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Chapter 12

Bank of Canada and Monetary Policy. Chapter 12. Bank of Canada. http://bankofcanada.ca/en/video_corp/videos.html. Monetary Policy. A process by which the government affects the economy by influencing the expansion of money and credit. Central Banks.

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Chapter 12

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  1. Bank of Canada and Monetary Policy Chapter 12

  2. Bank of Canada • http://bankofcanada.ca/en/video_corp/videos.html

  3. Monetary Policy • A process by which the government affects the economy by influencing the expansion of money and credit

  4. Central Banks • A public authority charged with regulating and controlling a country’s monetary and financial institutions and markets • Two Models: • Independence: complete autonomy to determine nation’s monetary policy • Subservience: in the event of a difference of opinion, the Government has the final say

  5. The Bank of CanadaCanada’s “Biggie” Bank • Canada’s central bank, in operation since 1935 • During great depression • Aimed to add stability to system and prevent a run on chartered banks

  6. The Bank of CanadaCanada’s “Biggie” Bank • Originally the bank was expected to: • Regulate credit and currency • Control external value of the Canadian Currency • Reduce fluctuations in production, trade, prices and inflation

  7. Structure of the BofC Please let the economy recover • The Governor (Mark Carney – 7 year term) • Board of Directors (meet once a month) • Senior Staff (economists and central bankers with considerable national and international experience)

  8. Key roles of BofC • To control the amount of money circulating in the economy • Deciding and implementing monetary policy • Issuing paper currency • affecting the activities of chartered banks to adjust the interest rate and the supply of money

  9. Inflation • Inflation Premium • Interest rates take into account inflation • Therefore interest rates have an inflation premium built in

  10. Interest rates • Two components • Nominal Rate of interest • Premium for risk of non repayment • Premium for delayed consumptions • Inflation Premium • Expected rate of inflation • Real Rate of interest • Nominal – Inflation Premium

  11. Inflation and interest rates • A dollar tomorrow is worth less than dollar today • Ex you borrow $1000 (interest free) • Inflation is 4% per annum • You repay $1000 in a year • In terms of purchasing power you have paid back $960 = ($1000 – ($1000 x 4%) • Inflation hurts lenders (why?)

  12. Interest rates • Inflation premium is key component of any interest rate • An interest rate should be at least be equal to the rate of inflation to protect the purchasing power of the money

  13. Interest rates • How do interest rates affect purchases? • What type of purchases should you finance with debt? • What effect do interest rates have on the dollar? • How do interest rates effect government spending?

  14. Interest rates How do they affect demand? • When rates rise major purchases become more expensive • When rates rise investments become less attractive • Rate of Return = 7% Interest Rate = 3% • Rate of Return = 7% Interest Rate = 7% • When rates rise governments (tax payers) pay more for borrowed money

  15. Interest rates How do they affect supply for money? • When rates increase savings rates increases • increases amount available for banks to loan • Decreases amount in circulation (spend less) • When rates increase banks want to lend more

  16. Types of interest rate • Prime rate: Rate offered by commercial banks to their best customers (?) • Prime plus “x” • Bank rate: Rate charged by bank of Canada to chartered banks • Overnight Rate: The main tool used by the BofC. Key way of indicating monetary policy

  17. Overnight Rate • Overnight rate • Tool of monetary policy • The rate that large financial institutions borrow money from each other • Operating band – difference between Bank of Canada’s loan rate (bank rate) 4% and their interest rate 3.5% Therefore the overnight rate is somewhere between 3.5% and 4% • Overnight rate is less than the bank rate so it encourages banks to lend to one another rather than from the BOC. • What happens if the Bank of Canada increases the bank rate?

  18. Decrease in Overnight Rate • Dollar goes down and Interest Rates Drop • Increase in demand • Increase prices • Rate of inflation increased STIMULATES THE ECONOMY

  19. Increase in Overnight Rate • Dollar goes up and Interest Rates go up • Decrease in demand • Decrease prices • Rate of inflation decrease SLOWS THE ECONOMY

  20. Monetary Policy • Easy Money: Increase the money supply (expansionary) • Tight Money: Restricts the money supply (contractionary)

  21. Tight Money • Used when economic times are good • Sales are up • Employment is up • Investment is up • Commercial banks are willing to lend money • Too much money in the economy will cause inflation • Limiting the money supply will slow the economy down

  22. Easy Money • Used when economic times are bad • Sales are down • Employment is down • Investment is down • Commercial banks are scared to lend money • Too little money in the economy will cause deflation • Increasing the money supply will jump start the economy

  23. When to apply monetary policy Tight Money Easy Money

  24. Bank Rates vs GDP

  25. Classwork • Read P 264-268 question 1-6

  26. Easy Money Policy • 4 stages • Stage 1: • Bank shifts money to the chartered banks to increase reserves and encourage lending • Stage 2: • Lower interest rates to encourage more borrowing for large purchases (homes, car, education, business, etc.). Business then responds by investing and borrowing more.

  27. Easy Money Policy • Stage 3: • Increased borrowing = increased money supply resulting in increased output (GDP) • Stage 4: • This increases aggregate demand and GDP leading to full employment

  28. Tight Money Policy • 4 stages • Stage 1: • Banks takes it’s deposits from chartered banks back to the BOC • This means less money for banks to lend • This leads to decreased money supply resulting in increased interest rates • Stage 2: • Higher interest rates =less borrowing • Business responds by cutting back (stock, equipment, expansion)

  29. Stage 3: • Less borrowing = less money supply • Stage 4: • Decreased spending by consumers and businesses shifts AD to the left • This results in decreased prices (deflation)

  30. Hardship Caused by Inflation • Pressure • Sadness Not enough • Fear • Divorce • Marriages of convenience • Bankruptcy • Lay offs • Welfare • Raise Taxes • Resentful • Affected everyone

  31. Mark Carney and the 3 bears I want the Economy … Not too Hot (Inflation) Not too cold (Unemployment) Just Right! (Full Employment) I hate Bear markets!

  32. Aggregate Demand and Aggregate Supply Graph • AD AS curve shows the Total amount of supply and demand for economy AS AD Price level Real GDP (Output)

  33. Aggregate Demand and Aggregate Supply Graph • The AS curve goes vertical because there is a limit (CP) to production AS AD Price level Real GDP (Output)

  34. Aggregate Demand and Aggregate Supply Graph • FE: Full employment. In Canada approx 6-7% unemployment. 1-3% Inflation. AS AD Price level Real GDP (Output) FE

  35. Aggregate Demand and Aggregate Supply Graph • If AD < FE then there is a recession. Low inflation/deflation. High Unemployment AS AD Price level Real GDP (Output) FE

  36. Aggregate Demand and Aggregate Supply Graph • If AD > FE then there is a boom. High inflation. Low unemployment AD AS Price level Real GDP (Output) FE

  37. Monetary Policy (Easy Money) P277 • Bank shifts government deposits to chartered banks. Increasing their reserves. Banks able to lend more. • Lower interest rates. Encourages borrowing. • Consumers spend on big ticket items goods • Businesses spend on capital goods (equipment) • Borrowing and spending by increases money supply. Which triggers more borrowing and spending

  38. Monetary Policy (Easy Money) • Increased spending shifts AD1 to AD2 thus reaching FE AS AD2 AD1 Price level Real GDP (Output) FE

  39. Monetary Policy (Tight Money) P277 • Bank shifts government deposits from chartered banks. Decreasing their reserves. Banks lend less. • Increase interest rates. Discourage borrowing. • Consumers delay on big ticket items goods • Businesses delay on capital goods (equipment) • Less borrowing and spending decreases money supply. Which triggers less borrowing and spending

  40. Monetary Policy (Easy Money) • Decrease spending shifts AD1 to AD2 thus ending high inflation AD1 AS AD2 Price level Real GDP (Output) FE

  41. Homework • P268 1-6 • P273 4 and 5 • P276 1, 2 3 • P279 2

  42. P268 question 1-6 • The bank of Canada insists on the right to issue currency in order to meet its function of controlling inflation • Accounts at the Bank of Canada • Chartered Banks: Settle debts among themselves. Location for short term loans • Federal Government: • Allows monetary policy • Deposit the proceeds of bond payments • Paying interest on bonds • Holding foreign reserves

  43. P268 question 1-6 • The BofC provides confidence to the financial system. In the case of a run on the bank the central bank could “bail out” a bank • Spending and Creating money are kept separate in order to resist the temptation to print money to pay for spending

  44. P268 question 1-6 • The Minister of finance is accountable to the voters and the PMO. The Governor of the BofC is accountable to the Minister • A directive would show a lack of confidence in the BofC.

  45. Beware of the Ninja!

  46. Beware of the Ninja! No INcome No JAb Loan

  47. P273 4 • Real = Nominal - Expected • A) Nominal interest rate: 7% • B) Real interest rate : 4% • C) Real interest rate: 3%

  48. P273 5 • Because they want to ensure that the funds when paid back have at least the same purchasing power as when they were loaned

  49. P276 1, 2 3 • The main tool to control inflation is interest rates. Price stability is key to healthy long term growth • Operating Band: Difference between the bank rate (what banks pay BofC) and the rate that BofC pays on deposits. Overnight rate sits in the middle • Bonds = assets / Deposits of the Chartered Bank = Liabilities

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