Monetary Policy - Lecture Notes

Chapter 13: Monetary Policy

Overview of Monetary Policy

• Focuses on how the Bank of Canada affects money market equilibrium.
• Discusses the influence of the Bank on the monetary transmission mechanism.
• Examines the inflation targeting system and Canadian monetary policy over the last 40 years (part skipped).

13.1 How the Bank Implements Monetary Policy

• The Bank of Canada influences the money market without directly setting the money supply or market interest rates.
• It targets these variables strategically.

Key Considerations

1. Independence of Targets

   • The Bank cannot target the money supply and interest rates independently.

2. Endogenous Money Supply

   • Money supply is not fixed; it’s determined by factors such as:

     • Deposit Expansion: Potential for banks to create money through excess reserves.
     • Cash-Deposit Allocation: Changes in the preference for cash versus deposits can affect the money supply.

   • Money Demand Function (MD):

     • Difficult to observe directly, making it hard to predict how changes in money supply influence interest rates.

3. Targeting Interest Rates

   • Focusing on interest rates is more efficient since:
     • It requires no knowledge of the unobservable money demand.
     • Easier communication with the private sector.
     • The Bank can adjust the policy interest rate (bank rate), influencing other market interest rates significantly.

Mechanism of Implementation

1. Policy Interest Rate Effect

   • Changing the policy interest rate shifts the behavior of borrowing/saving in the private sector.

2. Adjustment by Commercial Banks

   • Changes in private sector behavior impact commercial banks’ cash reserves, prompting adjustments in reserves that are indicative of movements along the money demand function.

3. Open-Market Operations

   • To balance changes in money demand, the Bank:
     • Buys or sells government securities.

Types of Monetary Policy

• Expansionary Monetary Policy:

  • Reducing interest rates by buying government securities to increase the money supply.
  • This action aims to expand aggregate demand.

• Contractionary Monetary Policy:

  • Increasing interest rates by selling government securities to reduce the money supply.
  • This aims to cool down economic activity.

Summary of Effects

• Expansion: Lowered interest rates lead to increased spending and investment, boosting economic activity.
• Contraction: Higher interest rates dampen spending and investment, which can slow down the economy.