Lecture Notes - ECON 22358G - Chapter 13-No Answers

CHAPTER 13
MONETARY POLICY
THE BANK OF CANADA 2
• The moving force behind Canada's monetary policy is the Bank of Canada.
• It has served as Canada's central bank since 1935.
• Its principal role is "to promote the economic and financial welfare of
Canada," as defined in the Bank of Canada Act.
• A wholly government-owned institution.

– Directors and governor are appointed by the federal cabinet
– Current governor (see in BOC website here)
ECON22358G - Macroeconomics
• The Bank of Canada performs four basic functions:
1. It manages the money supply.
– Conducts “monetary policy” by controlling the amount of money

circulating in the economy.
– Not only does it issue paper currency, but more importantly, it

affects the activities of chartered banks and similar financial
institutions (“near banks”) so that it can vary the supply of money
and interest rates.
1. It manages the money supply.
– In managing the money supply, the Bank is concerned with three goals:
1. Minimizing inflation to preserve the purchasing power of the dollar
2. Maintaining real output as close as possible to its potential level
3. Regulating the external value of the Canadian dollar in foreign exchange

markets.
2. It acts as the bankers’ bank:
– Holds deposits of members of the Canadian Payments

Association (CPA)
– Makes advances (loans) to CPA members at the “bank rate”
3. It acts as the federal government’s fiscal agent:
– holds some of the government’s bank deposits
– clears the government’s cheques
– handles the financing of the government’s debt by issuing bonds

(including Canada Savings Bonds and Treasury Bills)
4. It helps supervise the operations of financial markets to ensure

their stability.
– The Bank works in conjunction with the Office of the Superintendent of

Financial Institutions, and follows the global guidelines of the Basel
Committee on Banking Supervision.
– The success of Canada’s financial supervision has received

considerable attention since the 2008 financial crisis.
ACTIVE LEARNING 8
Which phrase best describes the Bank of Canada?

a) A privately-owned central bank, whose basic goal is to earn profits for its owners.
b) A government-owned central bank, whose basic goal is to control the money supply and
thereby help to promote general economic welfare.
c) A government-owned central bank, whose basic goal is to provide income for the
Government of Canada.
d) A privately-owned central bank, whose basic goal is to provide a market for

Government of Canada securities.
e) A privately-owned central bank, whose basic function is to minimize the risk for
commercial banks in order to make them reasonably secure and profitable.
ACTIVE LEARNING 9
• Which of the following is NOT one of the four major functions of the Bank of
Canada’s?
a) Managing the economy’s supply of goods and services.
b) The federal government’s fiscal agent.
c) Oversees the operations of financial markets to ensure their stability.
d) Is the bank for commercial banks.
CANADA AND THE FINANCIAL CRISIS 10
• Canadian financial institutions were less affected by the financial crisis than most
industrialized countries. Why?
– Canadian financial regulators had banned high-risk mortgage lending.
– Canadian banks engaged in far less risky behavior than many of their global
counterparts in trading risky derivatives such as mortgage-backed securities.
– Canada’s large banks had lower leverage ratios than many of their global
counterparts.
– The Canadian property market had not succumbed to the same bubble
conditions as in some other countries.
MONETARY POLICY 11
• Monetary policy relates to how a country’s central bank governs the supply of
money and interest rates in an economy in order to influence output,
employment, and prices.
• Recall that monetary policy involves the Bank of Canada changing interest
rates, altering the money supply, or both, to stabilize the economy.
• Our analysis of money and deposit-takers allows us to examine the way in

which monetary policy is conducted.
• Monetary policy can be broadly classified as either expansionary or

contractionary.
EXPANSIONARY MONETARY POLICY 12
• When real output falls short of its potential level, a recessionary gap is created.
• The Bank of Canada will use an expansionary monetary policy to stimulate

output and increase employment and close the gap:
– Such action is referred to informally as “easy money policy”.
– A policy of increasing the money supply and lowering interest rates.
– This shifts AD rightward by a magnified amount due to an initial increase in

investment and the consumption of durable goods.
SPENDING MULTIPLIER 13
• The change in AD, or total spending, is found by calculating the product of the spending
multiplier and the initial spending change:
❑
𝐓𝐨𝐭𝐚𝐥 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐨𝐮𝐭𝐩𝐮𝐭 ❑
= 𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐜𝐡𝐚𝐧𝐠𝐞 ×𝐒𝐩𝐞𝐧𝐝𝐢𝐧𝐠 𝐦𝐮𝐥𝐭𝐢𝐩𝐥𝐢𝐞𝐫 ¿
(𝐬𝐡𝐢𝐟𝐭 𝐢𝐧 𝐀𝐃 𝐜𝐮𝐫𝐯𝐞)
𝐢𝐧 𝐬𝐩𝐞𝐧𝐝𝐢𝐧𝐠
¿
• Suppose, for example, that the initial increase in investment and consumption totaled $9
billion and the value of the economy's spending multiplier is 1.67.
$9 billion ×𝟏 . 𝟔𝟕=$ 𝟏𝟓𝐛𝐢𝐥𝐥𝐢𝐨𝐧
• Thus, the total change in aggregate demand is then $15 billion:
FIGURE 13.1: EXPANSIONARY MONETARY POLICY
14
The Money Market The Economy
5 Sm0 Sm1 Initial

Recessionary
Nominal Interest Rate (%) Gap AS
Price Level (GDP deflator,

4 140 d
130 e
2007 = 100)
3
a c
120
2 AD1
b 110
1
Dm
100 Potential AD0
Output
0 30 40 50 60 0 790 795 800 805

Quantity of Money Real GDP
($ billions) (2007 $ billions)
• In a recession, the Bank can increase the money supply as shown by the shift from Sm0 to Sm1 on the left, thereby
pushing down the interest rate (point a to point b).
• The result as a whole, due to the spending multiplier, is an increase in AD of $15 billion (AD 0 to AD1on the right).
• However, output does not rise by the entire $15 billion (i.e. point c to e); rather, the price level and output both rise to
give a new equilibrium at point d, with output at the potential level of $800 billion and the recessionary gap
eliminated.
CONTRACTIONARY MONETARY POLICY 15
• When real output exceeds its potential level, an inflationary gap is created.
• The Bank of Canada will use a contractionary monetary policy to reduce

output and close the gap:
– Such action is referred to informally as “tight money policy”.
– A policy of decreasing the money supply and increasing interest rates.
– This shifts AD leftward by a magnified amount due to an initial decrease in

investment and the consumption of durable goods.
FIGURE 13.2: CONTRACTIONARY MONETARY POLICY
The Overall Economy
16
The Money Market
5 Sm1 Sm0 AS
150 e
Nominal Interest Rate (%) c AD0
4
a 140

d
3 130 AD1
b
2007 = 100)
Dm Initial
2 120 Inflationary
Gap
110
1
100 Potential
Output
0 30 40 50 60
0 790 795 800 805
Quantity of Money ($ billions)
Real GDP (2007 $ billions)
• During a boom, the Bank can lower the money supply, from Sm0 to Sm1 pushing up the interest rate (point b to point a).
• Because of the initial spending decrease and the spending multiplier, the result is a decrease in AD, as shown on the right as
the $15 billion shift from AD0 to AD1.
• Output does not fall by $15 billion (from point e to point c); rather, the price level and output both fall to give a new
equilibrium at point d, with output at the potential level of $800 billion and the inflationary gap eliminated.
ACTIVE LEARNING 17
• The tables show hypothetical money demand and
supply schedules as well as AD and AS schedules for
an economy whose natural unemployment rate is
estimated to be 7 percent.
a) Suppose the unemployment rate is 8.5% and a

declining rate of inflation. Is this economy facing a
recessionary or inflationary gap? Should its central
bank use a contractionary or expansionary
monetary policy?
b) Identify the steps by which this monetary policy

will affect the economy.
ACTIVE LEARNING 18
• The tables show hypothetical money demand and supply
schedules as well as AD and AS schedules for an
economy whose natural unemployment rate is estimated
to be 7 percent.
c) Draw one graph showing curves Dm and Sm0 in the
money market and another with curves AD0 and AS.
Plot four points for the demand curve Dm and four

points for the AS curve AS.
What is the initial equilibrium interest rate in the

money market? What are the initial equilibrium price
level and real GDP?
ACTIVE LEARNING 19
d) If the monetary policy applied in part b leads to a

$100 billion change in the money supply, then what
is the new equilibrium interest rate?
Add the new money supply curve Sm1 to your

graph.
ACTIVE LEARNING 20
e) If the change in the interest rate in part d causes a

$200 billion change in real expenditures at every
price level, then what are the new equilibrium
price level and real GDP?
Add the new aggregate demand curve AD1 to

your graph.
TOOL 1: OPEN MARKET OPERATIONS 21
• Open market operations are a tool the Bank of Canada uses to conduct
monetary policy on a day to day basis.
– A sale of bonds by the BoC lowers a CPA member’s deposit liabilities

and reserves, which causes a magnified decrease in the money supply
using the money multiplier.
– A purchase of bonds by the BoC raises a CPA member’s deposit

liabilities and reserves, which causes a magnified increase in the
money supply using the money multiplier.
FIGURE 13.3: A BOND SALE
22
Bank of Canada
Assets Liabilities
Bonds -$1000 Scotiabank’s Deposit -$1000
Scotiabank
Assets Liabilities
Reserves at Bank of Canada -$1000 Bondholder A’s Deposit -$1000
• When the Bank of Canada sells a bond to Bondholder A, its bond assets fall, as do its deposit liabilities to Scotiabank.
• Meanwhile, Scotiabank's cash assets at the Bank of Canada decrease, as do its deposit liabilities to Bondholder A.
• The drop in Bondholder A's deposit immediately reduces the money supply by $1000. With a reserve ratio of 10 percent,
Scotiabank’s excess reserves fall by $900 and the money multiplier has a value of 10.
• Because reductions to deposits are magnified, the money supply drops by as much as an extra $9000 (the $900 decrease
in excess reserves multiplied by the money multiplier).
FIGURE 13.4: A BOND PURCHASE
23
Bank of Canada
Assets Liabilities
Bonds +$1000 TD Bank’s Deposit +$1000
TD Bank
Assets Liabilities
Reserves at Bank of Canada +$1000 Bondholder B’s Deposit +$1000
• If the Bank of Canada purchases a bond from Bondholder B, its bond assets rise, and its deposit liabilities to TD Bank.
• From TD Bank’s perspective, its cash assets at the Bank of Canada increase, as do its deposit liabilities to Bondholder B.
• The new deposit from Bondholder B immediately adds $1000 to the money supply.
• With a reserve ratio of 0.10, TD Bank’s excess reserves increase by $900, while the money multiplier has a value of 10.
• Because deposits expand, the money supply increases as much as an extra $9000 (the $900 increase in excess reserves
multiplied by the money multiplier).
EXAMPLE: OPEN MARKET OPERATIONS TO EXPAND MONEY 24
SUPPLY
• Below is the sequence of events when the central bank uses open market operations to expand the
money supply. Bond
Cheque
(1)
Bank of Bank of Canada Bondholder
buys a bond from A
Canada
(4) a private
Increased bondholder A (2)
reserves Cheque is
deposited
Commercial
(3)
Cheque is
Bank
presented for (6)
payment (5)
Increased Money
reserves are Supply
lent out Increases
ACTIVE LEARNING 25
• The Bank of Canada buys a $10,000 bond from a member of the public
when the reserve ratio in the banking system is 5 percent. Outline the
effects on this bond purchase on each of the following variables:
a) The bond seller's bank deposit
b) Desired reserves at the bond seller's bank
c) Excess reserves at the bond seller's bank
d) The maximum change in the money supply
TOOL 2: TARGETING THE OVERNIGHT INTEREST RATE 26
• Commercial banks routinely borrow and lend money overnight among themselves in
order to cover their net shortfalls or surpluses from transactions during the day.
• At the end of the day, they need to settle with each other.
• One bank may have funds left over, while another bank may need money.
• This creates a market for short-term loans and the market price is the overnight interest
rate.
– The Bank of Canada’s key policy interest rate
• 8 times a year, the BoC announces its overnight target rate and then ensures it stays
within a publicized range of 50 basis points (= .5%).
– The target overnight rate is the rate at the midpoint of this range.
• The Bank keeps the overnight rate near the target overnight rate by using Tool 1 – open
market operations.
TARGETING THE OVERNIGHT RATE 27
Bank Rate 2.75% The rate the commercial banks pay to the
Bank of Canada on loans to cover a
shortfall in reserves.
Operating Band
Visit the Bank of Canada’s website to
Target for the see what the current rate is:
2.5%
overnight rate https://www.bankofcanada.ca
The rate that the Bank of Canada pays the

Bankers deposit commercial banks on deposits of excess
2.25%
rate reserves.
THE PRIME INTEREST RATE, THE BANK RATE, THE OVERNIGHT TARGET
RATE, AND THE OVERNIGHT LENDING RATE IN CANADA, 1998–2016
28
TARGETING THE OVERNIGHT RATE 29
• Changing the target overnight rate is a tool the Bank of Canada uses to
signify its monetary policy intentions.
– When the Bank of Canada changes its target band for the overnight rate
it also automatically adjusts the bank rate since this rate is at the top
end of the target band.
• Why do we care?
THE RATE AS A SIGNAL 30
• A rise in the target overnight rate signifies a contractionary policy.
• A fall in the target overnight rate signifies an expansionary policy.
• If the change in the target overnight rate is substantial, then banks and other deposit
takers also adjust their prime rate, which is the lowest possible rate charged on loans to
their best corporate customers.
• The interest rate is the price of credit.
• The lower the price the cheaper it is for businesses to borrow and invest and for
consumers to borrow and purchase big ticket items like cars and durable goods.
• Hence, lower interest rates stimulate the economy and higher interest rates slow the
economy down.
TYPES OF INFLATION 31
• There are two main types of inflation:
– Demand-pull inflation occurs as rightward shifts in the AD

curve pull up prices.
– Cost-push inflation occurs as leftward shifts in the AS curve

push up prices
FIGURE 13.5: DEMAND-PULL INFLATION 32
AS

150 b
2007 = 100) 140

a
AD1
AD0
0 750 770
• During expansionary times, aggregate demand increases, shown by a shift of the AD curve from AD 0 to AD1.
• The result is that the price level rises from point a to point b.
• In other words, increased demand pulls up prices.
THE PHILLIPS CURVE 33
• The Phillips curve is a graph showing the assumed inverse relationship

between unemployment and inflation  “the two economic evils”.
– From 1960 to 1972 the Canadian Phillips curve was relatively stable.
– From 1973 to 1982 the Canadian Phillips curve shifted rightward

resulting in stagflation.
– From 1983 to 2013 stagflation was reversed but no constant Phillips

curve emerged.
FIGURE 13.6: THE PHILLIPS CURVE
10 34
8 a
Inflation Rate (%)

6
b
2
c
0 2 4 6 8 10
Unemployment Rate (%)
• The Phillips curve expresses the Keynesian belief in the fixed and predictable inverse relationship between unemployment
and inflation that occurs with demand-pull inflation (but NOT cost-push inflation).
• When the economy moves from point b to point a—which may happen as a result of expansionary stabilization policies—
inflation increases and unemployment decreases.
• In contrast, contractionary policies cause the economy to move from point b to point c.
FIGURE 13.7: SHIFTS IN THE PHILLIPS CURVE
35
• During 1960 to 1972, inflation and unemployment
stayed in a broad band, from which a Phillips curve can
be drawn (shown as a solid line).
• In the period from 1973 to 1982, the predictable
relationship broke down.
• However, it seems that the Phillips curve moved to the
right (shown as a dashed line) as both inflation rates and
unemployment rates were above those in the previous
period.
• In the period from 1983 to 2013, the trend was to lower
inflation, but unemployment rates remained high until
just before the 2008–2009 recession. As a result, the
new position of the Phillips curve was not clear.
FIGURE 13.8: COST-PUSH INFLATION
AS1
36
AS0
c
150

140 d
2007 = 100)
AD
0 750 770
• Increased input prices cause businesses to decrease output. The resulting decrease in aggregate supply means a shift in the aggregate
supply curve from AS0 to AS1.
• The result is that prices increased from point d to point c.
• Increased costs push up prices while reducing total output. This bad combo of rising unemployment & inflation is called “Stagflation”
THE SELF-STABILIZING ECONOMY 37
• In theory, the economy has a self-stabilizing tendency due to long-run

movements in the AS curve.
– If equilibrium real output is above potential output, then higher wages

gradually push the AS curve leftward and decrease equilibrium output.
– If equilibrium real output is below potential output, then lower wages

gradually push the AS curve rightward and increase equilibrium output.
FIGURE 13.9: THE SELF-STABILIZING ECONOMY
AS
38
Potential
Output
(GDP deflator,2007 = 100)

110
c
Price Level
b
100
95
a
0 700 725 730

• At point b, the economy could remain indefinitely at its potential output.

• However, when equilibrium is at point c in a boom, the economy's self-stabilizing tendency will push the AS curve to the
left so that the potential output can be resumed.
• Similarly, if the equilibrium is at point a in a recession; the self-stabilizing tendency will push the AS curve to the right.
THE LONG-RUN AGGREGATE SUPPLY CURVE 39
• These movements mean that the vertical line on the graph at the potential output
level can be interpreted as the economy’s long-run aggregate supply curve (LAS).
• This is because it shows all points consistent with stable equilibrium in the long run.
• However, in real life the economy never gets a chance to settle into a long run stable
state. Instead, it is constantly being agitated by changes in prices, technologies,
taxes, demographics etc. and therefore fluctuates between expansion and contraction
in what’s known as the “business cycle”.
RECAP - TODAY’S KEY POINTS 40
• The BoC manages the supply with the main goals of controlling inflation and
stabilizing the economy near potential output.
• The BoC will use a contractionary (“tight”) monetary policy to reduce an
inflationary output gap.
• This has the effect of raising interest rates, reducing borrowing for investment and
consumption and shifting the aggregate demand curve left.
• The BoC will use a expansionary (“loose”) monetary policy to reduce a recessionary
output gap.
• This has the effect of reducing interest rates, increasing borrowing for investment and
consumption and shifting the aggregate demand curve right.
• The BoC conducts monetary policy through (1) open market operations – buying and
selling government bonds and (2) targeting the “over night rate” at which banks borrow
and lend excess reserves from one another.
• There are two sources of inflation: demand-pull and cost-push
• In theory, there is an inverse relationship between inflation and unemployment. If
the BoC tries to reduce inflation it can lead to higher unemployment. However,
that relationship doesn’t always hold.
• In theory, in the long run, economies should stabilize but in reality they tend to
fluctuate around potential output in “business cycles”.
TO DO LIST 43
• Read Chapter 13 in the textbook
• Complete Practice Problems: 13.1-13.3
• Complete End-of-Chapter: Problems 1-7
• Complete Self-Assessment Exercises in SLATE.

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CHAPTER 13

• It has served as Canada's central bank since 1935.

• A wholly government-owned institution.

• The Bank of Canada performs four basic functions:

1. It manages the money supply.

– Conducts “monetary policy” by controlling the amount of money

– Not only does it issue paper currency, but more importantly, it

• The Bank of Canada performs four basic functions:

1. It manages the money supply.

– In managing the money supply, the Bank is concerned with three goals:

1. Minimizing inflation to preserve the purchasing power of the dollar

2. Maintaining real output as close as possible to its potential level

3. Regulating the external value of the Canadian dollar in foreign exchange

• The Bank of Canada performs four basic functions:

2. It acts as the bankers’ bank:

– Holds deposits of members of the Canadian Payments

– Makes advances (loans) to CPA members at the “bank rate”

• The Bank of Canada performs four basic functions:

3. It acts as the federal government’s fiscal agent:

– holds some of the government’s bank deposits

– clears the government’s cheques

– handles the financing of the government’s debt by issuing bonds

• The Bank of Canada performs four basic functions:

4. It helps supervise the operations of financial markets to ensure

– The Bank works in conjunction with the Office of the Superintendent of

– The success of Canada’s financial supervision has received

Which phrase best describes the Bank of Canada?

d) A privately-owned central bank, whose basic goal is to provide a market for

a) Managing the economy’s supply of goods and services.

b) The federal government’s fiscal agent.

c) Oversees the operations of financial markets to ensure their stability.

d) Is the bank for commercial banks.

– Canadian financial regulators had banned high-risk mortgage lending.

• Our analysis of money and deposit-takers allows us to examine the way in

• Monetary policy can be broadly classified as either expansionary or

• The Bank of Canada will use an expansionary monetary policy to stimulate

– Such action is referred to informally as “easy money policy”.

– A policy of increasing the money supply and lowering interest rates.

– This shifts AD rightward by a magnified amount due to an initial increase in

$9 billion ×𝟏 . 𝟔𝟕=$ 𝟏𝟓𝐛𝐢𝐥𝐥𝐢𝐨𝐧

• Thus, the total change in aggregate demand is then $15 billion:

5 Sm0 Sm1 Initial

Price Level (GDP deflator,

0 30 40 50 60 0 790 795 800 805

• The Bank of Canada will use a contractionary monetary policy to reduce

– Such action is referred to informally as “tight money policy”.

– A policy of decreasing the money supply and increasing interest rates.

– This shifts AD leftward by a magnified amount due to an initial decrease in

Price Level (GDP deflator,

a) Suppose the unemployment rate is 8.5% and a

b) Identify the steps by which this monetary policy

c) Draw one graph showing curves Dm and Sm0 in the

money market and another with curves AD0 and AS.

Plot four points for the demand curve Dm and four

What is the initial equilibrium interest rate in the

d) If the monetary policy applied in part b leads to a

Add the new money supply curve Sm1 to your

e) If the change in the interest rate in part d causes a

Add the new aggregate demand curve AD1 to

– A sale of bonds by the BoC lowers a CPA member’s deposit liabilities

– A purchase of bonds by the BoC raises a CPA member’s deposit

a) The bond seller's bank deposit

b) Desired reserves at the bond seller's bank

c) Excess reserves at the bond seller's bank