ragan chapter29

Chapter 29: Monetary Policy in CanadaCopyright 2014 Pearson Canada Inc.

2014 Pearson Education Canada Inc.

Chapter Outline/Learning ObjectivesCopyright 2014 Pearson Canada Inc. *Chapter 29, Slide

SectionLearning ObjectivesAfter studying this chapter, you will be able to29.1How the Bank of Canada Implements Monetary Policyexplain why the Bank of Canada chooses to directly target interest rates rather than the money supply. 29.2Inflation Targetingunderstand why many central banks have adopted formal inflation targets.explain how the Bank of Canada's policy of inflation targeting helps to stabilize the economy.29.3Long and Variable Lagsdescribe why monetary policy affects real GDP and the price level only after long time lags. 29.4Thirty Years of Canadian Monetary Policydiscuss the main economic challenges that the Bank of Canada has faced over the past three decades.

Copyright 2014 Pearson Canada Inc.

29.1How the Bank of Canada Implements Monetary PolicyMoney Supply Versus the Interest RateFor any given money demand curve, any central bank must choose between:targeting the money supplytargeting the interest rateBoth cannot be targeted independently. Copyright 2014 Pearson Canada Inc. *Chapter 29, Slide


Money Supply Versus the Interest RateThe Bank of Canada chooses to implement its monetary policy by targeting interest rates (rather than the money supply) because:The Bank can influence an interest rate more easily than it can affect the money supply.Instability of money demand.Easier to communicate its policy through changes in interest rates.But which interest rate (of many) does the Bank target?

*Copyright 2014 Pearson Canada Inc. Chapter 29, Slide


The Bank of Canada and the Overnight Interest RateThe Bank can more or less control the overnight interest rate. It does this by:Setting a target for the overnight interest rateEstablishing the bank rate 0.25% above this targetEstablishing a borrowing rate 0.25% below target

keep actual overnight rate within 0.5% band



The Money Supply is EndogenousAs the Bank changes its target for the overnight rate:other interest rates changebank lending changesbanks' demand for currency changes the Bank responds by supplying currency or buying currency from commercial banks the need for open-market operations



But these transactions are done passively by the Bank of Canada: the money supply is endogenous



Expansionary and Contractionary Monetary PoliciesAn expansionary monetary policy occurs when the Bank of Canada reduces its target for the overnight interest rate. eventually increases MS (or its growth rate)An expansionary monetary policy occurs when the Bank of Canada increases its target for the overnight interest rate. eventually decreases MS (or its growth rate)



29.2Inflation TargetingWhy Target Inflation?Over the past few decades, central banks have come to realize two things:High inflation is costly for individuals and damaging for economies.Inflation is the one variable on which monetary policy can have a systematic and sustained influence.

Copyright 2014 Pearson Canada Inc. *Chapter 29, Slide


Why Target Inflation?Recognition of these points has led many central banks to adopt formal inflation targets:New Zealand (1990)Canada (1991)Israel, U.K., AustraliaFinland, Spain, Swedenplus many othersCanada has renewed its inflation targets several times since 1991:the current target of 2% lasts until 2016*Copyright 2014 Pearson Canada Inc. Chapter 29, Slide


The Role of the Output GapIn the short run, when an output gap opens, the Bank has two choices: allow the adjustment process to operateintervene with monetary policySince output gaps put pressure on inflation, the Bank monitors the output gap and may intervene in order to keep output near potentialthereby keeping inflation within the target band*Copyright 2014 Pearson Canada Inc. Chapter 29, Slide


*Copyright 2014 Pearson Canada Inc. Time1%3%Inflation RateInflation target bandt1t0t2t32%Output Gap0TimeBank's policy closes gapPositive shock opens gapBank's policy closes gapNegative shock opens gapChapter 29, Slide


Inflation Targeting as a Stabilizing PolicyAs the previous diagram suggests, inflation targeting tends to stabilize output:in response to a positive output shock, the Bank tightens policyin response to a negative output shock, the Bank loosens policy policy tends to keep output close to Y*But this is not automatic stabilizationthe Bank must actively change policy.



Complications in Inflation TargetingInflation targeting is complicated by two factors:Volatile Food and Energy Prices prices of many goods included in CPI are determined in world marketsthese may change suddenly for reasons unrelated to Canadian output gaps the Bank also monitors core inflation



The Exchange Rate and Monetary Policythe Bank must identify the cause of any exchange rate change before determining the appropriate policy responseconsider an appreciation of the Canadian dollar caused by an increase in demand for exportsor an appreciation of the Canadian dollar caused by an increase in demand for Canadian bonds




MyEconLab www.myeconlab.comFor a more detailed discussion of how movements in the exchange rate complicate the implementation of monetary policy, look for Monetary Policy and the Exchange Rate in Canada in the Additional Topics section of this book's MyEconLab.


29.3Long and Variable LagsWhat Are the Lags in Monetary Policy?Monetary policy operates with a time lag that is long and variable for two main reasons:changes in expenditure take timethe multiplier process takes timeCopyright 2014 Pearson Canada Inc. *Chapter 29, Slide


Destabilizing Policy?Long and variable lags some monetarists argued that central banks should not try to stabilize national income. They argued that attempts to stabilize will more likely be destabilizingthey advocate the use of a monetary rule increase bank reserves at a constant rateMost economists now agree that monetary policy can lead to more economic stability.*Copyright 2014 Pearson Canada Inc. Chapter 29, Slide


Political Difficulties*Copyright 2014 Pearson Canada Inc. Monetary policy must be forward-looking. often creates difficulties when policy is tightened now because of expected future inflationChapter 29, Slide Fig. 29-5Forward-Looking Monetary Policy


29.4Thirty Years of Canadian Monetary PolicyEarly 1980s:inflation reached 12% as a result of OPEC oil shocks in the mid and late 1970sthe Bank embarked on a strict policy of monetary restraintbut unanticipated surge in money demand led to a much tighter monetary policy than intended the most serious recession since the 1930s

Copyright 2014 Pearson Canada Inc. *Chapter 29, Slide


Economic Recovery: 19831987The main challenge was creating sufficient liquidity to accommodate the recovery without triggering a return to the high inflation rates.

Rising Inflation: 19871990Inflation crept upwards throughout the late 1980s.Many economists argued the need for tightening monetary policy.*Copyright 2014 Pearson Canada Inc. Chapter 29, Slide


Disinflation: 19901992The Bank of Canada embarked on its stated policy of price stability.When the tight monetary policy took effect:interest rates increasedthe Canadian dollar appreciatedinflation fell suddenlyThe economy entered a significant recession in the early 1990s.



Inflation Targeting I: 19912000The ensuing economic recovery was quite gradual:excessive stimulation could have led to a return of inflation insufficient stimulation could have caused the economy to stallBeginning in 1996, the recovery was more robust and inflation remained well within the 1 to 3% target band.By 2000, Canadian GDP was near its potential level and inflation was just below 2% and quite stable.*Copyright 2014 Pearson Canada Inc. Chapter 29, Slide


Two issues complicated monetary policy in the late 1990s:The Asian Crisis This presented a (confusing) combination of aggregate demand and aggregate supply shocks.

2. The Stock MarketThe bull market of the late 1990s presented some challengeshow should monetary policy respond?*Copyright 2014 Pearson Canada Inc. Chapter 29, Slide


Targeting Inflation II: 20012007The terrorist attacks of 9/11 presented substantial challenges for monetary policy:the U.S. economy was already slowing downpolicy interest rates were dramatically reducedThe 20022006 period presented other challenges:commodity prices were rising sharplyU.S. dollar was weakening against most currencies



Financial Crisis and Recession: 2007PresentThe decline in U.S. house prices that began in early 2007 led to widespread losses in financial institutions.Central banks responded with quite expansionary (and also creative) monetary policies, designed to maintain the smooth functioning of credit markets.The losses and failures of many financial institutions created severe disruptions in the global credit markets.The subsequent recession led to both monetary and fiscal expansions in all of the G20 countries.*Copyright 2014 Pearson Canada Inc. Chapter 29, Slide


By 2012, three years into a modest recovery, the Bank of Canada still had a historically low target for the overnight interest rate.The weakness of the U.S. and European economies at that time were offsetting the stronger economic performance within Canada.




MyEconLab www.myeconlab.comWith the success of many central banks in maintaining low and stable inflation, some economists have raised the concern that inflation may now be too low, and that the economy may actually function more smoothly with slightly higher inflation. For more details about this contentious debate, look for Can Inflation Be Too Low? in the Additional Topics section of this book's MyEconLab.


ragan chapter29

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