Ch 30 - Monetary Policy

Sunday, April 08, 2012

12:27 AM


    • Control quantity of money and interest rates to avoid inflation.
    • Prevent excessive swing in real GDP growth and unemployment


    Method: alter interest rates, exchange rates and the money supply


    Side Effects:

    • Unemployment rate might rise
    • Real GDP growth might be slow
    • Appreciate currency, suffer exports


    Overnight loan rate

    Interest rate on overnight loans that big bangs make to each other
    8 times yearly.
    (This is to maintain cash reserves)


    Important Determining the interest rate


    Instrument Rule

    Set the rate based on current state of economy

    Targeting rule

    Set the rate at a forecasted target that will be reached in the future


    Operating Band

    Bank rate

    Interest rate that BoC charges big banks on loans

    Settlement balances rate

    Interest rate the BoC pays on reserves


    Open market operation

    Purchase/sale of government securities by BoC from/to a chartered bank or public.

    Bank buy securities -> pay with newly created reserves
    Bank sell securities ->  are paid for with reserves held by banks



    Overnight rate = Settlement balances rate (lower of the band)

    No difference for bands to hold or lend reserves.

    Overnight rate between bank rate and settlement balances rate

    Banks are willing to borrow and lend at overnight rate.

    Equilibrium in the market for reserves

    This determines the overnight rate.



    BoC lowers the overnight loans rate

    BoC raises overnight loans rate

    Short-term interest rates fall
    Exchange rate fall

    Short-term interest rise
    Exchange rate rise

    Quantity of money increase
    Supply of loanable funds increase

    Quantity of money decrease
    Supply of loanable funds decrease

    Long-term real interest rate decrease

    Long-term real interest rate increase

    C, I, N-X increase

    C, I, N-X decrease

    AD increases

    AD decreases

    Real GDP growth increase

    Inflation rate increase

    Real GDP growth decrease
    Inflation decrease



    Expansionary Monetary Policy

    Increase supply of loanable funds

    Increase demand

    Lower overnight rate target
    (Decrease interest rates)

    Contractionary Monetary Policy

    Decrease supply of loanable funds
    Decrease demand

    Raise overnight rate target
    (Increase Interest rates)



    • Spending is affected by long-term interest rates. (only loosely connected to overnight rate)



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