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Chapter 29:

Monetary Policy
in Canada
Copyright 2014 Pearson Canada Inc.
Chapter Outline/Learning Objectives
Section Learning Objectives
After studying this chapter, you will be able to
29.1 How the Bank of
Canada Implements
Monetary Policy
1. explain why the Bank of Canada chooses to directly
target interest rates rather than the money supply.
29.2 Inflation Targeting

2. understand why many central banks have adopted formal
inflation targets.
3. explain how the Bank of Canada's policy of inflation
targeting helps to stabilize the economy.
29.3 Long and
Variable Lags
4. describe why monetary policy affects real GDP and
the price level only after long time lags.
29.4 Thirty Years of
Canadian Monetary
Policy
5. discuss the main economic challenges that the Bank
of Canada has faced over the past three decades.
Copyright 2014 Pearson Canada Inc. 2 Chapter 29, Slide
29.1 How the Bank of Canada Implements Monetary Policy
Money Supply Versus the Interest Rate
For any given money demand curve, any central bank must
choose between:
targeting the money supply
targeting the interest rate
Both cannot be targeted independently.
Copyright 2014 Pearson Canada Inc. 3 Chapter 29, Slide
Fig. 29-1 Two Approaches to the Implementation of Money Policy
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Money Supply Versus the Interest Rate
The Bank of Canada chooses to implement its monetary policy by
targeting interest rates (rather than the money supply) because:
1. The Bank can influence an interest rate more easily than it can
affect the money supply.
2. Instability of money demand.
3. Easier to communicate its policy through changes in interest
rates.
But which interest rate (of many) does the Bank target?

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The Bank of Canada and the Overnight Interest Rate
The Bank can more or less control the overnight interest rate.
It does this by:
1. Setting a target for the overnight interest rate
2. Establishing the bank rate 0.25% above this target
3. Establishing a borrowing rate 0.25% below target

keep actual overnight rate within 0.5% band



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Fig. 29-2 The Overnight Interest Rate: Target and Actual
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The Money Supply is Endogenous
As the Bank changes its target for the overnight rate:
other interest rates change
bank lending changes
banks' demand for currency changes

the Bank responds by supplying currency or buying currency from
commercial banks
the need for open-market operations

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But these transactions are done passively by the Bank of Canada:
the money supply is endogenous

9 Copyright 2014 Pearson Canada Inc.
APPLYING ECONOMIC CONCEPTS 29-1
What Determines the Amount of Currency in Circulation?
Chapter 29, Slide
Expansionary and Contractionary Monetary Policies
An expansionary monetary policy occurs when the Bank of Canada
reduces its target for the overnight interest rate.
eventually increases M
S
(or its growth rate)
An expansionary monetary policy occurs when the Bank of Canada
increases its target for the overnight interest rate.
eventually decreases M
S
(or its growth rate)

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Fig. 29-3 The Monetary Transmission Mechanism
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29.2 Inflation Targeting
Why Target Inflation?
Over the past few decades, central banks have come to realize two
things:
1. High inflation is costly for individuals and damaging
for economies.
2. Inflation is the one variable on which monetary policy
can have a systematic and sustained influence.

Copyright 2014 Pearson Canada Inc. 12 Chapter 29, Slide
Why Target Inflation?
Recognition of these points has led many central banks to adopt
formal inflation targets:
New Zealand (1990)
Canada (1991)
Israel, U.K., Australia
Finland, Spain, Sweden
plus many others
Canada has renewed its inflation targets several times since 1991:
the current target of 2% lasts until 2016
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The Role of the Output Gap
In the short run, when an output gap opens, the Bank has two
choices:
allow the adjustment process to operate
intervene with monetary policy
Since output gaps put pressure on inflation, the Bank monitors
the output gap and may intervene in order to keep output near
potential
thereby keeping inflation within the target band
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15 Copyright 2014 Pearson Canada Inc.
Time
1%
3%
I
n
f
l
a
t
i
o
n

R
a
t
e

Inflation target
band
t
1
t
0
t
2

t
3

2%
O
u
t
p
u
t

G
a
p

0
Time
Bank's policy
closes gap
Positive shock
opens gap
Bank's policy
closes gap
Negative shock
opens gap
Chapter 29, Slide
Inflation Targeting as a Stabilizing Policy
As the previous diagram suggests, inflation targeting tends to
stabilize output:
in response to a positive output shock, the Bank tightens policy
in response to a negative output shock, the Bank loosens policy
policy tends to keep output close to Y*
But this is not automatic stabilizationthe Bank must actively
change policy.


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Complications in Inflation Targeting
Inflation targeting is complicated by two factors:
1. Volatile Food and Energy Prices
prices of many goods included in CPI are determined
in world markets
these may change suddenly for reasons unrelated to Canadian
output gaps
the Bank also monitors core inflation


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Fig. 29-4 Canadian CPI and Core Inflation, 19922012
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2. The Exchange Rate and Monetary Policy
the Bank must identify the cause of any exchange rate
change before determining the appropriate policy response
consider an appreciation of the Canadian dollar caused by
an increase in demand for exports
or an appreciation of the Canadian dollar caused by
an increase in demand for Canadian bonds

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20 Copyright 2014 Pearson Canada Inc.

MyEconLa
b
www.myeconlab.com
For a more detailed discussion of how movements in the exchange
rate complicate the implementation of monetary policy, look for
Monetary Policy and the Exchange Rate in Canada in the Additional
Topics section of this book's MyEconLab.
Chapter 29, Slide
29.3 Long and Variable Lags
What Are the Lags in Monetary Policy?
Monetary policy operates with a time lag that is long and variable
for two main reasons:
changes in expenditure take time
the multiplier process takes time
Copyright 2014 Pearson Canada Inc. 21 Chapter 29, Slide
LESSONS FROM HISTORY 29-1
Two Views on the Role of Money in the Great Depression
Destabilizing Policy?
Long and variable lags some monetarists argued that central banks
should not try to stabilize national income.
They argued that attempts to stabilize will more likely be destabilizing
they advocate the use of a monetary rule
increase bank reserves at a constant rate
Most economists now agree that monetary policy can lead to more
economic stability.
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Political Difficulties
23 Copyright 2014 Pearson Canada Inc.
Monetary policy must be forward-looking.
often creates difficulties when policy is tightened now
because of expected future inflation
Chapter 29, Slide
Fig. 29-5 Forward-Looking Monetary Policy
29.4 Thirty Years of Canadian Monetary Policy
Early 1980s:
inflation reached 12% as a result of OPEC oil shocks in the mid
and late 1970s
the Bank embarked on a strict policy of monetary restraint
but unanticipated surge in money demand led to a much tighter
monetary policy than intended
the most serious recession since the 1930s

Copyright 2014 Pearson Canada Inc. 24 Chapter 29, Slide
Fig. 29-6 Short-Term Interest Rates, Canada and the United States,
19752012
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Economic Recovery: 19831987
The main challenge was creating sufficient liquidity to accommodate
the recovery without triggering a return to the high inflation rates.

Rising Inflation: 19871990
Inflation crept upwards throughout the late 1980s.
Many economists argued the need for tightening monetary policy.
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Disinflation: 19901992
The Bank of Canada embarked on its stated policy of price stability.
When the tight monetary policy took effect:
interest rates increased
the Canadian dollar appreciated
inflation fell suddenly
The economy entered a significant recession in the early 1990s.


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Inflation Targeting I: 19912000
The ensuing economic recovery was quite gradual:
excessive stimulation could have led to a return of inflation
insufficient stimulation could have caused the economy to stall
Beginning in 1996, the recovery was more robust and inflation
remained well within the 1 to 3% target band.
By 2000, Canadian GDP was near its potential level and inflation
was just below 2% and quite stable.
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Two issues complicated monetary policy in the late 1990s:
1. The Asian Crisis
This presented a (confusing) combination of aggregate demand
and aggregate supply shocks.

2. The Stock Market
The bull market of the late 1990s presented some challenges
how should monetary policy respond?
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Targeting Inflation II: 20012007
The terrorist attacks of 9/11 presented substantial challenges
for monetary policy:
the U.S. economy was already slowing down
policy interest rates were dramatically reduced
The 20022006 period presented other challenges:
commodity prices were rising sharply
U.S. dollar was weakening against most currencies


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Financial Crisis and Recession: 2007Present
The decline in U.S. house prices that began in early 2007 led to
widespread losses in financial institutions.
Central banks responded with quite expansionary (and also creative)
monetary policies, designed to maintain the smooth functioning of
credit markets.
The losses and failures of many financial institutions created severe
disruptions in the global credit markets.
The subsequent recession led to both monetary and fiscal
expansions in all of the G20 countries.
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By 2012, three years into a modest recovery, the Bank of Canada still
had a historically low target for the overnight interest rate.
The weakness of the U.S. and European economies at that time were
offsetting the stronger economic performance within Canada.



32 Copyright 2014 Pearson Canada Inc. Chapter 29, Slide
33 Copyright 2014 Pearson Canada Inc.

MyEconLa
b
www.myeconlab.com

With the success of many central banks in maintaining low and
stable inflation, some economists have raised the concern that
inflation may now be too low, and that the economy may actually
function more smoothly with slightly higher inflation. For more
details about this contentious debate, look for Can Inflation Be Too
Low? in the Additional Topics section of this book's MyEconLab.
Chapter 29, Slide