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Lecture notes

Lecture notes. Prepared by Anton Ljutic. CHAPTER TWELVE. Monetary Policy. This Chapter Will Enable You To:. Describe the various functions of Canada’s central bank - the Bank of Canada Understand the role of monetary policy and how the Bank of Canada influences interest rates

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Lecture notes

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  1. Lecture notes Prepared by Anton Ljutic

  2. CHAPTER TWELVE Monetary Policy

  3. This Chapter Will Enable You To: • Describe the various functions of Canada’s central bank - the Bank of Canada • Understand the role of monetary policy and how the Bank of Canada influences interest rates • Clearly understand why monetary policy is needed • Describe the arguments for and against • the activist approach to monetary policy • the non-activist approach to monetary policy • Realize why some argue that other direct controls are needed as alternatives to both fiscal and monetary policy

  4. Functions of the Bank of Canada • The issuer of currency • The government’s bank and manager of foreign currency reserves • The bankers’ bank and lender of last resort • The auditor and inspector of commercial banks • The regulator of the money supply

  5. Monetary Policy • Monetary policy is designed to change or influence the economy through changes in the money supply • The Bank of Canada sees the role of monetary policy as a means of providing a healthy economic environment that will assist the economy in achieving the goals of low inflation and low unemployment

  6. Types of Monetary Policy • Expansionary monetary policy • A policy that aims to increase the amount of money in the economy and make credit cheaper and more easily available • Contractionary monetary policy • A policy in which the amount of money in the economy is decreased and credit becomes harder to obtain and more expensive

  7. Tools of Monetary Policy (I) • Open-market operations • The buying and selling of securities by the Bank of Canada in the open (to the public) market • Switching government deposits • The government keeps deposits with commercial banks and the Bank of Canada. By switching deposits between these two accounts, it can influence the money supply • Moral suasion • The Bank of Canada informs the financial community of the direction it would like to take

  8. Tools Of Monetary Policy (II) • Setting the bank rate • Bank rate • The rate of interest payable by the commercial banks on loans from the Bank of Canada • Prime Rate • The rate that commercial banks charge their best customers

  9. Is Monetary Policy Needed? • If the money supply is increased too much, the result will be inflation • If the money supply is not increased sufficiently, the result will be a recession and low economic growth • The economic health of an economy depends on the money supply growing but not too quickly nor too slowly

  10. The Activist Approach to Monetary Policy • Keynesian monetary policy is used to assist in achieving four goals: • Steady growth in real GDP • An exchange rate that ensures a viable balance of trade • Stable prices • Full employment

  11. The Effect of Contractionary Monetary Policy Potential GDP P AS • Contractionary monetary • policy reduces AD1 to AD2 • the inflationary gap (YE – YFE)is thereby closed AD1 Figure 12.1 AD2 YFE YE

  12. The Effect of Expansionary Monetary Policy Potential GDP P AS • Expansionary monetary • policy Increases AD1 to AD2 • the recessionary gap (YFE - YE)is thereby closed Figure 12.2 AD2 AD1 YE YFE

  13. Criticisms of Keynesian Monetary Policy • The twin goals of full employment and stable prices are incompatible and it may not be possible to achieve them together • The best that a central bank can do is achieve a delicate balance between the two without ever attaining either goal

  14. Anti-Inflationary Monetary Policy (I) • The Bank of Canada now sees its role as preserving both the internal and external value of the currency. • Controlling inflation is done by keeping the pace of monetary expansion in line with economic growth and, occasionally, by using contractionary monetary policy

  15. Anti-Inflationary Monetary Policy (II) • This results in higher interest rates, which encourages foreigners to hold Canadian securities, which increases the demand for the Canadian dollar, causes a rise in the Canadian dollar and leads to a decrease in net exports • With fixed exchange rates, monetary policy cannot be used to bring about the change in the domestic economy

  16. Anti-Inflationary Monetary Policy (III) Tight money Low inflation Lower I Lower AD Higher r Lower netX Higher D for CA$ Higher ER of CA$

  17. Criticisms of Anti-Inflationary Monetary Policy • Because the Bank of Canada is overly concerned about controlling inflation, it will lose sight of other equally valid goals such as economic growth and low unemployment • Raises the question of lags • It takes time for for the effect of monetary policy to be felt in the economy • Monetary changes have an uncontrollable impact on the economy

  18. The Non-Activist School (I) • The focus is on ensuring that the quantity of money supplied is kept equal to the quantity of money demanded. • This would imply a constant interest rate • They believe that not only should interest rates be held constant, but that target should be announced to the world

  19. The Non-Activist School (II) • A variation to the same approach would be for the central bank to maintain a constant, pre-announced pace of monetary expansion and have the interest rate adjust to maintain the balance between quantities of money demanded and quantities of money supplied

  20. Criticisms of the Non-Activist School • While the objective is stability in the money markets, the result may be instability in the economy • The reason for this is that fixing the growth in the money supply is not of much use if you cannot also control the demand for money • A changing demand for money will cause interest rates to change unpredictably

  21. Beyond Fiscal and Monetary Policy • Stagflation • The simultaneous occurrence of high inflation and unemployment • It is caused by a decrease in the short-run aggregate supply, which could be caused by a significant increase in the price of imported resources such as oil

  22. The Cause of Stagflation Potential GDP AS2 • A leftward shift in AS will result in: • lower GDP • higher P AS1 P2 P1 Figure 12.4 AD Y2 Y1

  23. Aggregate Demand and Stagflation Potential GDP • A leftward shift in AD will result in lower P, but also lower GDP • A rightward shift in AD will result in higher GDP, but also higher P. AD2 AS AD1 AD3 P3 P1 P2 Y3 Y1 Y2 Figure 12.5

  24. Direct Controls (I) • They take the form of specific laws, rules, and regulations designed to modify the way people behave • They usually affect the supply side of the economy

  25. Direct Controls (II) • They include: • Tax incentive programs • Tax changes that help stimulate people’s incentive to work and save, and businesses to invest more • Pro-competition policies • These are aimed at loosening the power of big corporations and trade unions in order to make the marketplace more competitive and enable it to more easily adjust to the changing pattern of demand and technology • Employment policies • These include policies designed to increase the amount of employment and to reduce the natural rate of unemployment

  26. Chapter Summary:What to Study and Remember • the various functions of Canada’s central bank - the Bank of Canada • the role of monetary policy and how the Bank of Canada influences interest rates • why monetary policy is needed • the arguments for and against • the activist approach to monetary policy • the non-activist approach to monetary policy • why some argue that other direct controls are needed as alternatives to both fiscal and monetary policy

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