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 (BoC), 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.

In Canada, the guiding principles for inflation measurement are the Consumer Price Index (CPI) for long-term variations, and the core measurement of CPI for short-term variations. Core CPI excludes the most volatile industries at any given time. The BoC tolerates inflation between 1 and 3 percent, aiming at a 2 percent target. This means that if inflation rates were to be lower than 1 percent, then the BoC would apply expansionary monetary policy to stimulate the economy. If the inflation rates were to be higher than 3 percent, it would apply restrictive monetary policy to cool the economy down.

The Bank Rate is usually the lowest interest rate in the land. Why? Simply put, banks have to pay this as a basic cost of doing business. They cannot charge a lower interest rate to their 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.

In terms of enacting monetary policy, the Bank of Canada uses a technique called interest-rate targeting, rather than direct money-supply management. With interest-rate targeting, the first move is to modify the overnight rate. This acts as a signal, which allows the quantity demanded for money to adjust. Investors and home buyers change their minds about their demand for loans, given the new price. Since there are so many people involved, the overall price-sensitivity of demand for money is difficult to predict accurately. So it's become well understood by economists, that it is better to let demand reveal itself when faced with a new price, in this case, the price of money is the interest rate on loans.

Once demand is revealed, the bank will actively modify money supply to match the needed funds. Since the Canadian dollar is a fiat currency, the central bank can modify money supply without increasing or decreasing holdings of gold or other assets. The central bank can do two things: 1) modify bank deposits in its accounts, 2) buy or sell bonds on the money market. The central bank will usually do both, but the extent to which it uses deposits, or bond transactions depends on its financial situation and market conditions at the time of designing the policy.

Economists usually consider that a new monetary policy takes anywhere from 9 months to 24 months to work its way through financial markets into the producing economy. Until 1995, the Bank of Canada was actively managing money supply, and letting the financial markets set the interest rate. The hard facts of economics is that you can't set both the quantity and the price of any product, even if you are a monopoly, as is the case here for a central bank.

The following graph shows an example of a decrease in the overnight rate, as the main strategy to implement an expansionary monetary policy. This would be in effect if the annual inflation rate was below 1 percent. The first action is for the central bank to reduce the overnight rate, from 3 to 1.5 percent (orange arrow). Keep in mind that this example is using fictional yet realistic values for the Canadian economy. This creates a shortage of money, since at this lower price, quantity demanded is more important. In this example, Qd increases from 1.62 trillion dollars (T$), to 1.72 T$. Since Canadian currency is fiat, it is not produced by free-market suppliers. It's supply is fixed by the BoC.

The 100 B$ shortage means that people and corporations are lining up at banks for more and/or bigger loans. In Canada, the banks can create the money, but they need to respect currency reserve ratios. So in effect, they can't write up new loans unless the central bank gives them some financial room to do so. This is where the direct actions come in. The Bank of Canada now knows that it needs to increase money supply by 100 B$. It will increase deposits in chartered bank accounts at the BoC, and it will buy bonds from the money market (selling cash in return, thus increasing money supply). By the way, the BoC does not need to create 100 B$ of new cash, to create 100 B$ of Money Supply. There is a monetary multiplier effect, which is something we will leave to more advanced courses in monetary theory.

Graph - How a Decrease in the Policy Interest Rate affects Money Supply

Monetary policy has achieved an increase in money supply, which may grow output and GDP, as we will see in the next section.

The following graph shows an example of an increase in the overnight rate, as the main strategy to implement an restrictive monetary policy. This would be in effect if the annual inflation rate was above 3 percent. The first action is for the central bank to increase the overnight rate, from 3 to 4.5 percent (this example is using fictional values but realistic for the Canadian economy). This creates a surplus of money, since at this higher price, quantity demanded is less important. In this example, Qd decreases from 1.62 trillion dollars (T$), to 1.52 T$.

The 100 B$ surplus means that people and corporations are no longer asking banks for loans. Many investment projects are put on hold. In Canada, the banks don't want to hold money that is not lent out for profit. They can erase money to minimize their reserve ratios. They need to work with the BoC to do that. This is where the direct actions come in. The BoC now knows that it needs to decrease money supply by 100 B$. It will decrease deposits in chartered bank accounts at the BoC, and it will sell bonds on the money market (buying cash in return, thus decreasing money supply).

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

When you look at these graphs, you might be tempted to ask yourself why the BoC prefers to move interest rates first, rather than just shift the money supply curve. The answer is: ''been there, done that.''

Through the 1970's and 1980's, the BoC would act on financial markets and let banks figure out the overnight lending rate. It was difficult to execute that policy because it is difficult to estimate the monetary multiplier, and the slope of the demand curve. Those decades were notoriously hard to manage, with inflation rates as high as 12.5 percent in 1981, and mortgage interest rates as high as 22 percent.

You might be tempted to believe that clever use of statistics and scientific methods would have solved that, but empirical evidence has shown that it is much more efficient to move the interest rate first, and let demanders reveal their preferences. The move to interest-rate targeting in 1994 marked the end of inflation in Canada for almost three decades. Canada's central bank now has a solid international reputation for providing a stable price environment, which investors appreciate.

• Transmission

For most economists, monetary policy is the strongest (and most potentially harmful) means of government intervention. Keynes famously quipped that money was not that important. His most important critic, Milton Friedman, later argued quite convincingly that mismanaging money supply was the main reason that the 1929 stock market crash turned into a major depression.

The main question is: Do changes on the financial markets affect the production economy?

The answer is: it depends on the business cycle phase, and also on which economist answers the question.

The BoC provides this illustration to explain monetary policy and its inter-relationship with different markets.

St-Amant diagram HERE

For conservative economists, who identify with the Monetarist and/or Austrian schools of thought, monetary policy can do way more harm than good. The main temptation for any manager of a fiat currency, that is, a currency you can print to no end, is to do just that. If you increase the supply of any product, its value decreases. And with fiat money, because it has no intrinsic value, other than to be a means of exchange, it's value can drop to nothing. In this case, the sticker price of goods and services increases dramatically to cover the drop in value of the currency.

The formal presentation of this idea can be summarized in a neat, and very useful, equation. It is called the simple quantity of money theory.

M*V = P*Q

Where
M = stock of money supply
V = velocity (flow of money)
P = price level
Q = quantity of production (flow)

In essence, P*Q measures output, and can be replaced by real GDP. Money supply is known and accounted for. Velocity is a variable that has no direct measurement, and is not observable outside of this model. Velocity represents the churn rate of the stock of money in the economy for all of the transactions that need to take place to produce real GDP (sum of P*Q).

Getting back to the equation, if M increases, and V is held constant, then simple algebra dictates that P*Q must increase. Conservatives, especially Austrians, assume that increasing money supply is not a productive investment because it does increase the economy's physical capital, or labour, which could help produce more output. If this is true, we hold Q constant as well. The end conclusion is that any increase in the stock of money, will directly increase prices, thus we call it inflationary.

The model works the same way in reverse, when you apply a restrictive monetary policy. If you reduce the stock of currency, prices will decrease.

For conservative economists, monetary policy does not transmit to the productive economy and so its effects on prices are the only real effects. Inflation is thus the product of mismanaging a fiat currency. Some conservatives will argue for gold-standard free-banking instead of fiat central-banking, and in the case of central-banking they will argue for strict use of policy to avoid hyperinflation.

For Keynesian economists, the situation depends on the phase of the business cycle. Debates are never-ending on details, but in essence, Keynesians will agree with the quantity of money theory if the output level is equal to potential. The point of intervention is to help the economy when it's off its potential, such as in a recession, so there's a handle here for an argument in favour of monetary policy. Remember that fiscal policy requires the approval of public opinion and its elected representatives. That makes it a little slower to execute than it is for the board of a central bank to meet and act on interest rates.

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

By changing the Policy Rate, the central bank can have an impact on GDP. It will do this by changing the money supply to change Investment Spending. That, in turn, will affect Aggregate Demand, which is part of the process to determine GDP. If you are using the Keynesian-Cross model, consider that Investment is part of Aggregate Expenditure.

This set of domino effects is called the Keynesian Transmission Mechanism. Note that Keynesians are interested in maintaining a health output level as a means to ensure full-employment on the labour market. In Canada, the central bank is not mandated to do this, only to manage the rate of inflation and keep it around 2 percent. If the rate of inflation is below 1 percent, you can expect the BoC to increase money supply, and usually this is the case in a recession, that low inflation, or even deflation, is accompanied by high unemployment rates. However, in the case of stagflation, when there is price inflation and a drop in output, the BoC is expected to follow its inflation targets as a priority over any other issues.

Here is the mechanism in detail:

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

• • The central bank changes its policy rate
    • Decrease: Expansionary
    • Increase: Contractionary
  • Commercial banks follow suit and change their retail interest 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 = Y_p

EXPANSIONARY SCENARIO

Monetary Policy: EXPANSIONARY
Objective: CREATE JOBS
Means: THE KEY INTEREST RATE IS REDUCED

Graph - Expansionary Policy Transmission to Investment

The graph above shows that a lower interest rate will increase Quantity demanded for loanable funds, which are considered investments by Statistics Canada. Investments include buying homes, building factories and purchasing machines such as computers and robots.

As you remember from the AD-AS model, AD is composed of four variables, which are C + I + G + NetX. If we assume all variables to remain fixed, except for Investment (I), then an increase in Investments will generate an increase in AD. You can then shift the AD curve to the right, and use the AD-AS model to predict output and inflation results.

Graph - Transmission from Investment to Output and Inflation

 

 

 

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.