13.1: The Bank of Canada
What are the four basic functions of the Bank of Canada related to money and the financial system?
Issuing paper currency, setting tax rates, managing international trade agreements, and setting prices for all transportation
This monetary policy increases the money supply and lowers interest rates to stimulate the economy.
What is expansionary monetary policy?
What are the two main ways the Bank of Canada can implement monetary policy?
Adjusting the Policy Interest Rate (Overnight Rate) and Open Market Operations
What is the relationship between inflation and unemployment shown by the Phillips Curve?
The Phillips Curve illustrates an inverse relationship between inflation and unemployment in the short run. When inflation increases, unemployment tends to decrease, and vice versa.
What are the three different goals the Bank of Canada wishes to achieve when managing the money supply?
Minimizing inflation, maintaining real output close to potential output, regulating the value of the Canadian dollar on foreign and domestic markets.
If the spending multiplier is 1.67, calculate the total increase in aggregate demand when the Bank of Canada lowers interest rates, causing a $12 billion initial increase in investment and consumption.
20.04 Billion
Total Increase in Aggregate Demand = 12 billion × 1.67 = 20.04 billion
What are the two biggest benefits of monetary policy? Explain them.
Separation from Politics:
Central banks operate independently, allowing decisions to focus on economic stability rather than political agendas.
Speed of Implementation:
Monetary policy can be enacted quickly, unlike fiscal policy, which requires legislative approval and faces more delays.
What happens to the Phillips Curve during periods of stagflation?
During stagflation, the predictable inverse relationship between inflation and unemployment breaks down. Both inflation and unemployment can rise simultaneously
How does the Bank of Canada act as the “bankers’ bank” through its role with the Canadian Payments Association?
By holding the deposits of financial institutions that are members of the CPA as well as clearing payments and providing overnight loans or advances to maintain the funds in their accounts.
Explain why contractionary monetary policy, which decreases the money supply, leads to higher interest rates and how this impacts both businesses and households.
Higher interest rates discourage businesses from borrowing for investments and households from taking loans for durable goods, reducing aggregate demand.
The Bank of Canada buys back a $2,000 bond from Bondholder A, what monetary policy would this be? If the reserve ratio is 10%, how much will the money supply increase/decrease due to the money multiplier?
Expansionary Monetary Policy
Money Multiplier = 1/0.1 = 10
Increase = $2,000 x 10 = $20,000
How does the concept of core inflation help policymakers focus on underlying inflation trends, and why is it important to exclude volatile elements like food and energy prices when measuring inflation?
Core inflation excludes volatile elements like food and energy prices, providing a clearer view of long-term inflation trends. This helps policymakers avoid overreacting to short-term price fluctuations and allows central banks to make better decisions on interest rates and inflation targeting.
Describe the difference between a Canada Savings Bond and a Treasury Bill.
Treasury bills are short-term government bonds sold at a discount with interest based on the difference of purchase and face value, while CSB’s are long-term, interest paying bonds with a fixed rate.
When aggregate demand decreases during contractionary monetary policy, why does the reduction in equilibrium output not match the total decrease in aggregate demand?
Part of the decrease in aggregate demand is absorbed by falling price levels, which reduces the overall impact on real output.
Explain why monetary policy may be less effective during a severe recession, using the concept of excess reserves and lending behavior.
Banks may hold excess reserves instead of lending them out, due to concerns about borrowers' ability to repay.
Additionally, businesses and consumers may be unwilling or unable to take on new loans, limiting the impact of increased reserves on economic activity.
Explain how the economy self-stabilizes in the long run when output is below its potential level.
How did Canada’s approach to the 2008 financial crisis differ from other countries such as the U.S..
Upheld stability by maintaining strict regulations to protect the bank’s from collapsing and acting decisively to avoid prolonged activity.
The Bank of Canada raises interest rates during an economic boom. Explain how the higher nominal interest rate impacts both businesses and households, how this change influences aggregate demand, and why the total decrease in output is often smaller than the decrease in aggregate demand.
Higher nominal interest rates make borrowing more expensive, reducing investment and consumption. This causes aggregate demand to shift left, lowering total spending.
However, the decrease in output is smaller than the drop in demand because falling price levels absorb part of the impact on real GDP
If the Bank of Canada buys $20,000 worth of bonds and the reserve ratio is 8%, calculate the maximum potential increase in the money supply. Why might the maximum potential increase not be realistic?
Money Multiplier = 1/0.08 = 12.5
Increase in Money Supply = $20,000 x 12.5 = $250,000
During a recession, the Bank of Canada’s bond purchases may be less effective if banks hold excess reserves, as they may be reluctant to lend due to economic uncertainty or concerns about defaults. This limits the expected increase in the money supply and the policy’s ability to stimulate economic activity.
What distinguishes price-level targeting from inflation targeting, and how does it affect monetary policy?
Price-level targeting focuses on keeping the price level on a specific growth path, meaning if inflation exceeds the target in one year, the central bank must aim for lower inflation in subsequent years.
Inflation targeting allows the central bank to maintain inflation within a range without correcting for past deviations.