Slides are prepared by Dr. Amy Peng, Ryerson University Chapter Ten Central Banking and Monetary...

Slides are prepared by Dr. Amy Peng, Ryerson University

Chapter TenChapter TenCentral Banking and Central Banking and

Monetary PolicyMonetary PolicyMacroeconomics by Curtis, Irvine, and BeggMacroeconomics by Curtis, Irvine, and Begg

Canadian Edition, Canadian Edition, McGraw-Hill Ryerson, 2007McGraw-Hill Ryerson, 2007

©2007 McGraw-Hill Ryerson Ltd. Chapter 10 2

Learning Outcomes

This chapter explains:This chapter explains:• Central banking and the Bank of Canada• Central banking operating techniques to control

money supply and interest rates• Monetary policy targets in Canada• Monetary policy instruments and policy rules• The effects of monetary policy on aggregate

demand• The long-run neutrality of money• Monetary policy indicators

©2007 McGraw-Hill Ryerson Ltd. Chapter 10.1 3

Central Banking and the Bank of Canada

• Central Bank

• Monetary Policy– central bank action to change money supply,

interest rates, and exchange rates, to change aggregate demand and economic performance


The Balance Sheet of the Bank of Canada, 2005 (year-end, millions of

dollars)Assets Liabilities

Government of Canada securities Notes in circulation 46,078

Treasury bills 16,835

Government bonds Deposits

≤ = 3 years 10,337 Government 911

> 3 years 19,689 Chartered banks 33

Advances to members of the Canadian Payments Association

--

Other Canadian Payments Association Foreign central banks

143

Foreign currency deposits 88 Foreign currency liabilities --

Other assets 1,821 Other liabilities 1,138

Total 48,320 Total 48,320

17


Central Bank Operating Techniques

• Three main techniques to manage Monetary Base and Money supply

1. Establishing reserve requirements– Required Reserve Ratio– Determines money multiplier in money supply function

2. Using open-market operations– Main technique– Determines monetary base in money supply function

3. Setting the bank rate– Sets cost of borrowing monetary base– Signals monetary policy change


An Open-Market Purchase and the Money Supply

Central Bank Commercial Banks

Assets Liabilities Assets Liabilities

1. Open-market purchase of $100 million in government bonds

Govt bond +100 Cheque +100 No change

2. Pension fund deposits proceeds of bond sale in a commercial bank

No change Central bank cheque +100

Pension fund deposit acct +100

3. Central bank cheque clears giving commercial banks $100 million cash

No change Cheque o/s -100 Central bankcheque -100

No change

Cash issued +100 Cash reserves +100

If rr = 0.05, excess reserves +95


An Open-Market Purchase and the Money Supply



4. Commercial banks increase lending and create new deposits

No change Loans +1900 Deposits +1900

5. Final effect of central bank open market purchase

Govt bond +100 Cash (ΔH) +100

Cash reserves +100Loans +1900 +2000

Deposits +2000

6. Change in Money Supply

ΔM = ΔH/rr = $100/0.05 = $2,000


Money Supply Control or Interest Rate Control

• The Bank can control eithereither money supply or or interest rates but not bothnot both at the same time.– If money supply is controlled by the central

bank, the market determines the interest rate.– If interest rate is controlled by the central

bank, the market determines the money supply.

Illustrate Illustrate ➙➙



Inte

rest

Rat

e i

M0/P

M0/P

L(Y0)

i0

i1

Real Money Balances

E

L(Y1)

(a) Money Supply Control

A money supply fixed by the central bank results in an interest rate set by the money market

M/P



Inte

rest

Rat

e i

M0/P

L(Y0)

i0

M1/P

Real Money Balances

E

L(Y1)

(b) Interest Rate Control An interest rate fixed by the central bank results in a money supply set by the money market.

M/P

M/P


Monetary Policy Targets and Instruments in Canada

• Exchange rate target

• Money supply target

• Inflation rate target

• Monetary policy instrument– The variable the central bank manages in

pursuit of its policy target


Monetary Policy Targets and Instruments in Canada

Bank of Canada Operating Techniques• Policy instrument - the overnight rate• Set and announce target for the overnight

interest rate• SPRA: special purchase and resale agreement

– Temporarily increases monetary base– Offsets upward pressure on the overnight rate

• SRA: sale and repurchase agreement– Temporarily reduces monetary base– Offsets downward pressure on the overnight rate


The Bank of Canada’s Operating Band for Overnight Rates

0

1

2

3

4

5

6

7

Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05

Per

cen

t

Low

High

Overnight Rate


Setting and Maintain the Overnight Rate

MB0

MB0

D0

Overnight rate

Bank Rate

MB1

MB1

• Set overnight rate target

• Short term increase in demand for MB

• Upward pressure on Overnight rate

• SPRA to offset the upward pressure

• Temporary increase in MB

• SRA would offset downward pressure on overnight rate.

D1

Deposit rate

Monetary Base

Inte

rest

Rat

e


Bank of Canada Special Purchase and Resale Agreements and Sale and Repurchase Agreements

(monthly averages of daily data)

0

200

400

600

800

1000

1200

Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05

Mil

lio

n $

SPRA

SRA


Government Deposit Accounts



No change Reserve deposits of banks +10

Reserve deposits of banks +10

Government deposits +10

Government deposits -10

A Transfer of Government Deposits


Monetary Policy Rules

• The Taylor Rule

• When output temporarily exceeds potential output, the central bank raises interest rates. At levels of output below potential output, it lowers interest rates.

)(0 pYYbii


Interest Rates and Output with a Simple Taylor Rule

Nom

inal

Int

eres

t R

ate

i

Yp

Yp

i

i0

i1

Real GDPY1

(a) The Taylor Rule

Y2

i2


Interest Rates and Output with a Simple Taylor Rule

Exp

endi

ture

Yp

AE(i0),

Real GDPY1

(b) Equilibrium Output

AE′(i0)

AE′(i1)

Y = AE

Yp


Monetary Policy Rules

• Policy Rules when Prices Change

• Setting inflation targets *• Setting nominal interest rate i• Real interest rate (r = i - *) affects the

expenditure decision• bb measures how the interest rate responds

to an output gap.

)()( *0 pYYbaii


The Neutrality of Money

Quantity Theory of Money

MV = PY

assume V constant

(inverse of demand)

where V = 1/k

and L = kY- hi

So

P = M x V/Y



Nom

inal

Int

eres

t R

ate

i

Yp

Yp

MP0

i0

i1

Output

(a) Expansionary monetary policy

MP1



Pric

e Le

vel

Yp

AS0

OutputY1

(b) Short run and long run effects of expansionary monetary policy

AD1

AS1P1

P0

AD0


Monetary Policy Indicators

• Monetary policy indicators provide information about the stimulus or restraint coming from the central bank’s policy.– Interest rates– Exchange rates


Chapter Summary

• TheThe Bank of Canada Bank of Canada is Canada’s central bank.central bank. It conducts monetary policymonetary policy through its control of the monetary base and interest rate.

• Three operating techniques: reserve requirements reserve requirements imposed on commercial banksimposed on commercial banks, open-market operations, open-market operations, andand bank rate bank rate.

• The Bank of Canada sets an inflation rate target inflation rate target and uses the overnight interest rate the overnight interest rate as its policy instrument policy instrument.

• Overnight interest rate setting, SPRAs and SRAsOvernight interest rate setting, SPRAs and SRAs• Monetary Policy Rule – A Taylor RuleTaylor Rule• In the long run, when all prices are flexible, money is

neutralneutral.

Slides are prepared by Dr. Amy Peng, Ryerson University Chapter Ten Central Banking and Monetary...

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