Monetary PolicyAP Macroeconomics 12

Expansionary vs. Restrictive

Monetary Policy

Government Policy

Monetary

Expansionary Restrictive

Fiscal

Expansionary Contractionary

Interest RatesMoney Supply

TaxSpending

Expansionary Monetary Policy

Real GDP

Time for Bank of Canada to …

Initiate Expansionary Monetary Policy (Easy money policy)

Definition:

Policies designed by Bank of Canada that increase the money supply to lower interest rates and expand real GDP

The ultimate goal

Steps

• Bank of Canada will announce a lower target for the overnight loans rate

Lower overnight lending

rate

• Bank of Canada buys bonds from banks and the public

• Result--- increase in the reserves in the banking system

Open market

operation

Results of greater reserves

1. Supply of reserves in the overnight market increase, lowering the overnight rate to the new targeted rate

2. A multiple expansion of the nation’s money supply

a) What is the economic problem this country is facing?

b) What monetary policy should the government take?

c) How would the policy help this country to achieve its goals?

Example 1:Year Ago Quarter Last Quarter Estimate for Quarter

Now Ending

Real GDP $3049 $2678 $2588

Consumer Price Index

287 253 232

Unemployment Rate

6% 11% 15%

The economy is in a Recession

Expansionary Monetary Policy

The increase in money supply results decrease in interest rate; thus, investment would increase, causing real GDP to increase and bring the economy to equilibrium.

Prime interest rate

• It is a reference point for determining other interest rates charged on business and individuals. Ex. mortgage rate

• Higher than overnight lending rate• Fluctuates with overnight lending

rate and bank rate

Definition: the interest rate banks charge their most creditworthy borrowers.

In recession, business become…

Restrictive Monetary Policy

Oh no! Now it’s inflation!

We have to increase

the interest rate!

The busy Bank of Canada now…

Initiate Restrictive Monetary Policy (Tight money policy)

Definition:

Policies designed by Bank of Canada that restrict the growth of the nation’s money supply to reduce or eliminate inflation

The ultimate goal

Steps

• Bank of Canada will announce a higher target for the overnight loans rate

Higher overnight lending

rate

• Bank of Canada sells bonds from banks and the public

• Result--- decrease in the reserves in the banking system

Open market

operation

Results of smaller reserves

1. Supply of reserves in the overnight market decrease, increasing the overnight rate to the new targeted rate

2. A multiple contraction of the nation’s money supply. Other interest rate like prime interest rate will increase.

a) What is the economic problem this country is facing?

b) What monetary policy should the government take?

c) How would the policy help this country to achieve its goals?

Example 2:Year Ago Quarter Last Quarter Estimate for Quarter

Now Ending

Real GDP $2560 $2742 $2985

Consumer Price Index

230 250 270

Unemployment Rate

12% 9% 7%

This country is in a heavy inflation

Restrictive monetary policy

By decreasing the money supply in reserves, the interest rate increases and results decrease in investment and consumption, and ultimately reduce inflation.

The Taylor Rule--by John Taylor

The Taylor rule stipulates exactly how much a central bank should change interest rates to meet target real GDP and rate of inflation

situation Bank of Canada action

Real GDP increase 1% above target of 2%

Raise overnight lending rate by 0.5%

Inflation increase 1% above target of 2%

Raise overnight lending rate by 0.5%

Real GDP is equal to potential GDP, inflation is equal to the target of 2%

Overnight rate should remain at about 4%, and real interest rate at 2%

The Transmission Mechanism

Effects of Monetary Policy

Expansionary Monetary Policy

Unemployment &

recession

Central bank buys bonds

Excess reserves increases

Overnight rate falls

Money supply rises

Interest rate falls

Investment spending increases

Aggregate demand increases

Real GDP rises

Restrictive Monetary Policy

Inflation

Central bank sells bonds

Excess reserves

decreases

Overnight rate rises

Money supply falls

Interest rate rises

Investment spending decreases

Aggregate demand

decreases

Inflation declines

Advantage of Monetary Policy

Monetary Policy Fiscal Policy

Speedy & flexible

Political pressure

Practice Question:

1. If the economy is experiencing a sharp recession trend, what changes would you suggest to do? How would the policy affect the money supply and chartered bank cash reserves?

Suggesting Expansionary Monetary Policy.

As government buying bonds from banks, money from Central Bank is going to the chartered banks, as a result, increase banks’ reserves and money supply. The increase in money supply would lower the interest rate, causing investment increase, thus, the real GDP would also increase.

2. What would the government do if the economy is in a sharp inflation? What policy is used? What happens to the bank reserves and money supply?

The government would SELL bonds to banks and publics.

Restrictive Monetary policy is used, resulting decrease in money supply and bank reserves. Because of the decrease in money supply, the interest rate would increase, thus, decrease in investment and reduce inflation.

Summary

Expansionary Monetary Policy Used in a recessionGovernment buys bonds from chartered banks Money supply↑= Interest rate↓= Investment↑ = AD↑ = Real GDP↑

Restrictive Monetary Policy Used in a sharp inflationGovernment sells bonds from chartered banks Money supply↑= Interest rate↓= Investment↑ = AD↑ = Real GDP↑

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