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What is Monetary Policy?
policies made by the central bank that change money supply, interest rates and exchange rates to adjust aggregates demand
What is Central Bank?
is responsible for monetary policies using its control of monetary base and interest rates
What are the main differences between private commercial banks and the central bank?
- - private banks look to make profits.
- - the central bank just looks to influence private banks actions and the financial system in general (using monetary policy). They work more like a government agency than a private business.
Total currency in circulation depends on 2 factors:
the bank of canada's decision about the right size for the monetary base and interest rates.
the demand for cash, relative to deposits, coming from the public and the banks (this depends on the banks' reserve ratio (rr) and people's currency ratio (cr).
What are 3 ways the BoC has of controlling the money supply?
- 1 - Creating reserve requirements
- 2 - using open-market operations
- 3 - adjusting central bank lending rates
What's a Required Reserve Ratio?
A legal minimum ratio of cash reserves to deposits that all commercial banks must meet at all times.
Why would the BOC want to control the rr?
so it can control the size of the multiplier and money supply
an increase in rr, decreases the Money multiplier and a decrease in rr, increases the MM.
What's an Open Market Operation?
when the central bank buys or sells government securities (mainly bonds) in the open financial market. While required rr focuses on the multiplier, this technique focuses on controlling the monetary base.
What's an open Market Purchase?
this is when the BoC buys government bonds. It increases the BoC's assets and the monetary base in the economy. The higher monetary base increases bank lending (by creating bank deposits) and the money supply
What is Open Market Sales?
This is when the BoC sells some of its assets (gov bonds). This reduces the monetary base, bank lending, and the money supply
What's the bank rate?
the interest rate the central ank charges on its loans to commercial banks
- if a bank is running low on cash for its reserve ratio, they often borrow from other banks at the overnight rate
- if none of the other banks have enough cash reserves to lend, the bank must borrow from the central bank at the bank rate (which is higher than the overnight rate)
What is the Money Supply Target?
Its when the BoC tries to control the money supply by changing interest rates
What is the Inflation Rate Target?
Monetary policy aims to maintain a target inflation rate.
What is the Monetary Policy Instrument?
This would be the monetary variable that the central bank uses to reach its policy target. In the above examples, the interest rate has been the main monetary policy instrumentto achieve exchange rate, money supply, and the inflation rate targets.
What is the Overnight Rate?
The interest rate commercial banks (and other financial institutions) receive or pay on loans from one day until the next.
- banks use the overnight rate to borrow money from other banks when they don't have enough cash to meet their reserve ratio. they pay it back the next day (this is why it's called "overnight")
- It falls inbetween a range. the upper end is bank rate. the lower end is deposit rate.
What is the Prime Lending Rate?
The interest rate charged by banks on loans to their most credit worthy borrowers.
when the BoC raises the overnight rate, banks respond by raising the prime lending rate. Rates on business and consumer loans, and mortgage rates are tightly linked to the prime lending rate.
the interest rates cover about two thirds of bank lending in canada so it makes a strong link between monetary policy and aggregate expenditure and AD.
To maintain the overnight interest rate within the target range, the BoC must do what?
cover any shortages or remove any surplus money that would push the rates outside the range. It has two ways of doing this:
- Special Purchase and Resale Agreement (SPRA)
- Sale and Repurchase Agreement (SRA)
What is SPRA? Special Purchase and Resale Agreement
This is when the BoC buys securities (like bonds) one day and agrees to resell them the next day.
- this is uesd when there is a shortage of cash and there is fear that the overnight rate might rise too much because banks won't lend at current rates with the shortage of cash.
- with an SPRA, the BoC puts cash into the system for a day to avoid too much rise in rates. The difference between the buying and selling prices determines the interest rates for the SPRA
- Banks don't mind doing this because they get that cash for a lower rate than if they had to borrow from other banks at the overnight rate.
What is the SRA? Sale and Repurchase Agreement
- This is when the BoC sells securities one day and agrees to buy them back the next day.
- - this is used when there is fear that the overnight rate will fall too much.
- - the boc uses the SRA to take cash out of the system which reduces the monetary base and prevents the rates from falling too much.
About the government deposit accounts?
the government holds some of its funds on deposit in the BoC and some in commercial banks and allows the BoC to control how these funds are distributed.
because this gives the BOC another way of managing the monetary base in the short term.
What is the Taylor rule? formula
- the taylor rule says that the central bank sets interest rates according to the following targets:
- 1 - inflation targets
- 2 - output targets
i = i0 + a(π-π*)+ b(Y-YP)
What are Balance of Payments Accounts? and it's 3 main accounts
- Records transactions between one country and the rest of the world. The BOP has 3 main accounts.
- 1 - Current Account
- 2 - Capital Account
- 3 - Change in Official Reserves account (▲OR)
What is Current Account?
The part of the BOP that records the exports and imports in goods, services, and transfer payments. A current account surplus means a country's foreign income is greater than its foreign spending.
What is Capital Account?
The part of the BOP that records purchases and sales of real/physical assets and financial assets.
What are Changes in Official International Reserves (▲OR)?
The change in government of canada's balance of foreign currency. An increase in official reserves is like a payment (debit) item in the KA because the government has to buy foreign currency by paying for it in domestic currency. ▲OR is always equal to CA+KA when there is no statistical discrepancy.
What's the formula for Balance of Payments?
CA+KA - ▲OZ
What is Statistical Discrepancy?
Accounts for any mistakes there might have been in measuring the items in the BOP accounts.
What are the three main things that determine the price of foreign goods relative to domestic goods?
1 - the domestic price level. We can use the consumer price index or GDP deflators to measure this.
2 - the foreign currency price of foreign goods. If looking at Japan, Pf would be the price of goods in Japanese Yen. Again, CPI and GDP deflator can be used to measure this.
3 - This nominal exchange rate.
What is the Nominal Exchange rate?
the domestic currency price of a unit of foreign currency
What is Real Exchange rate? the formula
the relative price of goods and services from different countries measured in a common currency.
(er * Pf)/PCDN
What's the Purchasing Power Parity (PPP)?
Means a real exchange rate equal to one. It means that nominal er adjusts to value required to make net exports = 0.
What is Interest Parity?
Occurs when expected exchange rate changes make-up for interest rate differences between countries.
What 3 things determine the size of Net Capital Flow (CF) to money that appears as the balance on the capital account:
1- the difference between domestic and foreign interest rates.
2 - the current nominal er
3- the nominal er expected in the future
The net capital flow depends _____ on the difference between domestic and foreign nominal interest rates
The net CF depends ______ on the expected exchange rate
What's the Foreign Exchange Market?
the market in which the currencies of different countries are bought and sold. This is where the prices of currencies (foreign exchange rates) are decided
What is currency depreciates?
when the value of that currency falls. This means the exchange rate rises
What is currency Appreciates?
When the value of the currency increases. This means the exchange rate falls
What is convertible Currency?
the central bank will buy or sell unlimited quantities of this currency at a FIXED exchange rate
What is official exchange reserves?
all the foreign currencies that the government holds. it is managed by the central bank
A reduction in the value of the domestic currency
An increase in the value of the domestic currency
Why is Monetary Policy more powerful with flexible exchange rates than fiscal?
because with flexible er, monetary policy causes changes in both interest rates and exchange rates.
what is more effective with FIXED ER?
What is more effective with FLEXIBLE ER