AP Macroeconomics 12

Monetary Policy

Expansionary vs. Restrictive

Monetary Policy

Government Policy

Monetary

Fiscal

Expansionary

Restrictive

Expansionary

Contractionary

Expansionary Monetary Policy

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

Open market operation

Bank of Canada buys bonds from banks and the public Result--- increase in the reserves in the banking system

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 nations money supply

Example 1:
Year Ago Quarter Real GDP Consumer Price Index $3049 287 Last Quarter $2678 253 Estimate for Quarter Now Ending $2588 232

Unemployment Rate

6%

11%

15%

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

The economy is in a Recession

b) What monetary policy should the government take?

Expansionary Monetary Policy

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

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

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

In recession, business become

Restrictive Monetary Policy

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 nations money supply to reduce or eliminate inflation
The ultimate goal

Steps
Higher overnight lending rate Bank of Canada will announce a higher target for the overnight loans rate

Open market operation

Bank of Canada sells bonds from banks and the public Result--- decrease in the reserves in the banking system

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 nations money supply. Other interest rate like prime interest rate will increase.

Example 2:
Year Ago Quarter Real GDP Consumer Price Index $2560 230 Last Quarter $2742 250 Estimate for Quarter Now Ending $2985 270

Unemployment Rate

12%

9%

7%

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

This country is in a heavy inflation

b) What monetary policy should the government take?

Restrictive monetary policy

c) How would the policy help this country to achieve its goals?
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 Real GDP increase 1% above target of 2% Inflation increase 1% above target of 2% Real GDP is equal to potential GDP, inflation is equal to the target of 2% Bank of Canada action Raise overnight lending rate by 0.5% Raise overnight lending rate by 0.5% Overnight rate should remain at about 4%, and real interest rate at 2%

The Transmission Mechanism

Effects of Monetary Policy

Expansionary Monetary Policy

Unemploy ment & recession
Interest rate falls Investment spending increases

Central bank buys bonds

Money supply rises

Aggregate demand increases

Excess reserves increases

Overnight rate falls

Real GDP rises

Restrictive Monetary Policy

Inflation
Interest rate rises Investment spending decreases

Central bank sells bonds

Money supply falls

Aggregate demand decreases

Excess reserves decreases

Overnight rate rises

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 recession Government buys bonds from chartered banks Money supply= Interest rate= Investment = AD = Real GDP

Restrictive Monetary Policy

Used in a sharp inflation Government sells bonds from chartered banks Money supply= Interest rate= Investment = AD = Real GDP

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