Notes on Chapter 13: Monetary Policy

Learning Objectives

• After this chapter, you will be able to:
  • LO1: Explain the Bank of Canada’s function and the role of monetary policy
  • LO2: Outline the tools the Bank of Canada uses to conduct monetary policy
  • LO3: Identify the trade-off between inflation and unemployment

The Bank of Canada: Functions

• The Bank of Canada performs four basic functions:
  • Managing the Money Supply: Controls the amount of money circulating in the economy.
  • Bankers’ Bank:
  • Holds deposits of members of the Canadian Payments Association (CPA).
  • Makes advances to CPA members at the bank rate.
  • Fiscal Agent for Federal Government:
  • Holds some of the government’s bank deposits.
  • Clears government cheques.
  • Handles the financing of the government’s debt through bond issuance.
  • Supervision of Financial Markets:
  • Works with the Office of the Superintendent of Financial Institutions.
  • Follows Basel Committee guidelines for banking supervision.
  • Gained notable attention for its success following the 2008 financial crisis.

Monetary Policy

Expansionary Monetary Policy

• Definition: A policy that increases the money supply and lowers interest rates, shifting the Aggregate Demand (AD) curve to the right.
• Purpose: Used to eliminate a recessionary gap.
• Mechanism:
  • When the economy is in a recession, the Bank shifts the money supply from $S<em>{m0}$ to $S</em>{m1}$, which reduces interest rates, leading to an increase in aggregate demand from $AD<em>{0}$ to $AD</em>{1}$.

Contractionary Monetary Policy

• Definition: A policy that decreases the money supply and raises interest rates, shifting the AD curve to the left.
• Purpose: Used to eliminate an inflationary gap.
• Mechanism:
  • During an economic boom, the Bank shifts the money supply from $S<em>{m0}$ to $S</em>{m1}$, raising interest rates, which decreases aggregate demand from $AD<em>{0}$ to $AD</em>{1}$.

Tools of Monetary Policy

Open Market Operations

• Mechanism: The Bank of Canada conducts monetary policy through open market operations.
  • A sale of bonds decreases money supply by lowering a CPA member’s deposit liabilities and reserves.
  • A purchase of bonds increases money supply by raising deposit liabilities and reserves.

Target Overnight Rate

• Significance: Changing this rate signifies the Bank’s monetary policy intentions.
  • An increase signals contractionary policy; a decrease signals expansionary policy.
  • Adjustments to this rate affect deposit-takers' prime rates.

Benefits and Drawbacks of Monetary Policy

Benefits

• Independence from Politics: Monetary policy can be enacted without political interference.
• Speedy Decisions: Allows for quick reaction to economic changes.

Drawbacks

• Effectiveness: Less effective in expansionary measures than in contractionary.
• Regional Focus: Cannot target specific regional economic issues.
• Conflict with Financial Stability: Sometimes monetary policy aims can conflict with maintaining financial stability.

Types of Inflation

• Demand-Pull Inflation: Results from increased aggregate demand shifting the AD curve right, leading to higher prices.
• Cost-Push Inflation: Occurs from increased input costs causing the Aggregate Supply (AS) curve to shift left, pushing up prices.

The Phillips Curve

• Description: Illustrates the relationship between unemployment and inflation; traditionally indicates a trade-off between the two.
• Historical Context:
  • 1960-1972: Stable relationship.
  • 1973-1982: Shifted rightward, resulting in stagflation.
  • 1983-1997: Shifted leftward, reversing stagflation.
  • 1998-2021: Impact varied significantly without complete stability.

The Self-Stabilizing Economy

• Movements in the AS curve indicate a self-stabilizing economy.
  • Surpluses lead to increased wages, pushing the AS curve leftward (reducing equilibrium output).
  • Shortages lead to decreased wages, pushing the AS curve rightward (increasing equilibrium output).

The Long-Run Aggregate Supply Curve

• Represents the potential output level of the economy, signifying stable equilibria.

The Economics of Yes: Modern Monetary Theory (MMT)

• Advocated by Stephanie Kelton: Emphasizes the government's control over money supply and its implications.
  • Government levies taxes to create demand for its currency and views government bonds as money.
  • Central Banks’ Role: Should maintain low interest rates and coordinate with fiscal policy to minimize unemployment.
  • Suggests avoiding excessive inflation through a public job guarantee.

Chapter Recap

• Overview of the role of the Bank of Canada and monetary policy tools.
• Identified the relationship between inflation and unemployment throughout the chapter.