Ch 30 - Monetary Policy

Sunday, April 08, 2012

12:27 AM

Objectives:

• 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)

 

 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

 

Situations

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.

 

Causality

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)

 

Issues:

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