Chapter 11 - Monetary Policy

What is the main responsibility of the Bank of Canada?

To conduct monetary policy “in the best interests of the economic life of the nation”

Monetary Policy

The actions the BoC takes to manage the money supply and interest rates to achieve its macroeconomic policy objectives. 

The 4 goals of monetary policy

1. Price stability

2. High employment

3. Stability of financial markets and institutions

4. Economic Growth

Price stability

Rising prices reduce money’s usefulness as a medium of exchange and store of value.

What are the benefits of low inflation?

• More efficient resource allocation

• Allows the central bank to increase aggregate demand during recessions

High employment (or low rate of unemployment)

Unemployed workers and underused factories/office buildings reduce gross domestic product (GDP) below its potential level. 

• Hence, high employment is essential

What are the effects of unemployment?

• Financial distress

• Lower self-esteem for workers

Stability of financial markets and institutions 

Firms often need to borrow funds as they design, develop, produce, and market their products

What is the role of stable financial systems?

Ensure efficient flow of funds from savers to borrowers

Economic Growth

Raises the living standards 

How can policy promote economic growth?

• Encourage saving (more investment capital)

• Provide incentives for business investment

• Support stable growth for better planning

Money demand

The amount of money that households and firms choose to hold at a given interest rate.

• Need to understand the money market

What are the Bank of Canada’s key monetary policy tools?

• Open market buyback operations

• Lending to financial institutions. 

What percentage does the BoC try to keep inflation between?

1-3%

(however, the BoC can’t affect the inflation rate directly)

Monetary policy targets

Variables the central bank can directly control (like money supply or interest rates) to influence inflation, GDP, and employment.

What do monetary policy targets affect?

Inflation, real GDP, and employment.

Money Market

Which brings together the demand and supply for money. 

Demand for Money Graph

• The vertical axis = interest rate. 

• Horizontal axis = Quantity of money  

Why is the demand for money curve downward sloping? 

Households have a choice between holding money and holding other financial assets, such as Canada bonds 

Desirable and undesirable characteristics of money that households take into account:

• Desirable characteristics: You can use it to buy goods, services, or financial assets. 

• Undesirable characteristics: It earns either a zero interest rate or a very low interest rate

Why does money have an opportunity cost?

Money earns little/no interest, so its opportunity cost is the interest rate

The relation between money demand and interest rates

Interest rate ↑ → money demand ↓
Interest rate ↓ → money demand ↑

The 3 variables that cause the money demand curve to shift

1. Real GDP

2. The price level

3. Technology

Money demand curve to shift - Real GDP

• Real GDP ↑ → more transactions → money demand ↑ (shift right) 

• Real GDP ↓ → fewer transactions → money demand ↓ (shift left) 

Money demand curve to shift - Price Level

• Price level ↑ → need more money for purchases → money demand ↑ (shift right) 

• Price level ↓ → need less money → money demand ↓ (shift left) 

Money demand curve to shift - Technology

(e.g., digital payments) → reduces need for cash → money demand ↓ (shift left)

How does the Bank of Canada manage the money supply?

The BoC changes the money supply by buying or selling government securities.

Money Supply - Buys securities

Increases bank reserves → more lending → money supply ↑ 

Money Supply - Sell securities

Decreases bank reserves → less lending → money supply ↓ 

Equilibrium in the Money Market

Equilibrium occurs where money demand = money supply, which determines the equilibrium interest rate. 

Increases and decreases in the money supply

• Increase in money supply → shifts supply right → interest rate ↓ 

• Decrease in money supply → shifts supply left → interest rate ↑ 

Money Supply Graph

Money supply is fixed by the Bank of Canada (vertical curve) 

What happens when the money supply increases or decreases?

• Increase: excess money → buy assets → interest rate ↓ → money demand ↑ → equilibrium restored

• Decrease: too little money → sell assets → interest rate ↑ → money demand ↓ → equilibrium restored

Two interest rate models

Two different models that explain interest rates, depending on the context:

• Loanable funds model

• Money market model

Loanable funds model

• Long-term real interest rate (savings and investments).

• Relevant for saving, investing, and borrowing for long-term projects (e.g., mortgages, factories) 

Money market model

• Focuses on the short-term nominal interest rate (policy-driven)

• Directly influenced by the Bank of Canada's monetary policy

What target does the Bank of Canada mainly use and why?

It mainly targets the overnight interest rate to influence real GDP, inflation, and overall economic activity.

What is the overnight interest rate?

Rate banks charge each other for short-term (overnight) loans of reserves

Why is the overnight rate important?

• BoC targets it using an operating band and open market operations

• Changes in this rate affect other interest rates and the entire economy

(Formula) Real interest rate

Nominal interest rate − Inflation rate 

How do interest rates affect aggregate demand?

They affect consumption, investment, and net exports (not including government spending).

How do interest rates impact consumption?

Low rates → more borrowing & spending; high rates → less

How do interest rates impact investment?

Low rates → more business & housing investment; high rates → less

How do interest rates impact net exports?

High rates → stronger currency → exports ↓; low rates → weaker currency → exports ↑

How does monetary policy affect real GDP and the price level?

By changing interest rates, which shift aggregate demand (AD).

Expansionary monetary policy

Actions by the Bank of Canada to increase the money supply and lower interest rates to boost spending, increase real GDP, and reduce unemployment (especially during a recession).

Contractionary monetary policy

(used to reach its goal of price stability) 

• The BoC’s increasing interest rates to reduce inflation. 

  • Decreasing the money supply and increasing interest rates 

Can the Bank of Canada Eliminate Recessions?

The BoC cannot completely eliminate recessions, but it can reduce their severity and duration through monetary policy. 

The Taylor Rule

• Explains how the Bank of Canada sets the overnight interest rate.

• It starts with the equilibrium real interest rate (≈2%) and adds: 

  • Inflation gap – difference between current inflation and target inflation 

  • Output gap – difference between real GDP and potential GDP 

Taylor Rule - Equation

Taylor Principle

When inflation rises, the Bank of Canada raises the overnight rate by more than the increase in inflation to keep the real interest rate positive and stabilize the economy.

What happens if interest rates rise less than inflation?

Real interest rates fall → spending increases → inflation rises further.

Inflation targeting

Committing the central bank to achieve an announced level of inflation. 

Average-inflation targeting

Keeping inflation close to the target on average over time, not every year.

Income/Money "Decision Tree" 

Households earn income → consume or save → savings add to wealth → wealth held as physical assets (house, jewelry) or financial assets (money or stocks/bonds).

Market Diagram (Shell)

Vertical Axis: Nominal interest rate (i) 

Horizontal Axis: Quantity of money (M)  

 

• Demand for money has a negative slope. 

  • Higher interest rates = the quantity of money goes down.

• The money supply "set" by the Bank of Canada 

  • Vertical

Suppose that Y (income) increases. What happens to the quantity of money and the interest rate? 

When income increases, consumption will also increase, and people will want to have more money to pay for all of this extra stuff that they're buying 

Monetary Policy - Recession

• High unemployment 

• BoC wants to shift AD out to the right to restore long-run equilibrium 

Monetary Policy - Expansion

• Risk of coming inflation 

• BoC wants to shift AD to the left  

What would the BoC do to prevent inflation?

Shift the AD curve to the LEFT (reduce spending)

What would the BoC do to fight a recession?

Shift the AD curve to the RIGHT (increase spending)

Bank Panic

When many banks simultaneously experience large withdrawals by depositors.

How does the Government of Canada influence the conduct of monetary​ policy?

It determines the objectives of monetary policy jointly with the Bank of Canada.

How can investment banks be subject to liquidity​ problems?

They often borrow short​ term, sometimes as short as​ overnight, and invest the funds in​ longer-term investments.

When the government established the Bank of Canada in​ 1934, what was its main​ responsibility?

Prevent bank panics by making loans to banks.