Chapter 13 Monetary Policy.notebook. February 03, Chapter 13: Monetary Policy Pages

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1 Chapter 13: Monetary Policy Pages Stabilization Policies policies that influence the amount spent and produced in an economy which attempt to keep the economy as close as possible to potential output. Two categories: 1) expansionary policies used to eliminate a recessionary gap by reducing unemployment and stimulating total output. Two sets of instruments available to the government that affects spending and output: 1) Monetary Policy a policy which uses interest rates and the money supply to stabilize the economy. 2) Fiscal Policy a policy which uses government spending and taxation to stabilize the economy. 2) contractionary policies used to eliminate an inflationary gap by reducing inflation and suppressing total output. The Bank of Canada: Canada's central bank since Oversees monetary policy. Performs four basic functions: 1. Manages the money supply. 2. The bankers' bank. 3. Federal government's fiscal agent 4. Ensures the stable operation of financial markets (borrowing and loaning of funds) #1 Managing the Money Supply: Most important role by controlling the amount of money circulating in the economy. Controls the amount of paper currency in circulation and varies supply of money and interest rates at chartered banks and near banks. Three main goals: 1. Minimize inflation. 2. Maintain real output as close to potential as possible. 3. Regulating value of Canadian dollar in foreign markets. 1

2 #2 The Bankers' Bank: B of C holds deposits for financial institutions that are members of the Canadian Payments Association (CPA). CPA acts as a clearing house each day for all transactions of its members. Members of the CPA can borrow funds (receives and "advance") from the B of C when its account at the B of C gets low. The interest rate charged on these advances is called the bank rate. The interest rate on these advances is usually higher than other loans so the number of advances are minimized. #3 Fiscal Agent of Federal Government: Three main tasks: 1. B of C holds some of its deposits and decides where other deposits should be held. 2. Clears federal government cheques. 3. Finances the federal government's debts by issuing bonds. Two main types of bonds: Canada Savings Bonds (CSB) guarantee a minimum rate of interest, unlike ordinary bonds whose interest rate fluctuates with the economy's interest rate. Treasury bills no interest payment is given. Instead, they are sold at a marked down price so that,when sold, the buyer makes money by receiving the face value of the treasury bill. Price for treasury bills are determined at an auction held every second Tuesday by the B of C. The main buyers are chartered banks, large near banks, and investment dealers. #4 Ensuring the Stability of Financial Markets: Oversees the activities of the chartered banks which helps protect the safety of depositors' funds and confidence in the financial markets. This task was duly noted during the credit meltdown in 2008 when several major financial institutions in the US and Europe, not Canada, were threatened with collapse. As a result of this meltdown, even heaver regulations are being enforced a s outlined by the international banking rules. 2

3 Monetary Policy: Page 356 expansionary monetary policy ("easy money policy") action by the B of C, when a recessionay gap results from a fall in real output, to stimulate output and increase employment. achieved by expanding the money supply. The result is a lower interest rate which results in businesses increasing their investment spending and households increasing their purchases. contractionary monetary policy ("tight money policy") action by the B of C, when an inflationary gap results from a peak in real output, to suppress output and decrease inflation. achieved by decreasing the money supply. 3

4 Page 357 The result is a higher interest rate which results in businesses decreasing their investment spending and households decreasing their purchases. Tools of Monetary Policy: Open Market Operations the buying and selling of bonds by the B of C in the open market. To decrease the money supply, B of C sells bonds. To increase the money supply, B of C purchases bonds. Target Overnight Rate the interest rate on overnight loans between chartered banks and other financial institutions. The buying of bond by the B of C, increases the accounts of members of the CPA, reducing the need to borrow funds, which reduces the overnight rate, and vice versa This activity indicates where monetary policy is heading. prime rate lowest possible rate charged by deposit takers on loans. deposit takers may change their prime rate if the change in the overnight rate is significant. digest/ 4

5 Monetary Policy Advantages Disadvantages Separation from politics Weak expansionary tool Speed of application Affects every region the same Low interest rates may encourage risky lending practices 5