Learning

Objectives
Describe the Bank of Canadas monetary policy objective, and its

THE IMPORTANCE OF POLICY : Monetary, Fiscal & Structural Policy & Central Bank Role And Policy.. continued
CHAPTER9A/10 SLIDESET10

monetary policy instrument.

Understand the two theories of interest rate determination vertical money supply theory modern central banking theory of interest rate determination

through central bank control of the overnight rate

Understand how the Bank of Canada influences real and nominal

interest rates, plus looks at the economic effects of changes in interest rates.
Explain how central bank control over nominal interest rates

translates into control over real interest rates.

Two Theories of Interest rate Determination

What are the

differences and similarities ?

Vertical Money Supply Theory

What is the Vertical Money Supply Theory of Interest Rate Determination?

The vertical money supply theory states

To really look at the theory ...

Need to explain : Demand for money Supply of money Money market equilibrium

that the central bank changes interest rates by shifting a vertical money supply curve. Theory includes: Demand for Money Supply of Money that is set by Bank of Canada Interest rate changes result from S & D Logic: Given demand for money .. If Central Bank changes money supply that changes short term interest rate that affect expenditures by business and consumers Bank of Canada does not affect interest rates directly but through the money supply.

Demand for Money

Individual: The amount of wealth an individual chooses to hold in Benefit of holding money is its convenience in making

the form of money M1

Businesses: Must also must decide how much money to hold Why? cash in till needed to make change chequing accounts needed for payroll, etc

transactions higher income means more transactions, hence more money held BUT Technological and financial innovation has also made money less useful to hold (e.g. credit cards, internet payments) ATMs make frequent cash replenishment easier
Costs of holding money = opportunity costs The interest that could have been earned by holding interest

(Businesses hold more than twice as much money as individuals in chequing accounts)

Costbenefit criterion tells us that an individual (or firm) will

increase money holdings if the benefit of doing so exceeds the cost. What are the costs and what are the benefits to consider?

bearing assets Bonds and stocks pay a positive nominal return Cash and chequing accounts pay little or no interest

Macroeconomic Factors Affecting Money Demand

Nominal interest rate = the opportunity cost of holding money Why does the Nominal interest rate affect money demand? The higher the nominal interest rate, the greater the opportunity Real output Affects the benefits of holding money More stuff to buy as there is an increase in real output results in

increases the value & # of transactions needing cash

cost of holding money and the less money demanded

Price level Note: The nominal interest rate is some average measure of interest Affects the benefits of holding money Increase in price level and people need more cash to make

rates. Thousands of different assets each with their own rate of return, or interest rate. However, rates tend to rise and fall together.

transaction .. Movies: 2$ 1950 versus 12$ 2007

What is the Money Demand Curve?

Money demand curve: based on the cost benefit idea and 3 factors

affecting demand. Specifically:

Nominal interest rate defines the NEGATIVE slope As nominal interest rate increases the quantity of money

The Money Demand Curve

demanded decreases inverse relationship and therefore the money demand curve slopes down.
GDP and/or price levels causes shifts of curve An increase in real GDP and/or an increase in the price level

will shift the money demand curve to the right. Why?

Be sure you understand what makes the demand curve slope

and shift!

What is the Money Supply Curve?

Central bank controls

What is the Money market equilibrium?

Occurs at the intersection of supply and demand where price is

the money supply

Quantity of money (M)

the nominal interest rate (i) Money market equilibrium determines the nominal interest rate in the economy.
The vertical money supply theory says that : if the Bank of Canada wants to increase interest rates, it must

is a vertical line set by the central bank

How does the Central

decrease the supply of money.

if the Bank of Canada wants to decrease interest rates, it must

banks changes this? (last set of slides)

increase the supply of money.

What is the Modern Central Banking Theory of Interest Rate Determination?

Modern Central Banking Theory of Interest Rate Determination

ThetheoryofhowtheBankofCanada controlsinterestratesdirectly.

Theory holds that central banks, including the

Bank of Canada, directly set their official interest rates, and that M1 changes in response to the change in interest rates. Money demand same as last theory Money supply not a curve here .. Just interest rate level that defines money supply Logic: a change in the real interest rate => change in spending

The Modern Central Banking Theory: details

Direct Central Bank Manipulation of the Nominal Interest Rate
i i' MD It is the official view of many central banks.. including the

Bank of Canada
Theory holds that central banks, including the Bank of Canada,

directly set their official interest rates, and that M1 changes in response to the change in interest rates
Contrast to the vertical money supply theory as the Bank of

Canada expressly states that a change in interest rates leads to a change in M1

M'

 The central bank influences market interest rates directly by

changing its key policy rate

The Bank of Canada controls nominal interest rates through its

The Bank takes additional actionsborrowing and lending

overnight rate target overnight rate target: rate at which it wants private banks to lend to each other overnight
These changes usually lead to moves in the prime business rate at

commercial banks and in other interest rates affecting business and household borrowing to finance purchases Prime business rate: the interest rate that commercial banks charge to their least risky business borrowers

operationsto ensure that the overnight rate stays very close to the target Large Value Transfer System (LVTS) Settlement Balance Operating band o A term used by the Bank of Canada to describe the range of possible overnight interest rates o from 0.25 percentage points below the overnight rate target to 0.25 percentage points above the target o Bank rate: upper limit of the operating band BOC announces interest changes by basis points. Basis point is one hundredth of a percentage point; term often used in describing interest rates

Downward Shift of the Operating Band for the Overnight Rate, January 2008

How does the Bank of Canada maintain its overnight rate target?
Willing to borrow at 0.25% below the target; willing to lend at

0.25% above the target Keeps the overnight rate within 0.25% of the target
Buys or sells Government of Canada bonds overnight Keeps the overnight rate very close to the target

How does the target for the overnight rate work?

The Bank carries out monetary policy raising and lowering the

Is it really Overnight? And why?

Canada's major financial institutions

target for the overnight rate. The overnight rate is the interest rate at which major financial institutions borrow and lend oneday (or "overnight") funds among themselves; the Bank sets a target level for that rate. This target for the overnight rate is often referred to as the Bank's key interest rate or key policy rate. Changes in the target for the overnight rate influence other interest rates, such as those for consumer loans and mortgages. They can also affect the Canadian dollar. EXCHANGE RATE. In November 2000, the Bank introduced a system of eight "fixed" dates each year on which it announces whether or not it will change the key policy rate

routinely borrow and lend money among themselves overnight, in order to cover their transactions during the day. ..settle up
The interest rate charged on those

loans is called the overnight rate.

The Modern Central Banking Theory: details

Since the institutions know that the Bank of Canada will always

lend them money at the rate at the top of the band, and pay interest on deposits at the bottom, there is no reason for them to trade funds at rates outside the band. The Bank can also intervene in the overnight market at the Target rate, if the market rate is moving away from the Target.

Note that in this theory: The central bank does not directly control the money supply Aim is to change interest rates, not to affect the money supply If anything, changes in nominal interest rates cause changes in the money supply Vertical money supply theory claims its the other way around

Changes in the target for the overnight rate usually lead to

changes in other interest rates, and so affect people's spending decisions.

influences the level of demand for goods and services. When demand exceeds supply, prices will risethink inflation!! Influences the exchange rate of the Canadian dollar.

HOW DOES THIS CONNECT WITH INFLATION?

If inflation threatens to rise above the 3 percent range, the Bank

responds with an increase in interest rates. Save more spend less Not take loans Results in less spending and thus less GDP
If inflation is expected to fall below the 1 percent range, the

Can the Bank of Canada Control the Real Interest Rate?

Bank lowers interest rates. Reverse idea

BE SURE YOU UNDERSTAND WHAT DOES THIS INCREASED

INTEREST RATE DOES??

Can the Central Bank control the Nominal Interest Rate? Yes ST rate mostly by controlling the overnight rate that the Central Bank controls the nominal interest rate. Generally assumed control over short term interest rates is better than control over long term. Can the Central Bank control the Real Interest Rate? Or is it Inflation control? We know that real interest rate = nominal interest rate inflation We also know that the Bank of Canada can control the short term nominal interest rate (i) quite precisely And that inflation () changes relatively slowly after policy changes. Thus, changing nominal interest rates causes real interest rates to change by the same amount So, Yes they can control r because of lag and slow adjust of inflation

Be sure to read the Economic Naturalist 10.2 page 247 Really try to understand the concepts and terms in the article

Who is this? Why is the chairman of the U.S. Federal Reserve described by

some as the most influential individual no one knows?

Is he elected or appointed ? Background? Does it matter where he was

educated??

Harvard College, B.A. in economics in 1975. PhD in economics from the Massachusetts Institute of Technology

What about Canada?

in 1979.
He taught at the Stanford Graduate School of Business , New York

University , & Princeton University

He is ranked among the 50 best economists in the world according

to IDEAS/RePEc.

Mark Carney, 47, governor of the Bank of Canada.

A native of Fort Smith, N.W.T., Bachelor's degree in economics from Harvard University in 1988. Master's degree in economics in 1993 and a Doctorate in economics in 1995, both from Oxford University.
Prior appointment senior associate deputy minister of

End of Chapter Slides

finance.

deputy governor of the Bank of

Canada.

Goldman Sachs for 13 years, rising to

the post of managing director.