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Part II

Exploring Monetary Policy

“Monetary policy is about money. The Bank of Canada is concerned with how much money circulates in our economy and how much that money is worth. The ultimate objective of the Bank of Canada, working through monetary policy, is to enhance the standard of living of Canadians.”

Bank of Canada

Instruments (aka: Tools)

of Monetary Policy

Key Definitions

Monetary Policy: Actions taken by a central bank to regulate a nation’s money supply.

Central Bank: An independent institution responsible for the regulation of a nation’s money supply. (In Canada, the bank of Canada; in the US, the Federal Reserve.)

Expansionary (“Easy Money”) Policy: The central bank uses the instruments at its disposal to increase the money supply. Thus increasing aggregate demand and Real GDP by an even greater amount.

Contractionary (“Tight Money”) Policy: The central bank uses the instruments at its disposal to decrease the money supply. Thus decreasing aggregate demand and Real GDP by an even greater amount.

Monetary Policy Objective

The Bank of Canada Act states that the central bank’s job is to regulate: a) the quantity of money, and b) interest rates in order to i) avoid inflation, and ii) prevent excessive swings in real GDP.

Presently, the Bank of Canada has agreed to maintain an inflation control target range between 1% and 3%.

$

$ If interest rates are too low: we could experience inflation!

If interest rates are too high: we could see a drop in real GDP!

$

$ If interest rates are too low: we could experience inflation!

If interest rates are too high: we could see a drop in real GDP!

Bank

keeps its

eye on

two

things…

Core Inflation (CPI minus sales taxes and eight volatile prices:

1. fruit, 2. vegetables, 3. gasoline, 4. fuel oil,

5. natural gas, 6. mortgage interest, 7. intercity transportation,

and 8. tobacco Consumer Price Index

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The Bank Rate: The rate of interest paid by chartered banks on money borrowed from the Bank of Canada; determined by setting an operating band for the overnight lending rate.

Increase interest rates

à reduce consumer / investment spending à lowers aggregate expenditure à lowers NDI by even greater amount

So then, how is this operating band established?

à reduce incentive to borrow

Here’s an example of how this tool could be used to carry out

a “contractionary” policy.

NOTE: Doing the opposite would have an expansionary effect.

The Target for the Overnight Loans Rate

The “Target for the Overnight Rate” is the main tool used by the Bank of Canada to conduct monetary policy. It tells major financial institutions the average interest rate that the Bank of Canada wants to see in the marketplace where these institutions lend each other money for one day… or "overnight." When the central bank changes the Target for the Overnight Rate, this change usually affects other interest rates, including mortgage rates and prime rates charged by commercial banks.

Canada's major financial institutions routinely borrow and lend money among themselves overnight in order to cover their transactions during the day. Through the “Large Value Transfer System” (LVTS), these institutions conduct large transactions with each other electronically.

At the end of the day, the financial institutions need to settle with each other. One bank may have funds left over at the end of this process, while another bank may need money. The trading in funds that allows all the institutions to cover their transactions is called the “overnight market.” The interest rate charged on those loans is called the “overnight rate.”

Think of the LVTS as EBay for money! lvtS

The Bank of Canada operates a system to make sure trading in the overnight market stays within its "operating band." This band, which is one-half of a percentage point wide, always has the Target for the Overnight Rate at its centre. For example, if the Target for the Overnight Rate = 4.50%, then the operating band would range from 4.25 to 4.75 per cent.

Since the chartered banks know that the Bank of Canada will lend them money at the top of the band,

Operating Band 0.50%

4.75%

4.25%

The central bank will loan the chartered banks

money at this rate.

The central bank will pay the chartered banks

this rate on deposits.

4.50%

and pay interest on deposits at the bottom, there is no reason for the chartered banks to trade funds at rates outside the band. The Bank can also intervene in the overnight market (borrow or loan money) at the Target rate if the market rate is straying too far from the Target.

This is the “bank”

rate!

When the Bank changes the Target for the Overnight Rate, this sends a clear signal about the direction in which it wants short-term interest rates to go. These changes usually lead to moves in the prime rate at commercial banks, which serves as a benchmark for many of their loans. These changes can also indirectly affect mortgage rates, as well as the interest paid to consumers on bank accounts, GICs, and other savings. The Bank of Canada announces changes in the Target for the Overnight Rate eight times a year, or approximately every six weeks.

Open Market Operations: the buying and selling of government bonds by the Bank of Canada in order to adjust the money supply.

Sell government bonds

à reduces consumer spending à lowers aggregate expenditure à lowers NDI by even greater amount

à reduces available money supply

Here’s an example of how this tool could be used to carry out

a “contractionary” policy.

NOTE: Doing the opposite would have an expansionary effect.

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Deposit Switching: the switching of the federal government’s deposits from the Bank of Canada to the chartered banks, and vice versa. This will have an obvious influence on the chartered banks’ cash reserves – ergo, it will influence the money supply.

Switch deposits from chartered banks to central bank:

à reduces cash reserves à lowers quantity of loanable funds à lowers investment spending (& AE) à lowers NDI by even greater amount

NOTE: Doing the opposite would have an expansionary effect.

Here’s an example of how this tool could be used to carry out

a “contractionary” policy.

Reserve Ratio: The “required reserve ratio” is the fraction of deposits that banks must keep in reserve (i.e. not loan out).

As we have studied before, the more money that banks are required to keep on reserve, the less money they are able to loan out, and vice versa. Given that bank loans will increase the money supply through the bank money multiplier, the more that banks are able to loan out, the more the money supply will grow. • Increasing the reserve ratio will decrease the money supply. • Decreasing the reserve ratio will increase the money supply. Similar to the spending multiplier, the “bank” or “money” multiplier is calculated by dividing 1 by the percentage held back. In this case, the reserve ratio represents the percentage held back. Thus, if the reserve ratio was 5%, then the bank multiplier would be 1 / 0.05 = 20

1 1 Bank Multiplier = ----- = ------ = 20

rr 0.05 Note: In Canada, the reserve ratio was phased out in the Bank of Canada Act in 1992.

Moral Suasion: a request made by the Governor of the Bank of Canada to the chartered banks to support a certain aspect of its monetary policy.

Ask chartered banks to reduce personal loans:

à reduces consumer spending à lowers aggregate expenditure à lowers NDI by even greater amount

Here’s an example of how this tool could be used to carry out

a “contractionary” policy.

NOTE: Doing the opposite would have an expansionary effect.

The Federal Reserve essentially has three tools of monetary policy at its disposal:

1. Open Market Operations, 2. The Discount Rate, and 3. The Reserve Ratio

*Note: Of these three tools, the method most popularly used by the Fed is open market operations. In fact, the Fed even adjusts the discount rate (interest rates) through open market operations.

The American Federal Reserve

Open Market Operations: The Federal Reserve System controls the size of the money supply by

conducting open market operations, in which the Federal Reserve sells or purchases various types of securities (i.e. bonds) with authorized participants, known as primary dealers.

All open market operations in the United States are conducted by the Open

Market Desk at the Federal Reserve Bank of New York, with an aim to making the federal funds rate as close to the target rate as possible.

The Open Market Desk has two main tools to adjust the monetary supply:

i)  repurchase agreements (similar to Canada’s deposit switching), and

ii)  outright transactions (buying and selling of bonds).

However, the bottom line is this: If the Fed sells bonds, they will shrink the money supply (they give

bonds but they take cash). [Mnemonic: SELL bonds = SMALL bucks]

If the Fed buys bonds, they will expand the money supply (they take

bonds but they give cash). [Mnemonic: BUY bonds = BIG bucks]

Interest Rates: The other main tools available to the Fed are related to interest rates. The Federal Funds Rate: Similar to Canada’s “overnight rate,” the US has their Federal Funds Rate. This is the rate that banks charge each other on short term loans. This rate is really a “target” interest rate. While the Fed can declare such a target, such a declaration serves only as a signal to the market. In order to actually reach the target, the Fed engages in the open market operations (buying and selling of securities) that we explored earlier. Increasing the Federal Funds Rate will reduce borrowing, which will reduce the money supply, and vice versa. Discount Rate: Similar to Canada’s “Bank Rate,” the US has their Discount Rate. When banks want to borrow money from the Fed, they are charged the Discount Rate. Increasing the Discount Rate will reduce the amount of money that commercial banks borrow from the Fed, which will reduce the money supply, and vice versa.

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Reserve Ratio: The final tool available to the Fed is the reserve ratio. The “required reserve ratio” is the fraction of deposits that banks must keep in reserve (i.e. not loan out). As we have studied before, the more money that banks are required to keep on reserve, the less money they are able to loan out, and vice versa. Given that bank loans will increase the money supply through the bank money multiplier, the more that banks are able to loan out, the more the money supply will grow. Increasing the reserve ratio (increasing the amount of deposits that banks must keep in reserve) will contract (shrink) the money supply, [Mnemonic: Reserve TALL = Cash STALL] Decreasing the reserve ratio (decreasing the amount of deposits that banks must keep in reserve) will expand (grow) the money supply. [Mnemonic: Reserve LOW = Cash GROW]

A Critical Spectrum

Adam Smith

John Maynard Keynes

Thus, classical thinkers will tend to focus on

monetary policy because they believe fiscal policy

will just cause crowding out!

While Keynesian thinkers will tend to

focus on fiscal policy because they believe monetary policy will

just cause a liquidity trap!

Where do our opposing schools of economic thought stand on monetary policy?

Keynes’ Liquidity Trap! Keynes believed that in times of low economic output the government could actually shoot itself in the foot by increasing the money supply. Why?

1. Yes, it is true that increasing the money supply will indeed reduce interest rates.

2. However, lower interest rates (in times of very low output) will just encourage people to hold their money – neither spending nor saving (in banks or bonds).

Quantity of Money

Nom

inal

Rat

e of

In

tere

st

MD

MS2 MS1 MS3

If interest rates are too low, people will just hold their money! That’s right! If interest rates fell low enough the economy could fall into a partial liquidity trap, where decreased interest rates just encourage more holding of money, or even a complete liquidity trap – where the money demand curve becomes completely elastic (horizontal), and people will hold all quantities of money at such a low interest rate.

Adam Smith

Real GDP

Price Level SRAS

AD1

AD2

Y1&2

Scenario C

P1

P2

Clearly, classical economists would be against monetary expansion because they felt it would just cause inflation. However, they didn’t like Keynes’ idea of fiscal stimulation either! Why? We will need to look at the classical loanable funds model to understand why.

Leave the economy alone, you’ll just make

things worse!

Classical Crowding Out Classical economists believe that if the government tries to stimulate aggregate demand by spending then they will essentially drive up interest rates, thus crowding out consumption and investment spending. Why?

1. Yes, it is true that government spending will indeed increase GDP.

2.  However, higher output will create greater demand for money (to buy things).

3. This higher output will also create sudden inflation, reducing the “real” money supply.

Thus, the increased demand for money combined with the decreased “real” money supply will cause an increase in interest rates that will be severe enough to reduce consumption and investment spending by either a portion of the government spending (partial crowding out) or even by as much as the original government spending (complete crowding out).

Quantity of Loanable Funds

Rea

l Rat

e of

In

tere

st

Market for Loanable Funds

r1

D

D2

Q

SS2

r2

A Critical Spectrum

Classical View of Fiscal Policy If the government tries to stimulate aggregate output by spending:

•  GDP will increase by even more because of the multiplier

•  higher output creates greater demand for money (to buy things)

•  higher output creates sudden inflation, reducing “real” money supply

•  á demand for money and â real money supply causes such high interest rates that interest-sensitive expenditure decreases by as much (or more) than the government spending (complete “crowding out”)

Keynes’ View of Monetary Policy If the government tries to stimulate aggregate output by increasing the money supply:

•  the increased money supply may lower interest rates, but this will just cause people to hold onto their money

•  the interest rates will fall so low that the economy will fall into a liquidity trap – where the demand for money becomes completely elastic (horizontal), and people will hold all quantities of money at such a low interest rate.

•  thus, changing the money supply will no longer affect the interest rate

Adam Smith

John Maynard Keynes

Thus, classical thinkers will tend to focus on

monetary policy because they believe fiscal policy

will just cause crowding out!

While Keynesian thinkers will tend to

focus on fiscal policy because they believe monetary policy will

just cause a liquidity trap!