# Monetary Policy Bank of Canada

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2 The Canadian Conduct of : Short Term Interest Rate Targeting Choice of Policy Instrument 1. Quantity of Money: The Monetary Base, recalling what is defined as the Monetary Base. 2. Short Term Interest rate: Which determines the opportunity cost of holding money. The instrument of choice for Canada, and the USA. 3. Exchange Rate: Which determines the price of money on the foreign exchange market. This last item will be covered later. The instrument of choice for economies that rely heavily on international trade, such as Singapore. As you will recall the central bank cannot choose all three or a combination of two policy instruments. The reason being the choice of one determines the other two. Consider the demand for money market, once the quantity of money supply is set, the interest rate is then determined as a consequence. Controlling Short Term Interest Rate Since the instrument of choice for Canada is through controlling short term interest rate, we will focus our discussion on this in more detail, and examine the other instruments subsequently. The specific interest rate that the Bank of Canada controls is the Overnight Loans rate, i.e. the interest rate at which banks lend each other their excess reserves. Since 2000, the Bank of Canada has 8 preset dates on which it announces the overnight interest rate (This rate is sometimes referred to as the interbank rate). The degree of movement in this interest rate is in the magnitude of a quarter of a percentage point, for example, 1 percent is So a quarter of one percentage point is , or 25 basis points, where 1 basis point is , or 1/1000. The Decision Process within the Central Bank 1. Instrument Rule: It is a decision rule for monetary policy that sets the policy instrument at a level that is based on the current state of the economy. The most common is the Taylor rule. Let the overnight rate be R, and the neutral real overnight rate be R* (Typically thought of as 2%), the inflation rate be π and the target inflation rate be π*, and the difference between the GDP and the potential level of output, G. Then the Taylor rule says that the overnight rate should be set * * at R = R + π + 0.5( π π ) G. That is this rule sets the overnight rate dependent on deviation of inflation from the target and the size and difference between the GDP from the potential output level. The principal reason this rule is 2

7 which hence makes this method in turn unreliable. 7

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