WHY MONETARY POLICY MATTERS

READING

- Monetary Policy- maintaining confidence in the value of money by providing stability in the general level of
prices
o BOC adjusts very short-term interest rates to achieve a growth rate of real output consistent w/
maintaining a low and stable rate of inflation
- 2 reasons central banks focus on the control of inflation:
o #1 monetary policy cannot have a systematic and sustained effect on macroeconomic variables
other than the inflation rate
o #2 high inflation is damaging to the economy due to the uncertainty it generates
- 2 reasons relative stability in output growth is desirable:
o #1 relatively smooth output growth makes it more likely that actual output will remain close to
potential output (the economy’s production capacity)
 As a result, firms and workers avoid situations in which they are pushed to work beyond
their limits (excess demand) and situations in which they are idle for considerable periods
of time (excess supply)
o #2 by avoiding situations of excess demand or excess supply, the pressures for inflation to either
rise or fall are kept to a minimum
- 4 transmission channels of monetary policy:
o #1 Commercial Interest Rates
 Decline in commercial interest rates reduces both the cost of borrowing and the money
paid on interest-bearing deposits, which tends to encourage borrowing, spending, and
investing, and to discourage saving resulting in overall boost in demand for goods
o #2 Asset Prices
 Increase in interest rates can damper the prices of assets, thus decreasing household
wealth, which in turn may discourage borrowing and spending
o #3 Exchange Rate
 Rise in interest rates relative to rates in other countries makes Canadian dollar-
dominated assets more attractive to investors which can raise demand for the dollar
making many imported goods cheaper and making Canadian products more costly, thus
reducing demand for them
o #4 Expectations
 If inflation were expected to rise in the future, longer-term interest rates would typically
rise to reflect this expectation

WHAT’S THE DIFFERENC E BETWEEN THE BOC AN D THE DEPARTMENT OF FINANCE?

- Bank of Canada
o Role: to promote the economic and financial welfare of Canada
- Department of Finance
o Role: provide the Government of Canada with analysis and advice on broad economic and
financial affairs of Canada
WHAT IS THE CURRENT MONETARY POLICY IN C ANADA? WHY HAS THE B OC TAKEN THIS
STANCE?

- BOC takes the view that it can make the best contribution to the health of the Canadian economy by
maintaining low and relatively stable inflation
o Adopted a system of inflation targeting with a target of 2% and within a range of 1% to 3%
- BOC believes that in such an environment of low and stable inflation, Canadian firms and households can
make better spending, saving, and investment decisions that lead to steadily rising living standards
- Only policy instrument is the target it sets for the overnight interest rate
o By changing its target for the overnight interest rate, the BOC can alter the actual overnight rate at
which banks transact
o By changing the overnight interest rate, the BOC’s actions influence the entire spectrum of market
interest rates
 As these interest rates rise, firms and households reduce their demand for credit
 As these interest rates fall, firms and household increase their demand for credit
 w/ an increase in the amount of credit, there is an increase in the volume of
transactions for goods and services, and thus an increase in the overall demand
for money

IF THE BOC ADOPTS AN EXPANSIONARY/CONTRA CTIONARY POL ICY, HOW DOES IT

IMPACT THE PROSPECTS FOR FIRM BORROWING, CAPITAL INVESTMENT, AND SALES?

- 1. The increase in the target overnight interest rate tends to increase longer-term interest rates and, as a
result of the subsequent inflow of financial capital to Canada, tends to cause an appreciation of the dollar
- 2. The increase in longer-term interest rates dampens the growth of households’ consumption and firms’
investment; the appreciation of the dollar dampens the growth of Canadian net exports
- 3. Taken together, these effects on consumption, investment, and net exports imply a dampening in the
growth of Canadian aggregate demand
- 4. The reduction in the growth of aggregate demand leads firms to reduce the growth in their actual output
- 5. By keeping actual output from rising above potential output, the pressures for inflationary wage-and-
price increases are avoided