Chapter 14
Monetary Policy
The Bank of Canada
Making Monetary Policy
When the BOC announces a policy change, its
press release talks about the overnight rate or
bank rate.
The Board meets eight times a year and formally
approves interest rate decisions.
Monetary Policy Indicators
Monetary policy indicators are the current
features of the economy that the Bank looks at
to determine whether it needs to apply the brake
or the accelerator to influence future inflation,
real GDP, and unemployment.
Currently, the overnight loans rate is the main
monetary policy indicator.
Monetary Policy Tools
Four Monetary Policy Tools
1. Required reserve ratio (no loner used in
Canada).
2. Bank rate and bankers’ deposit rate.
3. Open market operations.
4. Government deposit shifting
Controlling the Quantity of Money
Ripple Effects of Monetary Policy
Ripple Effects of Monetary Policy
MP to Lower
Unemployment
If BOC buys
securities in
Open Market,
AD shifts to the
right to restore
full employment.
Ripple Effects of Monetary Policy
MP to Lower
Inflation
Monetary policy
decreases AD to
restore full
employment and
avoid inflation.
Ripple Effects of Monetary Policy
Time Lags in the Adjustment Process
The BOC needs a combination of good judgment
and good luck to achieve its monetary policy
goal of low and stable inflation and full
employment.
The Bank is handicapped by the fact that the
ripple effect of its actions are not entirely
predictable.
Ripple Effects of Monetary Policy
Money Target Versus Interest Rate Target
The BOC prefers to target the interest rate and
change the quantity of money automatically if the
demand for money fluctuates.
Ripple Effects of Monetary Policy
Bank targets the
interest rate.
Fluctuations in
the demand for
monetary base
now bring
fluctuations in the
quantity of money
and hold the
interest rate
steady.
How BOC Raises Interest Rates?
The BOC sells securities in the open market.
This action mops up bank reserves. Some
banks are short of reserves and seek to borrow
reserves from other banks.
The overnight rate rises.
With fewer reserves, the banks make a smaller
quantity of new loans each day and the quantity
of money decreases.
1. The current interest
rate is 5 % a year.
2. The Bank’s target
interest rate is 6 % a
year.
3. To raise the interest
rate to the target, the
BOC must sell
securities in the open
market and decrease
the quantity of money
to $98 billion.
How BOC Lowers Interest Rate?
If the BOC fears recession, it acts to increase AD.
The BOC announces that it will lower the short-term
interest rates.
To achieve this goal, the BOC buys securities in the
open market.
This action increases bank reserves.
Flush with reserves, banks now seek to lend reserves to
other banks.
The overnight rate falls.
With more reserves, the banks increase their lending
and the quantity of money increases.
1. The current interest
rate is 5 % a year.
2. The Bank’s target is
4 % a year.
3. To lower the interest
rate to the target, the
BOC buys securities in
the open market and
increase the quantity of
money to $102 billion.
Ripple Effects of Monetary Policy
Suppose that the BOC increases the interest
rate. Then
Investment and consumption expenditure
decrease.
The dollar rises, and net exports decrease.
A multiplier process induces a further decrease
in consumption expenditure and AD.
Ripple Effects of Monetary Policy
Bank targets the
quantity of
money.
Fluctuations in
the demand for
monetary base
bring unwanted
fluctuations in the
interest rate.
Money Multiplier
The Multiplier Process
Taking these effects together, investment, consumption
expenditure, and net exports are all interest-sensitive
components of expenditure.
So a rise in the interest rate brings a decrease in AE.
Real GDP and disposable income decrease further, and
so does consumption expenditure.
Real GDP growth slows, and the inflation rate slows.
BOC’s Fight against Inflation
Investment demand
curve.
The interest rate is 5 %
a year and investment
is $200 billion.
1. The BOC raises the
interest rate and the
quantity of investment
decreases.
2. Expenditure
decreases by ∆I.
3. The multiplier induces
additional expenditure
cuts.
The AD curve shifts to
AD1, real GDP
decreases to potential
GDP, and inflation is
avoided.
BOC’s Fight Against Recession
The interest rate
is 5 % a year
and investment
is $200 billion.
1. The BOC lowers
the interest rate
and the quantity
of investment
increases.
BANK OF CANADA AND MONETARY POLICY
2. Expenditure
increases by ∆I.
3. The multiplier induces
additional expenditure.
The AD curve shifts to
AD1, real GDP
increases to potential
GDP, and recession is
avoided.
Size of Multiplier
The Size of the Multiplier effect of monetary
policy depends on the sensitivity of expenditure
plans to the interest rate.
The larger the effect of a change in the interest
rate on AE, the greater is the money multiplier
and the smaller is the change in the interest
rate that achieves the BOC’s objective.
Limitations of Monetary Policy
Monetary policy has an advantage over fiscal
policy because it cuts out the law-making time
lags.
But monetary policy shares the other two limitations of
fiscal policy:
• Estimating potential GDP is hard
• Economic forecasting is error-prone.
Macroeconomic Policy Debates
How should fiscal policy and monetary policy be used?
Two historical schools of thoughts on Macroeconomic
policy: Keynesians and monetarists.
The debate concerns three issues:
• Fiscal policy versus monetary policy
• Interest rate versus quantity of money
• Real GDP versus inflation
Macroeconomic Policy Debates
Fiscal Policy Versus Monetary Policy
Either tool can be used to influence AD, so the choice
between them turns on their side effects:
• Fiscal policy influences the allocation of resources
and the distribution of income and wealth.
• Monetary policy influences the allocation of
resources between consumption and investment
and exports and imports.
Stabilization policy relies on both tools.
Macroeconomic Policy Debates
Interest Rate Versus Quantity of Money
Set the interest rate and let the quantity of money be
determined by the demand for money, or
Set the growth rate of the quantity of money and let the
interest rate fluctuate with the demand for money.
• Monetarists favor a target for the money growth rate
• Keynesians favor a target for the interest rate
The BOC is Keynesian on this issue. It sets the
overnight rate and has no target for money growth.
Macroeconomic Policy Debates
Real GDP Versus Inflation
Keynesians place more weight on real GDP.
• They want policy to restore real GDP to potential
GDP quickly. They pay little attention to inflation.
Monetarists place more weight on inflation.
• They want the inflation rate slowed if it rises and no
action if the inflation rate is low.
BOC monetarist on this issue.
The Bank of Canada in Action
Gerald Bouey’s Fight Against Inflation
In the early 1980s, when Gerald Bouey was
governor of the BOC, the Bank slowed the
growth rate of money and interest rates rose
dramatically.
Real GDP decreased in a deep recession.
The unemployment rate increased and remained
high through the 1980s.
The inflation rate slowed.
The Bank of Canada in Action
John Crow’s Push for Price Stability
John Crow became governor of the BOC in
1987.
Crow was a fierce inflation fighter.
He brought the inflation rate down to less than
3%, but at the cost of another recession during
1990-1991.
The Bank of Canada in Action
Gordon Thiessen’s and David Dodge’s Balancing Acts
Gordon Thiessen succeeded John Crow as governor of
the BOC in 1994.
Thiessen held the inflation rate inside its target range
and helped set the scene for the strong expansion of the
late 1990s and early 2000s.
David Dodge succeeded Thiessen in 2001.
Dodge attempted to keep the economy expanding
through a U.S. recession and permitted inflation to exceed
its target for the first time since inflation targeting began.
