Chapter 13

Monetary Policy

Prepared by Murray Davidson, Centennial College.

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Learning Objectives
After this chapter you will be able to:

 Explain the Bank of Canada’s function and the

role of monetary policy

 Outline the tools the Bank of Canada

uses to conduct monetary policy

 Identify the tradeoff between inflation

and unemployment.

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The Bank of Canada (a)
The Bank of Canada (i.e. “central bank”)performs four basic
functions:

1. It manages the money supply:

 printing money (paper notes, coins)
 Controlling the amount of money in circulation
 Setting benchmark interest rates.

2. It acts as the bankers’ bank:

 holding deposits of financial institutions (members of

the Canadian Payments Association)

 making advances to CPA members at the bank rate.

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The Bank of Canada (b)
3. It acts as the federal government’s bank or
fiscal agent:
 holding some of the government’s bank
deposits
 clearing the government’s cheques

 handling the financing of the government’s

debt by issuing bonds (including treasury bills)

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The Bank of Canada (c)
4. It helps supervise the operations of financial
markets to ensure their stability.

 The Bank works in conjunction with the Office

of the Superintendent of Financial Institutions,
and follows the global guidelines of the Basel
Committee on Banking Supervision.
 The success of Canada’s financial supervision

has received considerable attention since the

2008 financial crisis.

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Canada and the Financial Crisis
Canadian financial institutions were less affected by
the financial crisis than most industrialized countries.

 Canadian financial regulators had banned high-risk

mortgage lending and trading in risky financial
instruments.
 Canada’s large banks had lower leverage ratios

than many of their global counterparts.

 The Canadian property market had not

succumbed to the same bubble conditions as in

some other countries.
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Central Bank Policies
Central banks’ policies can be:

Expansionary monetary policy or loose monetary

policy - a monetary policy that increases the supply
of money and the quantity of loans.

Contractionary monetary policy or tight monetary

policy - a monetary policy that reduces the supply of
money and loans

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Expansionary Monetary Policy
Expansionary monetary policy is:

 a policy of increasing the money supply and

lowering interest rates, which shifts AD rightward
by a magnified amount due to an initial increase
in investment and the consumption.

 used to eliminate a prolonged downturn in

economic activity (recessionary gap).

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Expansionary Monetary Policy
FIGURE 13.1

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Contractionary Monetary Policy
Contractionary monetary policy is:

 a policy of decreasing the money supply and

raising interest rates, which shifts AD leftward by
a magnified amount due to an initial decrease in
investment and the consumption.

 used to eradicate an overheated economy and

strongly rising prices (inflationary gap).

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Contractionary Monetary Policy
FIGURE 13.2

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 Monetary Policy Tools
• Open market operations - central bank sells or buys short-term (up
to \90 days) government bonds to influence the quantity of money
and the level of interest rates.
● Reserve requirements for commercial banks - the percentage of a
commercial bank’s deposits held as reserves at the central bank.
• Greater reserve requirement = less money available to lend out.
• Smaller reserve requirement = more money available to lend
out.
● Target Overnight Rate (Discount rate) - the interest rate charged by
the central bank on the loans to the commercial banks.
• Higher discount rate reduces lending, the money supply falls,
and market interest rates rise.
• Lower discount rate, the process works in reverse. 12
Open Market Operations - A Bond Sale
FIGURE 13.3

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Open Market Operations - A Bond Purchase
FIGURE 13.4

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The Target Overnight Rate
Changing the target overnight rate is a tool the Bank
of Canada uses to signify its monetary policy
intentions (rise or lower interest rates).

 When the Bank of Canada changes its target band

(range) for the overnight rate it also automatically
adjusts the bank rate since this rate is at the top
end of the target band (range).

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The Rate as a Signal
 A rise in the target overnight rate signifies a
contractionary policy in the near future while a
fall in the target overnight rate signifies an
expansionary policy.

 If the change in the target overnight rate is

substantial, then deposit-takers also adjust their
prime rate, which is the lowest possible rate
charged on loans to deposit-takers’ best
corporate customers.

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Example of Interest Rates Structure

 Central bank’s band (range) for overnight rate: 1.0% - 2.5%

 Central bank’s benchmark Bank Rate: 2.5%

 Commercial banks’ Prime Rate: 4.0% (Bank Rate + 1.5%)

 Commercial bank’s loans to customers: Prime Rate + x%

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Benefits/Drawbacks of Monetary
Policy
Monetary policy has two main benefits:
 It is separated from day-to-day politics.

 Decisions regarding monetary policy can be made

quickly and have immediate impact on the economy.

Monetary policy has three main drawbacks:
 It is less effective as an expansionary tool than as a

contractionary tool.
 It cannot be focused on particular regions.

 It might lead to a potential conflict with financial

stability.
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Types of Inflation
There are two main types of inflation:

 Demand-pull inflation occurs as rightward shifts

in the AD curve pull up prices.

 Cost-push inflation occurs as leftward shifts in the

AS curve push up prices.

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Demand-Pull Inflation
FIGURE 13.5

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The Phillips Curve
The Phillips curve is a graph showing the assumed
inverse relationship between unemployment and
inflation.

 From 1960 to 1972 the Canadian Phillips curve

was relatively stable.
 From 1973 to 1982 the Canadian Phillips curve

shifted rightward resulting in stagflation.

 From 1983 to 2013 stagflation was reversed but

no constant Phillips curve emerged.

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The Phillips Curve
FIGURE 13.6

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Shifts in the Phillips Curve

23
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Cost-Push Inflation
FIGURE 13.8

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The Self-Stabilizing Economy
The economy is deemed to have a self-stabilizing
tendency in the long run.
 If equilibrium real output is above potential output,

then higher wages gradually push the AS curve

leftward and decrease equilibrium output.
 If equilibrium real output is below potential output,

then lower wages gradually push the AS curve

rightward and increase equilibrium output.

In the short-run however, the economy requires active

monetary and fiscal policies to avoid the recessionary
or inflationary gaps.
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The Self-Stabilizing Economy
FIGURE 13.9

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Conclusion
Described the Bank of Canada’s function and the
role of monetary policy.

Explained the tools of Bank of Canada uses to

conduct monetary policy.

Identified the relationship between inflation and

unemployment.

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