Order Monetary Policy in Canada Discussion

Order Monetary Policy in Canada Discussion
Order 58093777
Order Monetary Policy in Canada Discussion
Question 2
a) rate of inflation; 1; 3
b) output gap
c) the money supply; the interest rate; bank rate; open-market operations (or shifting of
government deposits)
d) deposit creation takes time; changes in expenditure tax time; the multiplier process
takes time
e) 9–12 months; 18–24 months
f) destabilizing
Question 4
Commercial Banks Bank of Canada
Assets Liabilities Assets Liabilities
Reserves
$100 000
Deposits
$100 000
Bonds
No change
Currency: no change
Commercial bank deposits: $100 000
Government deposits: – $100 000
Order Monetary Policy in Canada Discussion
a) The commercial banks receive an electronic transfer of cash of $100 000 into their
reserves. This is an asset. But they also now have higher deposit liabilities of $100 000
since government deposits at the commercial banks have increased.
b) There is no change in the bonds for the Bank of Canada. It is only a change in the types
of liabilities for the Bank. Government deposits at the Bank fall by $100 000 and
commercial bank deposits at the Bank (reserves) rise by $100 000.
c) The key is to understand that the government deposits at the Bank of Canada cannot be
“expanded” into more money supply. But those same deposits, once transferred to the
commercial banks, can be expanded. So this switching of government deposits is like a
new deposit into the commercial banks and will lead to a multiple expansion of the money
supply.
Question 6
The interest rate is determined by the demand for and the supply of money. For a given MD
curve, it follows that the equilibrium interest rate must lie along the MD curve. If the Bank
wants to set a target for the money supply, it must accept the resulting interest rate.
Conversely, if the Bank wants to set a target for the interest rate, it must provide the money
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supply necessary to make that target interest rate the equilibrium. But two independent
targets — like points A or B in the figure — are not feasible.
b) The increase in money demand leads to a rightward shift in the MD curve, to MD
1
in the
figure above. At the initial interest rate, there is now an excess demand for money. Firms
and households try to sell bonds to satisfy their demand for cash, and this reduces bond
prices and increases the interest rate. Interest rates rise to i1, at which point firms and
households are only prepared to hold the available (unchanged) amount of money. The rise
in interest rates leads to a reduction in desired investment spending.
c) See the box on “contractionary” monetary policy in this chapter. Even though the money
supply has not fallen, it has fallen relative to the demand for money. And the effect of this
change is to raise interest rates and reduce desired investment (and thus, through the
multiplier, to reduce real GDP). Thus we think of monetary policy as being contractionary
if supply falls relative to demand. In the face of this MD shift, a neutral monetary policy
would require an increase in money supply so as to keep the interest rate unchanged.
Question 8
a) The rising stock market implies an increase in wealth, at least as measured on paper. If
we assume that some of this increased wealth gets consumed, then the rising stock market
fuels an increase in aggregate demand, and may contribute to an inflationary gap. This is
shown by a rightward shift in the AD curve, possibly raising GDP above Y*.
b) In this case, a tightening of monetary policy may be appropriate as a means of keeping
output near potential. A tightening of monetary policy will, in general, slow the rise in the
stock market, and may cause an outright fall in stock-market values. This is because, first, a
rise in interest rates reduces the PV of any given flow of earnings and, second, the
monetary tightening reduces the future steam of firms’ profits. Thus a monetary tightening
© 2005 Pearson Education Canada Inc.
will reduce values in the stock market and reduce wealth, thus leading to less desired
consumption expenditure.
One problem with monetary tightening in this situation is that it is difficult to
determine precisely how much to tighten. It is relatively easy to measure the increase in
wealth associated with an increase in stock-market values. But it is difficult to know by
how much aggregate expenditure is increasing as a result.
c) A sudden crash in the stock market reduces the amount of wealth and thus reduces
desired aggregate expenditure. This is a leftward shift in the AD curve. It may also lead
firms to reduce their desired investment if they are unable to finance their projects by the
issuance of new shares.
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