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28.1 How the Bank of Canada Implements Monetary Policy - Coggle Diagram
28.1 How the Bank of Canada Implements Monetary Policy
Money Supply vs. Interest Rate
BOC can only implement monetary policy either by targeting money supply or i-rate
if targeting money supply,
money equilibrium will determine i-rate;
money supply → total amount of money in circulation or in existence in a country,
so money equilibrium – supply and demand equal to each other – determines i-rate
if targeting i-rate
, money supply must adjust to accommodate movement along Md curve; i-rate determines people's will of spending money, therefore movement along Md curve, money supply will adjust to demand (seeing it's public's money)
IF TARGETING MONEY SUPPLY, BOC
can attempt to shift Ms curve to the right by changing amount of currency in circulation in economy (through
open-market-operations
, e.g buying or selling gov. bonds → new reserves in bank, and new deposit money from reserves leads to increased money supply, shifting Ms curve to the right)
for Md curve, increase in money supply → reduction in equilibrium i-rate, therefore increase in aggregate demand
Why the Bank of Canada Does Not Target the Money Supply (American Way)
Bank cannot
control
deposit expansion carried out by commercial banks
; e.g. if BOC increases amount of cash reserves in system, commercial banks might choose not to expand their lending (fractional banking system?) → increase in money supply would be far smaller than Bank initially intended
There is uncertainty regarding the slope of the Md curve
; targeting the money supply would make BOC unsure about change in i-rate that would result from change in money supply → Δi-rate leads to Δaggregate demand, so not foreseeing aftermaths of such changes makes controlling monetary policy difficult
There is uncertainty regarding the position of the Md curve
; changes in both real GDP and P causes changes in money demand SO unpredictable fluctuations in money demand make monetary policy based on direct control of money supply hard to implement
BOC would have little control over resulting i-rate (e.g. Δi-rate → Δmoney demand) which is key link b/w Bank's actions and aggregate demand
Why the Bank of Canada Targets the Interest Rate
if BOC Δi-rate → Δ in quantity money demanded
; for new i-rate to be consistent with monetary equilibrium, Bank must
accomodate
Δ in amount of money demanded – alter money supply in order to satisfy change in desired money holdings by firms and households) = lowering Md curve
ADVANTAGES
BOC is able to almost completely control a particular i-rate
BOC's uncertainty around slope and position of Md curve is not a problem when BOC chooses instead to target i-rate
; any uncertainty about Md curve implies uncertainty about Δ in quantity of money, BUT it is i-rate that matters – through transmission mechanism – for determine level of aggregate demand
BOC can easily communicate its interest-rate policy to the public;
Δ in i-rate lets people know what's going on compared to targeting money supply
The Bank of Canada and the Overnight Interest Rate
the overall pattern of i-rate corresponding to gov. securities of different maturities is known as
term structure of interest rates OR yield curves
; different types of i-rate include
overnight interest rate → the i-rate that commercial banks charge one another for overnight loans
by influencing overnight interest rate, BOC also influences longer-term i-rate that are more relevant for determining aggregate consumption and investment expenditure; overnight i-rate
indirectly
affects longer-term i-rate
*overnight rate target is announced 8 time per year on fixed announcement dates (FADs)
bank rate → the i-rate the BOC charges commercial banks for loans,
0.25 percentage points above target rate
BOC promises to lend at bank rate any amount that commercial banks want to borrow, and at the same time, offers to borrow (accept deposits) in whatever amounts from commercial banks and pay commercial banks i-rate of 0.25 percentage points below target rate; overnight interest rate stays within 0.5 percentage point around target rate
BOC establishes a target for overnight i-rate → through BOC's borrowing and lending activities with commercial banks;
by raising or lowering its target rate, BOC affects actual overnight irate → Δovernight i-rate = to Δ in other longer-term i-rate
↓ONR → ↓i-rate → ↑L → ↑passive M
The Money Supply Is Endogenous
when BOC changes its target for overnight rate, change in actual overnight rate happens almost instantly
; commercial banks' changes in how they deal with i-rate of their choosing (e.g home mortgages) takes time after reduction or increase in basis point has been made
BOC increases the amount of currency in circulation in the economy via an
open-market operation → the purchase or sale of gov. securities on the open market by central bank
; seen as a passive way
**OMO's aren't generally initiated by BOC but rather they conduct it to accommodate changing demand for cash reserves by commercial banks SINCE commercial banks rely on economic decisions of households, firms or in other terms money supply in economy
b/c money supply is sum of bank deposits and currency in circulation, and that bank deposits are determined by economic decisions of households, firms, and commercial banks →
money supply is endogenous
Expansionary and Contractionary Monetary Policies
depending on how the policy affects i-rates is what determines the policy being expansionary or contractionary
↓i-rates = expansionary monetary policy
b/c it leads to
↑aggregate demand
;
↑i-rates = contractionary monetary policy
b/c
↓aggregate demand