocks overvalued and begin to sell
 Why pay more for stocks
 Investor caught up in enthusiasm of moment and, by failing to gather sufficient info,
overestimate true value of stocks
 Investor expect to profit from buying stocks at inflated prices if investor can sell them at
higher prices before bubble bursts

 Decline in housing market affected other markets

The changing mortgage market in the United States

 Barrier to creating secondary market in mortgages was investors unwilling to buy mortgages b/c
afraid of losing money if borrower stopped making payments (defaulted)
 US govt used 2 govt-sponsored enterprises (GSEs)
1. Federal National Mortgage Association (“Fannie Mae”)
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2. Federal Home Loan Mortgage Corporation (“Freddie Mac”)