CHAPTER 13: Monetary Policy

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1 CHAPTER 13: Monetary Policy 1a. FIGURE 13A 1 An Expansionary Monetary Policy Nominal Interest Rate (%) Price level (GDP deflator, 2002= 100) Quantity of Money ($ billions) Real GDP (2002 $billions) An expansionary monetary policy causes the money supply to increase from S m0 to S m1 in the left-hand graph, reducing the nominal interest rate as equilibrium in the money market moves from point a to point b 0 in the graph. The decline in the interest rate pushes up aggregate demand from AD 0 to AD 1 in the right-hand graph, raising real output as equilibrium moves from point c to point d 0. However, a higher real output and price level mean another effect must be considered, given the resulting rise in the transactions demand for money. This causes an outward shift in the money demand curve from D m0 to D m1 in the left-hand graph, moving equilibrium in the money market from point b 0 to point b 1. With a higher nominal interest rate, aggregate demand is pushed down from AD 1 to AD 2 in the right-hand graph, reducing real output as the economy moves from point d 0 to d 1. The initial impact of this expansionary monetary policy on spending and output has therefore been partly counteracted because of the resulting change in the transactions demand for money. b. Monetary policy is not as effective as the analysis in Figure 13.1 suggests, since the initial effect on spending and output is counteracted by resulting trends in the money market and in the macroeconomy. 2a. If a one-year treasury bill has a purchase price of $ , its nominal rate of interest is 2.6 percent, which is found by dividing the difference between the face value and the purchase price ($1 million - $ = $25 Chapter

2 000) by the purchase price ($ ), then multiplying by 100. If the purchase price of a one-year treasury bill falls to $ , its nominal rate of interest rises to 4.2 percent, which is found by dividing the difference between the face value and the purchase price ($1 million - $ = $40 000) by the purchase price ($ ), then multiplying by 100. b. As in any market, a rise in a product s supply reduces its price, while a drop in supply leads to a price rise. Because the purchase price and nominal rate of interest of treasury bills vary inversely, their nominal rate of interest can be decreased if the Bank of Canada raises their price through less supply. Conversely, the nominal rate of interest on treasury bills can be raised if the Bank of Canada reduces their price through greater supply. c. In any market, a change in a product's demand affects its price in the same direction. The inverse relationship between the purchase price and nominal rate of interest of treasury bills means that their nominal rate of interest can be decreased through a rise in price caused by the Bank of Canada raising its own purchases. Conversely, the nominal rate of interest on treasury bills can be increased through a decline in price caused by the Bank of Canada reducing its own purchases. 3. When nominal interest rates are rising, the prices of ordinary bonds fall, while a decline in nominal interest rates raises the prices of ordinary bonds. Because the prices of Canada Savings Bonds stay constant regardless of changes in interest rates, it is most advantageous to hold Canada Savings Bonds when prices on ordinary bonds are falling due to a rise in nominal interest rates. 4. Bank of Canada's T-Account On the assets side, the Bank s holdings of government bonds rise by $1 million. On the liabilities side, Frontenac Bank s deposit at the Bank of Canada rises by $1 million. Frontenac Bank's T-Account On the assets side, the reserves at the Bank of Canada rise by $1 million. On the liabilities side, Bondholder X s deposit rises by $1 million. Changes in Reserves and the Money Supply Frontenac Bank s actual reserves have risen by, $1 million while its desired reserves have risen by $ (= 0.5 x $1 million in deposits). Therefore, the Bank s excess reserves have increased by $ [= ($1 million) - ($50 000)]. The final maximum effect on the money supply is an increase of $20 million. This is found by multiplying the initial change in excess reserves (-$50 000) by the money multiplier, which is the reciprocal of the reserve ratio expressed as a decimal [= (1/.05) = 20], giving $19 million, plus the initial $1 million increase in Bondholder X s deposit. 5a. A $100 million purchase of bonds by the Bank of Canada leads to an immediate $100 million increase in the money supply as sellers of these bonds deposit payments from the Bank of Canada in their accounts with CPA members. Given a reserve ratio of 5 percent, the actual reserves of CPA members have been raised by $100 million while their desired reserves have risen by $5 million (.05 x $100 million in new deposits). Therefore, CPA members' excess reserves have risen by $95 million. Through the process of multiple lending, there is an additional potential increase in the money supply of $1.9 billion ($95 million x (1/.05)). As a result, the maximum amount by which the money supply can increase is $2 billion ($100 million + $1.9 billion). b. A $50 million sale of bonds by the Bank of Canada leads to an immediate $50 million decrease in the money supply as the Bank of Canada receives payments Chapter

3 from buyers of these bonds and these funds are withdrawn from their accounts with CPA members. Given a reserve ratio of 7.5 percent, the actual reserves of CPA members have declined by $50 million while their desired reserves have fallen by $3.75 million (.075 x $50 million in lost deposits). Therefore, CPA members' excess reserves have declined by $46.25 million. Through the process multiple lending, there is an additional potential decrease in the money supply of $616.7 million (-$46.25 million x (1/.075)). As a result, the maximum amount by which the money supply can decrease is $666.7 million (-$50 million - $616.7 million). 6. This statement is true. For example, in the case of an expansionary monetary policy, the Bank of Canada can reduce the target overnight rate. However, the overnight rate will stay at this new level only if the money supply is increased through the Bank of Canada s open-market purchases of bonds. In the opposite case, the overnight rate will stay at its new target only if the supply of money is decreased with open-market sales of bonds. 7. In this case, any contractionary moves the Bank of Canada makes to deal with the boom in the Albertan provincial economy will exacerbate the downturn in spending being experienced in Ontario. 8a. - b. Between 2010 and 2011, inflation has fallen and unemployment has risen, which could have been caused by contractionary fiscal or monetary policies. Between 2011 and 2012, inflation has risen and unemployment has fallen, which may have been the result of expansionary fiscal or monetary policies. c. Between 2010 and 2011, there has been a reduction in the arbitrary redistribution of purchasing power created by inflation and an increase in the human costs of joblessness as well as an increased discrepancy between the economy s actual and potential output. d. Between 2011 and 2012, the benefits and costs are the reverse of those occurring between 2010 and e. Because both the inflation rate and the unemployment rate are higher than they were in the years between 2010 and 2012, the Phillips curve must have shifted to the right. This shift could have been caused by a decrease in the aggregate supply curve due to such factors as rising input prices or lower labour productivity. 9. With a vertical long-run aggregate supply curve, changes in aggregate demand (which cause movements along a given Phillips curve) lead to alterations in the price level but not in real output. In this case, the Phillips curve must also be vertical in the long run, since unemployment remains unaffected by variations in aggregate demand. 10. Evidence in favour of Murphy s Law of Economic Policy can be found in the disagreements that have existed among economists over the reasons for shifts in the Phillips curve. Economists have a great deal of influence concerning this issue, and it is one over which there has been significant controversy within the economics profession. Evidence against Murphy s Law of Economic Policy can be found in the agreement that has arisen among most economists that wage and price controls are not the best way to fight inflation. As with shifts in the Phillips curve, economists have a great deal of influence concerning this issue, and it is one over which there is relatively little controversy within the economics profession. Chapter

4 Internet Application Questions a. Answers are found in link to 'Publications'. b. Answers are found in same link as in part a. 3a. Answer found in links to 'Economy', 'Business Enterprises', 'Data', 'Business Finance', and '941' (Bank of Canada Money Market and Other Interest Rates (Daily)). Click on 'Daily B Bank Rate'. Then click on 'Go' and 'Go'. Under 'Output Format' click on '2D Line Graph'. Then press 'Go'. You can print out the resulting graph. b. Periods when the bank rate has been rising are those in which the Bank has been following a contractionary policy, and vice versa. 4. Answer found in links to 'Monetary Policy', 'Inflation', and 'Core Inflation'. At present, the eight volatile elements that are excluded are: fruit, vegetables, gasoline, fuel oil, natural gas, mortgage interest, intercity transportation, and tobacco products as well as the effect of changes in indirect taxes on the remaining components. ANSWERS TO QUESTIONS AT THE END OF 'MONEY MATTERS' 1a. Using information in the question, we can calculate the original price level: $100 billion x 10 = P x $800 billion P = ($1 trillion/$800 billion) = 1.25 If V and Q stay constant, then the new price level is: $112 billion x 10 = P x $800 billion P = ($1.12 trillion/$800 billion) = 1.4 The rate of inflation is therefore 12% [=(( )/1.25) x 100%]. b. If V rises to 12 and Q stays constant, then the new price level is: $112 billion x 12 = P x $800 billion P = ($1.344 trillion/$800 billion) = 1.68 The rate of inflation is therefore 35% [=(( )/1.25) x 100%]. c. If V stays constant at 10 and Q rises by 3% to $824 billion, then the new price level is: $112 billion x 10 = P x $824 billion P = ($1.12 trillion/$824 billion) = 1.36 The rate of inflation is therefore 9% [=(( )/1.25) x 100%]. Chapter

5 2. If the pace of technological change increases, then so does the long-term real growth rate in the economy. Unless the monetary rule is changed to take account of this higher real growth rate, there will be downward pressure on prices, since real output will be growing more quickly than the money supply. 3. Based on the monetarist interpretation of the equation of exchange, the real money supply (M/P) should stay relatively constant. This can be seen by rearranging the equation as follows - (M/P) = (Q*/V*). When both V* and Q* are presumed to be stable, then each side of the equation stays constant. ANSWERS TO QUESTIONS AT THE END OF 'A CRISIS TOO FAR' (at the Online Learning Centre) 1. The financial investors who held credit default swaps on risky CDOs as a speculative investment made huge gains when the debt obligations on which their swaps were based went into default. For a relatively minor annual premium which they paid for their swap, they received in return the full value of the CDOs value, representing an extremely high rate of return on their financial investment. 2. The main economic purpose of financial institutions is to turn the funds of savers into productive investment, making a steady, relatively predictable profit in doing so. Yet in the decade previous to the 2008 meltdown, many global financial institutions seemed most concerned with the returns they were making from speculative financial investments. As Keynes s observation suggests, this casino-like behaviour ended up compromising the long term capital development of those countries most affected by the meltdown and its aftermath. ANSWERS TO QUESTIONS AT THE END OF 'MONEY MAKERS' (at Online Learning Centre) 1. During a period of fixed exchange rates, a country such as Canada will necessarily import any inflation that exists in the country of the currency against which we fix our exchange rate. For example, during the 1960s, when Canada had a fixed exchange rate, as the prices of American products imported into Canada automatically rose. 2. In other words, Crow subscribed to Milton Friedman's view that economies stabilize themselves in the long run. According to this perspective, any discrepancy between a country's real output and its potential level should cause shifts in aggregate supply that gradually eliminate the gap. Therefore, there is no tradeoff between unemployment and inflation in the long run. Instead, monetary authorities should conduct policy based on the assumption that the Phillips curve is vertical in the long run.. Chapter

CHAPTER 11: Fiscal Policy

CHAPTER 11: Fiscal Policy 1a. Unemployment is below its natural rate and inflation is an increasing problem, so that real output must be above its potential level, and the economy faces an inflationary