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Monetary Policy

- Why Should I Care?

When the Bank of Canada prints too much money, we are all the poorer. But if money is too tight, we will suffer as well. We have to get this right.

- This Lecture Has 4 Parts

  • Definition
  • Tools
  • Transmission
  • Effectiveness

- What is Monetary Policy?

Managing money supply is not the job of politicians. They would be easily tempted to run the printing press and create havoc with rampant hyperinflation. That’s why we give independence to the Bank of Canada, and ask the impartial men and women at its helm to govern monetary policy.

  • Definition of Monetary Policy

Monetary Policy refers to actions taken by the central bank to change the money supply in order to achieve economic objectives.

These objectives are:
To ensure low levels of inflation
To maintain high levels of production and employment
To avoid an imbalance of international trade and payments

In Canada, the explicit mandate of the Bank of Canada is to contribute to the economic well-being of Canadians, by overseeing monetary policy, the financial system, the currency, and federal funds management.

In regards to monetary policy, the objective is to preserve the confidence of Canadians in the value of the currency, by maintaining inflation at a low rate, which is stable and predictable. Contrary to the USA’s Federal Reserve, Canada’s central bank has no mandate to achieve full-employment.

  • Tools of Monetary Policy

Three tools: changes to the overnight interest rate, open-market bond transactions, and direct deposits to bank accounts.

The Policy Interest Rate, also known as the Target Rate, or the Key Bank Rate, is the interest rate the Bank of Canada charges on its loans. These loans are granted to commercial banks only. They usually contract these loans amongst themselves on the overnight loan market, at the end of a given day when they need extra cash to balance their financial statements. The money is paid back the next morning with fresh money from new deposits.

However, if the private overnight loan market is using an interest rate that is too high, or too low, the Bank of Canada will intervene until the market interest rate matches the Bank Rate. This is where the open-market bond transactions, and the direct deposits come into play. This being said, the most important objective of the central bank is to manage the rate of inflation. Changes to any of its tools is directed by inflation pressures.

The Bank Rate is usually the lowest interest rate in the land. Why? Simply put, banks have to pay this as a basic cost. They cannot charge less to other clients, or they won’t make a profit. Hence, if the Overnight Rate changes, all the other interest rates in the economy will also change in the same direction..

Graph - How an Increase in the Policy Interest Rate affects Money Supply

 

 

 

  • Transmission

How does the central bank eliminate a recessionary or inflationary gap?

By changing the Bank Rate, the central bank can have an impact on GDP. But it will do this by changing the money supply to change Investment Spending. That, in turn, will affect GDP.

  • Target Inflation is set at 2 percent annual change
  • New Bank Rate is Set
  • Adjustments in loan interest rates, stock prices, house prices, the exchange rate, and expectations about the future
  • More affordable loans will increase Aggregate Demand
  • A higher exchange rate will decrease Aggregate Demand

St-Amant diagram HERE

A simpler version of this set of domino effects is called the
Keynesian Transmission Mechanism. Here is the mechanism in detail:

1. Central bank modifies key rate to signal later changes to Money Supply (MS).

    • The central bank changes its key rate
      • Decrease: Expansionary
      • Increase: Contractionary
    • Commercial banks follow suit and change their rates
    • Creditors modify their demand for loans
      • Lower rates increases demand for loans
      • Higher rates reduces demand for loans

2. New demand for loans means new level of Investment (I).

    • Lower rates increase investments
    • Higher rates decrease investments

3. New investment levels will directly affect Aggregate Demand (AD) and the level of employment. (Also applies to AE in Keynesian Cross).

    • More Investment grows AD
    • Less Investment shrinks AD

END RESULT:

Hopefully, the economy returns to the long-run equilibrium of full-employment.

Where Y = Yp

SCENARIO

Monetary Policy: EXPANSIONARY

Objective: CREATE JOBS

Means: THE KEY INTEREST RATE IS REDUCED

Banks reduce rates     →        Investment increases →  AD increases

ADD GRAPHS

SCENARIO

Monetary Policy: CONTRACTIONARY

Objective: STOP INFLATION

Means: THE KEY INTEREST RATE IS INCREASED

Banks hike rates     →      Investment decreases      →    AD decreases

ADD GRAPHS

 

  • Effectiveness

It is difficult to hard scientific evidence as to how effective monetary policy is because we cannot generate a laboratory experiment to test its effects on people. However, from historical case studies and careful study of data over the past centuries, economists provide confident arguments about when monetary policy works, and when it does not.

Monetary policy works better on the way down. Hikes in interest rates will usually have a quicker and more important impact on the economy, compared to reductions in interest rates. This means that Contractionary Monetary Policy is more effective than Expansionary Monetary Policy.

The first reason is that bankers prefer to follow suit on a rate hike quickly, because if they don’t their margins are squeezed. Inversely, bankers might take more time to implement rate reductions because their margins are now larger and they want to benefit from this lucrative situation.

Second, investors are highly sensitive to rate hikes, but they might not be immediately interested by a rate reduction. This is especially true of business investment in capital goods (machines, equipment and plants). A rate reduction is enticing, but above all else, investors need a worthy project. The existence of these projects is a function of many factors such as consumer demand, industry cycles, innovation, political stability, expectations of demand and perceived profitability.

Liquidity Trap: Monetary Policy is useless, according to Keynes, in the extreme event of a very drastic recession. In this situation, when the overnight rate has been lowered regularly, demand for savings overwhelms the financial system. In this case, the AS curve is completely flat, as people prefer to hold cash, rather than loanable funds (investments). Investors and ordinary citizens prefer to hoard cash, than to deposit their money in interest-based savings accounts, term deposits or even bonds. At this point, an interest rate decrease does not grow money supply because “Cash is King”.

Policies Must Work Together: Fiscal and monetary policies must work hand in hand to grow or slow the economy. This may not be the case because Parliament, which decides fiscal policy, does not control the Bank of Canada, which plans and executes monetary policy.

Not Region-Specific: Monetary Policy is not region specific, and a single monetary unit may hurt/help different regions according to cycles. A contractionary policy aimed at cooling off Alberta or Ontario, could hurt another region, such as the Maritimes, which needs expansionary policy to grow out of structural unemployment.

Overall, the main historical lessons of monetary policy are that

1. Don't print too much money.
2. Don't add money supply when the economy is hit with supply-side shock.
3. Don't shrink money supply when the economy is hit with a demand-side recession.
4. It's easier to fix interest rates, than money supply.

Summary Table

Expansionary  Monetary Policy

Contractionary Monetary Policy

What?

Interest rates (i) ↓       MS UP

i ↑       MS DOWN

Why?

To Create Jobs

To Reduce Inflation

Who?

Bank of Canada

Bank of Canada

When?

Recession

Over-heating

How?

More loanable funds, more investment, AE increases, Y increases.

Less loanable funds, less investment, AE decreases, Y decreases

Pros

No budget deficit.

Affordable.

Money is cheap.

No Political Pain.

Works.

Cons

Inflationary.

Not region specific.

 

Lack of coordination with fiscal policy.

 


CLIMATE CHANGE -

CONTINUE HERE

 

https://www.bankofcanada.ca/2019/11/researching-economic-impacts-climate-change/

 

 

- Wrap-Up

Monetary Policy refers to measures taken by the central bank to manage the supply of money in the economy. Its objective is to keep stability in prices, output, and foreign exchange rates.

Tools are open-market transactions, direct deposits in accounts at commercial banks, and changes to the overnight rate.

These measures wind up in GDP through changes to the amounts of loans, and investments such as new equipment, or new homes.

Tight, or contractionary, monetary policy is very effective to cool the economy down. But it is uncertain that loose, or expansionary, monetary policy is very effective to increase GDP.

- Cheat Sheet

Expansionary Monetary Policy:
A policy designed and executed by the central bank to increase the money supply when the economy is in recession.

Contractionary Monetary Policy:
A policy designed and executed by the central bank to decrease the money supply when the economy is over-heating.

- References and Further Reading

Binnhammer, H. H., & Sephton, P. S. (2001). Money, Banking, and the Canadian Financial System, Eighth Edition. Toronto: Nelson Thomson Learning.

 

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