Controlling the Money Supply: Bond Purchases in the Open Market

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1 Money Supply By the Bank of Canada and Inteest Rate Detemination Open Opeations and Monetay Tansmission Mechanism The Cental Bank conducts monetay policy Bank of Canada is Canada's cental bank supevises financial institutions, conducts monetay policy Monetay policy attempts to contol inflation and business cycle by changing money supply, exchange ate, inteest ates 2...but does the govenment o the Bank pevail? Two models fo elationship between cental bank and govenment Independent cental bank detemines monetay policy with no govenment intefeence Subodinate cental bank must follow govenment diections, but can still have significant powe The Bank of Canada s Balance Sheet Bank of Canada balance sheet shows Liabilities = bank of canada notes + deposits (eseves) of chateed banks + govenment deposits Assets = govenment secuities + loans to banks Monetay base = bank of canada notes + bank eseves + coins in ciculation Bank of Canada is a subodinate cental bank 3 The Bank of Canada gazes indicatos Monetay policy conduct is difficult because consequences of cuent policy actions ae felt with a delay in futue need to pedict economy's futue Monetay policy indicatos cuent economic featues that help pedict futue Ovenight loans ate inteest ate on loans banks make to each othe 5 Monetay instuments used by the Bank of Canada Monetay policy tools Bank of Canada attempts to bank eseves ovenight ate quantity of money, etc., though equied eseve atio minimum eseves banks must hold (cuently = ) bank ate loan ate to chateed banks bank ate = uppe end Bank s taget ange fo ovenight loans ate banke s deposit ate = lowe end Bank s taget ange fo ovenight loans ate

2 The Bank of Canada s Influence on Excess Reseves The B of C contols/influences the eseves of the banking system. How? Open maket opeations buying/selling new o existing Govenment of Canada secuities/bonds monetay base and movement ovenight loans ate within taget ange Govenment deposit shifting tansfeing govenment funds between Bank of Canada and chateed bank deposits Contolling the Money Supply: Bond Puchases in the Open Maket The B of C buys back a $1 T-bill fom you When you get a $1 cheque witten on the B of C, you go to you bank You bank deposits (and the bank s liability) incease by $1 The bank sends the cheque to the B of C fo collection The B of C cedits you bank the $1 The B of C s inceased liabilities ae matched by its inceased assets of the Govenment of Canada bonds 7 8 Changes in Balance Sheets Changes in You Balance Sheet Assets Liabilities Bonds -$1 No change Deposits +$1 Changes in the Bank s Balance Sheet The Bank of Canada s Balance Sheet Changes in the B of C Balance Sheet Assets Liabilities Bonds +$1 Deposits (of commecial banks) +$1 Assets Liabilities Reseves Deposits +$1 (at the BofC) +$1 9 1 Switching Govenment Deposits to Change Money Supply A tansfe of govenment deposits at the B of C to govenment s account at a commecial bank povides the commecial bank excess cash eseves The bank will loan out the excess eseves and the money supply expands though the money multiplie channel Switching govenment deposits to the chateed banks is simila to the puchases of bonds on the open maket 11 Fom Monetay-Base Changes to Money Supply Changes: The Money Multiplie Money multiplie amount monetay base (MB) is multiplied by to get esulting in quantity of money = M / MB money multiplie is lage if cuency dain ( cuency held by public) is smalle desied eseve atio is smalle 12

3 Multiplie Effect of an Open Maket Opeation The sequence Open maket opeation $1, Loan $1, Cuency Deposit $33,333 Reseve Loan $,7 $, Cuency Deposit $, Reseve Loan $, $3, The unning tally Reseves Deposits Cuency Money $,7 $,7 $33,333 $1, $2, $,7 $1,7 $53,333 $1, Cuency $12, Deposit $2, $1,7 $13,7 $5,333 $19, and so on... $1,7 $1,7 $83,333 $25, Open Maket Opeations Influencing Bond Pices and Inteest Rates Changes in eal money supply (MS) inteest ates () and pice bonds MS excess money holdings people buy bonds pice bonds MS shotage of money people sell bonds pice bonds 13 1 Contolling the Money Supply: A Summay Inteest Rate Changes Open maket opeations ae majo policy tool of Bank of Canada Same essential outcome if open maket opeations with banks o with public Bank of Canada buying govenment bonds money supply Bank of Canada selling govenment bonds money supply MS MS 1 Incease MS MD 5 Real money 15 1 Investment and Inteest Rates Business investment ule invest if expected pofit ate > eal inteest ate Expected pofit ate investment Expected pofit ate in expansion, in ecession Advances in technology eventual expected pofit ate Oppotunity cost of capital funds to finance investment = eal inteest ate Investment demand cuve (ID) elationship between level of investment and eal inteest ate Downwad sloping Expected pofit ate ightwad shift ID Fluctuations in expected pofit ate main souce of Investment Demand: The Effect of a Change in the Real Inteest Rate fluctuations in ID Real 8 c b inceases I deceases I a ID Investment

4 Investment Demand: The Effect of a Change in the Expected Pofit Rate Real 1 2 expected pofit ate ID expected pofit ate ID ID 2 ID ID Investment 19 Wold Real Inteest Rate In Equilibium Real 8 Shotage savings Suplus savings SS Equilibium 8 Wold saving, investment ID 2 Real Inteest Rate in Long-Run Equilibium in the Global Economy Real inteest ate detemined by equilibium in the wold capital maket Whee wold ID = wold SS Inteest ate adjusts to achieve equilibium Because capital vey mobile, quick elimination inteest ate diffeentials Money, Inteest and Aggegate Demand Poduct maket equilibium whee AE = Y AE is function of C, I, G, NX I is function of along investment demand cuve I ( C, NX) AE Y Y depends on Unique and Y give simultaneous equilibium in money maket and poduct maket Equilibium Inteest Rate and Real GDP Fist Round Effects of an Incease in the Money Supply MS MS MS 1 2 Real GDP = $ b (a) Money and the inteest ate MD 5 Real money 2 ID 1 Investment (b) Investment and the inteest ate 1 MS... MD 5 5 Real money (a) Changes in money supply 1 and I ID 1 25 Investment (b) Changes in investment 23 2

5 Equilibium Inteest Rate and Real GDP: Expenditue and Real GDP AE AE 9 AE when = % Equilibium expenditue 3 1 5º line I when = % Real GDP I 25 Monetay Tansmission Mechanism: Open Maket Opeations to and Inteest Rates An expansionay monetay policy: The puchase of govenment bonds in open maket opeations by the B of C ceates excess demand fo bonds and bond pices incease The cash fom selling bonds people deposit in thei bank accounts Banks gain excess eseves and would stat making loans New loans tanslate in still highe deposits and the money supply expands by the money multiplie 2 The Monetay Adjustment: Excess Reseves to Aggegate Demand Shifts The excess supply of money causes inteest ates to decline and bond pices to incease Lowe inteest ate make financing new investment in physical capital cheape The highe investment expenditue by fims means that the AE expenditue schedule shifts vetically up At the initial pice level, the highe demand fo output is eflected by a ightwad shift of AD cuve 27 Fist Round Effects of an Incease in the Money Supply: Change in Expenditue AE 12 AE 1 Equilibium expenditue, AE eal GDP stats º line 9 I AE I 1 I 12 Real GDP 28 Money supply and the negative slope of the aggegate demand cuve AD cuve is negatively sloped because: A high pice level goes hand in hand with a lage demand fo money and a high inteest ate A high inteest ate educes investment and tanslates into low levels of desied aggegate expenditues A high pice is associated with lowe aggegate demand, actual output and national income Thus, a lage ise in the pice level will be needed to eliminate an inflationay gap Howeve, this mechanism can be fustated if the Bank of Canada validates highe pices by inceasing the money supply 29 Monetay Policy and Aggegate Demand Expansionay monetay policy to AD money supply ( MS) Expansionay monetay policy has 1st ound effects MS I AE Y 2nd ound effects Y ightwad shift MD I AE smalle Y, patial offset 1st ound Y 3

6 Monetay Policy Stimulates In The Shot-Run Output and Employment P Policy effect 9 SAS AD 1 Pice level effect AD 95 1 Real GDP 31 The Tansmission Mechanism Links Money Supply to National Income Fo a given shot-un aggegate supply cuve, the excess demand fo output causes the pice level to incease At highe pices, additional output sold would incease pofits of copoations In the new shot-un equilibium, employment and GDP would expand A decease in the supply of money shifts the aggegate demand cuve to the left An incease in the supply of money tends to shift the aggegate demand cuve to the ight 32 P Monetay Policy to Lowe Unemployment LAS A Summay of the Monetay Tansmission Mechanism An expansionay monetay policy lowes the eal inteest ate and stimulates desied investment SAS The highe investment spending expands the desied aggegate expenditue demand and aises the level of national income 85 9 AD 95 AD 1 Real GDP The highe desied expenditue means that the aggegate demand cuve shifts out and to the ight 33 3 Open Maket Opeations Influencing Inteest Rates and the Exchange Rate Expansionay monetay policy also has exchange ate effect Changes in eal money supply (MS) exchange ate (pice of C $ in anothe cuency) MS demand Canadian dolla exchange ate net expots ( NX) Y MS demand fo C $ exchange ate US / C$ Equilibium Exchange Rate 8 7 Shotage at 2 Suplus at 8 3 S Equilibium at 7 D Q (C$) 35 3 Textbook p. 9

7 The Exchange Rate Speculations Expectations of changing exchange ates due to foces of Puchasing powe paity two cuencies have same value o puchasing powe Inteest ate paity two cuencies ean same inteest ate, adjusted fo expected depeciation Inteest ate paity almost always holds (adjusted fo isk), but if etuns highe in Canada quick demand Canadian $ quick exchange ate 37 Foeign Exchange Maket Intevention US / C$ S Taget exchange ate s D D 1 Q (C$) 38 Textbook p. 97 Inteest Rate vs. Exchange Rate Policy? Bank of Canada can affect exchange ate by Monetay policy inteest ates exchange ate Inteest ates exchange ate Buying o selling Canadian $ diectly Buying $ demand exchange ate Selling $ supply exchange ate Bank of Canada inteventions in foeign exchange maket official intenational eseves Buying Canadian $ equies selling foeign cuency official eseves Quantity of official eseves limits amount of Effects of Monetay Policy: A Recap Quantity of money also affects AD eal GDP and pice level Open maket opeations buying bonds MS which exchange ate net expots AD eal GDP and pice level Consumption and investment AD eal GDP and pice level Open maket opeations selling bonds MS which exchange ate net expots AD eal GDP and pice level consumption and investment AD eal GDP and pice level intevention 39 Global Cuency Cental Bank Independence? Fo a cuency to play a global ole: The size of its undelying economy and global tade The beadth, depth, and liquidity of the economy s capital makets The economy s independence fom extenal constaints The economy s stength, stability and extenal position Avoidance of exchange contols 1 To tackle inflation inteest ates have to be changed months ahead, which politicians may not foesee justified An independent cental bank can anticipate highe inflation and aise inteest ates pomptly The incease in ates would be smalle than if the emedy wee delayed Lowe inflation should foste investment and gowth An independent cental bank can taget pice stability and assue holdes of assets/cuency that thei popety ights will not be compomised by shot-tem political pessues to ceate inflation 2

8 A Politically Accountable Cental Bank? In the shot-un, the tade-off exists between lowe unemployment and high inflation An unelected cental bank will choose how many jobs to sacifice in ode to hit the inflation taget quickly athe than slowly An independent cental bank means a lage democatic deficit But, the govenment can set the taget fo inflation Democatic loss is moe than matched by the economic gain Next, Monetay Policy 3

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