Chapter 13 Flashcards
2 policy options for central bank to implement monetary policy
- directly change the money supply
- change the interest rate
(for a given MD curve, both can’t be targeted independently)
central bank could attempt to shift the MS curve directly…
ie. change the amount of currency in circulation by BUYING or SELLING gov securities in financial markets
ie. using currency to buy $100 000 of gov bonds
^ this increases the cash reserves in the banking system by $100 00
^ commercial banks can then lend out these new reserves - increases the amount of cash reserves
BoC conducts monetary policy by targeting _____ _____ (and three reasons why)
interest rate
- can control a particular interest rate very well
- don’t have to predict the slope and position of the MD curve (this is hard to do)
- can easily community policy pertaining to interest rate changes to the public
overnight interest rate
interest rate at which major financial institutions BORROW and LEND one-day (overnight) funds among themselves
- banks that need cash because they’ve run short of reserves BORROW in the overnight market from other banks that have excess reserves
- BoC sets a target level for that rate
- BoC exercises considerable influence over the overnight interest rate
when BoC announces target for overnight rate, it also announces…
- rate that it charges for loans (BANK RATE)
- rate that it pays for DEPOSITS
bank rate
interest rate the BoC charges commercial banks for LOANS
0.25% ABOVE the target rate
bank promises to lend at this bank rate ANY AMOUNT that commercial banks want to borrow
rate that central bank pays for deposits
Bank offers to borrow (accept deposits) in UNLIMITED AMOUNTS from commercial banks
and PAY them an interest rate 0.25% points BELOW the target
when BoC changes target overnight rate, what changes almost instantly?
- actual overnight rate
- exchange rate
after overnight rate changes, how long does it take for market/more long term interest rates to change?
usually a day or two
as these rates adjust, firms and households begin to adjust their borrowing behaviour
as demand for new loans gradually adjusts, commercial banks often find themselves…
in need of MORE CASH RESERVES with which to make loans
what does the BoC when commercial banks find themselves in need of more cash reserves with which to make new loans?
the BoC can buy GOV SECURITIES from commercial banks
then commercial banks can use this cash to EXTEND NEW LOANS
open market operation
refers to the PURCHASE and SALE of government securities on the open market
between central bank and commercial banks
what does the BoC change through its open market operations?
changes the amount of currency in circulation
what do we mean when we say the money supply and the amount of money in circulation is endogenous?
we mean that it responds to changes in interest rates
what controls the amount of currency in circulation?
not directly controlled by the BoC
instead, it’s determined by the ECONOMIC DECISIONS of:
- households
- firms
- commercial banks
BoC is _______ in its decisions regarding the money supply
passive
it conducts open-market operations to accommodate the changing demand for currency coming from the commercial banks
(by buying or selling gov securities)
if banks need more cash…
the central bank will buy their gov securities
(open-market purchase)
if banks have excess cash…
the central bank will sell them gov securities
(open-market sale)
expansionary monetary policy occurs when BoC does what?
reduces its target for the overnight rate
this will eventually INCREASE MS (or its growth rate)
contractionary monetary policy occurs when BoC does what?
increases its target for the overnight rate
this will eventually DECREASE MS (or its growth rate)
monetary transmission mechanism
- central bank announces its target overnight rate
- commercial banks adjust their longer term market interest rates
- a) exchange rates adjust and capital flows change
- a) i) exchange rate determines net exports
- b) interest rates determine consumption and investment
- AD = AS determines equilibrium Y and P
why target inflation?
- high inflation = costly for individuals and damaging for economies
^ high and uncertain inflation leads to arbitrary income redistributions and undermines efficiency of price system
- inflation is the one variable on which monetary policy can have a systematic and sustained influence
what happens when expectations of deflation are fostered?
gives customers incentives to postpone purchases
so, AD declines - this puts further downward pressure on prices
since private and public debts = nominally fixed, declining prices increase the real burden of the debt
this is because lower prices means that firms/households are spending a bigger fraction of their savings on debt services
means that they have to cut down on spending on goods and services
this in turn increases the intensity of the deflationary process
first country to adopt inflation targeting
New Zealand, in 1991
Canada was second
