Learning Objectives

 Describe the Bank of Canada’s monetary policy objective, and its

THE IMPORTANCE OF POLICY : Monetary, Fiscal & Structural Policy & Central Bank Role And Policy.. continued
CHAPTER 9A/10 SLIDE SET 10

monetary policy instrument.
 Understand the two theories of interest rate determination  vertical money supply theory  modern central banking theory of interest rate determination

through central bank control of the overnight rate
 Understand how the Bank of Canada influences real and nominal

interest rates, plus looks at the economic effects of changes in interest rates.
 Explain how central bank control over nominal interest rates

translates into control over real interest rates.

Two Theories of Interest rate Determination
 What are the

differences and similarities ?

Vertical Money Supply Theory

What is the Vertical Money Supply Theory of Interest Rate Determination?
 The vertical money supply theory states

To really look at the theory ...
Need to explain :  Demand for money  Supply of money  Money market equilibrium

that the central bank changes interest rates by shifting a vertical money supply curve. Theory includes:  Demand for Money  Supply of Money that is set by Bank of Canada  Interest rate changes result from S & D Logic: Given demand for money .. If Central Bank changes money supply that changes short term interest rate that affect expenditures by business and consumers Bank of Canada does not affect interest rates directly but through the money supply.

1

rates tend to rise and fall together. the greater the opportunity  Real output  Affects the benefits of holding money  More stuff to buy as there is an increase in real output results in increases the value & # of transactions needing cash cost of holding money and the less money demanded  Price level  Note: The nominal interest rate is some average measure of interest  Affects the benefits of holding money  Increase in price level and people need more cash to make rates.Demand for Money  Individual: The amount of wealth an individual chooses to hold in  Benefit of holding money is its convenience in making the form of money M1  Businesses: Must also must decide how much money to hold  Why?  “cash in till” needed to make change  chequing accounts needed for payroll. hence more money held  BUT ‐ Technological and financial innovation has also made money less useful to hold (e.. Why?  Be sure you understand what makes the demand curve slope and shift! 2 . However. or interest rate. Movies: 2$ 1950 versus 12$ 2007 What is the Money Demand Curve?  Money demand curve: based on the cost benefit idea and 3 factors affecting demand. transaction .  GDP and/or price levels – causes shifts of curve  An increase in real GDP and/or an increase in the price level will shift the money demand curve to the right. internet payments)  ATMs make frequent cash replenishment easier  Costs of holding money = opportunity costs  The interest that could have been earned by holding interest‐ (Businesses hold more than twice as much money as individuals in chequing accounts)  Cost‐benefit criterion tells us that an individual (or firm) will increase money holdings if the benefit of doing so exceeds the cost. Specifically:  Nominal interest rate – defines the NEGATIVE slope  As nominal interest rate increases the quantity of money The Money Demand Curve demanded decreases – inverse relationship and therefore the money demand curve slopes down.g. Thousands of different assets each with their own rate of return. credit cards. What are the costs and what are the benefits to consider? bearing assets  Bonds and stocks pay a positive nominal return  Cash and chequing accounts pay little or no interest Macroeconomic Factors Affecting Money Demand  Nominal interest rate  = the opportunity cost of holding money  Why does the Nominal interest rate affect money demand?  The higher the nominal interest rate. etc  transactions  higher income means more transactions.

 if the Bank of Canada wants to decrease interest rates. including the Bank of Canada  Theory holds that central banks.. including the Bank of Canada. Just interest rate level that defines money supply  Logic: a change in the real interest rate => change in spending The Modern Central Banking Theory: details Direct Central Bank Manipulation of the Nominal Interest Rate i i' MD  It is the official view of many central banks. and that M1 changes in response to the change in interest rates.  Theory holds that central banks. it must banks changes this? (last set of slides) increase the supply of money. including the Bank of Canada.  The vertical money supply theory says that :  if the Bank of Canada wants to increase interest rates. it must is a vertical line set by the central bank  How does the Central decrease the supply of money.. What is the Modern Central Banking Theory of Interest Rate Determination? Modern Central Banking Theory of Interest Rate Determination The theory of how the Bank of Canada  controls interest rates directly. directly set their official interest rates.What is the Money Supply Curve?  Central bank controls What is the Money market equilibrium?  Occurs at the intersection of supply and demand where price is the money supply  Quantity of money (M) the nominal interest rate (i)  Money market equilibrium determines the nominal interest rate in the economy.  Money demand – same as last theory  Money supply not a curve here . directly set their official interest rates. and that M1 changes in response to the change in interest rates  Contrast to the vertical money supply theory as the Bank of Canada expressly states that a change in interest rates leads to a change in M1 M M' 3 .

25% below the target.  The overnight rate is the interest rate at which major financial institutions borrow and lend one‐day (or "overnight") funds among themselves.settle up  The interest rate charged on those loans is called the overnight rate. the Bank introduced a system of eight "fixed" dates each year on which it announces whether or not it will change the key policy rate routinely borrow and lend money among themselves overnight. EXCHANGE RATE. the Bank sets a target level for that rate. willing to lend at 0. The central bank influences market interest rates directly by changing its key policy rate  The Bank of Canada controls nominal interest rates through its  The Bank takes additional actions—borrowing and lending overnight rate target  overnight rate target: rate at which it wants private banks to lend to each other overnight  These changes usually lead to moves in the prime business rate at commercial banks and in other interest rates affecting business and household borrowing to finance purchases  Prime business rate: the interest rate that commercial banks charge to their least risky business borrowers operations—to ensure that the overnight rate stays very close to the target  Large Value Transfer System (LVTS)  Settlement Balance  Operating band o A term used by the Bank of Canada to describe the range of possible overnight interest rates o from 0. They can also affect the Canadian dollar..  Changes in the target for the overnight rate influence other interest rates. This target for the overnight rate is often referred to as the Bank's key interest rate or key policy rate. . in order to cover their transactions during the day. 4 . January 2008 How does the Bank of Canada maintain its overnight rate target?  Willing to borrow at 0.  In November 2000.25% above the target  Keeps the overnight rate within 0. such as those for consumer loans and mortgages.25 percentage points above the target o Bank rate: upper limit of the operating band  BOC announces interest changes by basis points.25% of the target  Buys or sells Government of Canada bonds overnight  Keeps the overnight rate very close to the target How does the target for the overnight rate work?  The Bank carries out monetary policy raising and lowering the Is it really Overnight? And why?  Canada's major financial institutions target for the overnight rate. term often used in describing interest rates Downward Shift of the Operating Band for the Overnight Rate. Basis point is one hundredth of a percentage point.25 percentage points below the overnight rate target to 0.

Note that in this theory:  The central bank does not directly control the money supply  Aim is to change interest rates.The Modern Central Banking Theory: details  Since the institutions know that the Bank of Canada will always lend them money at the rate at the top of the band.  influences the level of demand for goods and services. When demand exceeds supply. the Bank responds with an increase in interest rates.  Reverse idea  BE SURE YOU UNDERSTAND WHAT DOES THIS INCREASED INTEREST RATE DOES?? 5 .  Save more spend less  Not take loans  Results in less spending and thus less GDP  If inflation is expected to fall below the 1 percent range.  HOW DOES THIS CONNECT WITH INFLATION?  If inflation threatens to rise above the 3 percent range. the Can the Bank of Canada Control the Real Interest Rate? Bank lowers interest rates. and so affect people's spending decisions. prices will rise…think inflation!! Influences the exchange rate of the Canadian dollar. not to affect the money supply …If anything. there is no reason for them to trade funds at rates outside the band. and pay interest on deposits at the bottom. The Bank can also intervene in the overnight market at the Target rate. if the market rate is moving away from the Target. changes in nominal interest rates cause changes in the money supply  Vertical money supply theory claims it’s the other way around  Changes in the target for the overnight rate usually lead to changes in other interest rates.

 Thus.A.S. & Princeton University  He is ranked among the 50 best economists in the world according to IDEAS/RePEc. Can the Central Bank control the Real Interest Rate? Or is it Inflation control?  We know that real interest rate = nominal interest rate – inflation  We also know that the Bank of Canada can control the short term nominal interest rate (i) quite precisely  And that inflation (π) changes relatively slowly after policy changes.  PhD in economics from the Massachusetts Institute of Technology  What about Canada? in 1979. B. changing nominal interest rates causes real interest rates to change by the same amount So. Yes they can control r because of lag and slow adjust of inflation  Be sure to read the Economic Naturalist 10. 6 .2 page 247  Really try to understand the concepts and terms in the article  Who is this?  Why is the chairman of the U. in economics in 1975. New York University . Federal Reserve described by some as the most influential individual no one knows?  Is he elected or appointed ?  Background?  Does it matter where he was educated??  Harvard College.  He taught at the Stanford Graduate School of Business .Can the Central Bank control the Nominal Interest Rate?  Yes – ST rate mostly …by controlling the overnight rate that the Central Bank controls the nominal interest rate. Generally assumed control over short term interest rates is better than control over long term.

 Goldman Sachs for 13 years. Bachelor's degree in economics from Harvard University in 1988.W. governor of the Bank of Canada. rising to the post of managing director. N.. A native of Fort Smith. Master's degree in economics in 1993 and a Doctorate in economics in 1995. both from Oxford University. 7 .  Prior appointment  senior associate deputy minister of End of Chapter Slides finance.T.Mark Carney.  deputy governor of the Bank of Canada. 47.