Chapter 22 - Monetary Policy

Examines how the Bank of Canada uses interest rate policy to stabilize the economy. Connects to Chapter 15 - The Financial Sector (BoC functions) and Chapter 21 - Aggregate Demand and Aggregate Supply (how policy shifts AD).

Key Concepts

• The Bank of Canada is independent but accountable to Parliament; its mandate is price and financial stability
• The BoC targets 2% inflation (within a 1–3% band) — not zero — for four deliberate reasons
• Monetary policy is implemented primarily by setting the overnight rate
• A Taylor-type rule guides the policy rate using the neutral real rate, inflation gap, and output gap
• The BoC has four tools for hitting the overnight rate target: deposit rate, bank rate, repos, and open market operations
• Rate changes ripple through the economy via other interest rates, consumption timing, and the exchange rate
• Unconventional tools (forward guidance, QE) are used when the overnight rate hits zero

---

1. The Bank of Canada

History and Mandate

• Created in 1934 during the Great Depression to stabilize the financial system
• Parliamentary mandate: promote the economic and financial welfare of Canada
  • In practice: price stability (low, stable inflation) and financial stability
• The BoC does not maximize employment directly — that is a secondary concern

Independence and Accountability

• The BoC is operationally independent: politicians cannot dictate day-to-day rate decisions
• But it is accountable: the Governor reports to Parliament and must explain decisions publicly
• Why independence matters: prevents politicians from cutting rates before elections to boost short-run growth at the cost of long-run inflation

The Monetary Policy Process

The BoC follows a five-step process for each rate decision (8 decisions per year):

Step	Description
1. Economic Projections	Staff build forecasts for GDP, inflation, and the output gap
2. Major Briefing	Senior staff present analysis and risks to the Governing Council
3. Policy Recommendations	Staff recommend a rate path based on models and judgment
4. Making the Decision	The Governing Council reaches a consensus and sets the rate
5. Communication	Rate announcement + press conference + Monetary Policy Report

Remember

Communication is itself a policy tool. By clearly explaining decisions, the BoC shapes expectations, which affects long-term rates and economic behaviour immediately.

---

2. Monetary Policy Targets and Tools

The Inflation Target

• The BoC targets 2% inflation within a 1–3% control range
• This target has been in place (and renewed) since 1995
• The CPI is the primary measure used

Exam Alert

The target is 2%, not 0%. This is deliberate — see the four reasons below.

Why Not Target Zero Inflation?

Reason 1: Greases the Labour Market

• Wages are downwardly rigid (workers resist nominal pay cuts)
• With 2% inflation, employers can reduce real wages without cutting nominal wages — preserving employment

Reason 2: Greater Ability to Lower Rates

• Nominal interest rates cannot go below zero (approximately)
• If inflation is 2%, the real rate can be cut further before hitting the zero lower bound
• More room to stimulate → more effective monetary policy during recessions

Reason 3: Deflation Risk

• Targeting 0% puts the economy one bad shock away from deflation
• Deflation is dangerous: it raises real debt burdens, delays spending (why buy today if prices fall tomorrow?), and can spiral into a depression

Reason 4: CPI Overstates True Inflation

• The CPI has upward biases (substitution bias, new-goods bias, quality bias)
• A measured 2% likely represents true inflation close to 0% — so the target is effectively near-zero anyway

Four Policy Factors

When setting the overnight rate, the BoC considers:

1. Neutral real interest rate ($r^{\ast }$) — the rate consistent with full employment and 2% inflation; neither stimulative nor restrictive
2. Current nominal overnight rate — where rates sit now relative to neutral
3. Inflation gap — how far current inflation is above or below the 2% target
4. Output gap — how far actual GDP ($Y$) is from potential GDP ($Y^{\ast }$)

The Monetary Policy Rule

The BoC’s rate-setting follows a Taylor-type rule:

$\underset{\text{Real overnight rate}}{\underbrace{\text{Overnight rate}-\text{Inflation}}}=r^{\ast }+\frac{1}{2}(\text{Inflation}-2\%)+\text{Output gap}$

Using the Policy Rule

Suppose: $r^{\ast }=2\%$, inflation $=4\%$, output gap $=+1\%$

$\text{Real overnight rate}=2\%+\frac{1}{2}(4\%-2\%)+1\%=2\%+1\%+1\%=4\%$

$\text{Nominal overnight rate}=\text{Real rate}+\text{Inflation}=4\%+4\%=8\%$

Policy is contractionary — rates are well above neutral to cool overheating.

Exam Alert

The output gap and inflation gap both push in the same direction during a normal business cycle:

• Recession: $Y<Y^{\ast }$ (negative gap) + inflation below target → cut rates
• Boom: $Y>Y^{\ast }$ (positive gap) + inflation above target → raise rates

---

3. Implementing Monetary Policy

The Overnight Rate

• The overnight rate is the interest rate at which major banks lend to each other for one business day
• Banks borrow overnight to meet settlement balances (clearing payments at end of day)
• The BoC sets a target for this rate; actual transactions occur between banks

Four Tools to Hit the Target

Tool 1 & 2: The Corridor System The BoC creates a corridor around the target rate:

Rate	Level	Role
Bank rate (ceiling)	Target + 0.25%	Maximum rate BoC charges banks for emergency loans; no bank borrows above this
Deposit rate (floor)	Target − 0.25%	Rate BoC pays on deposits; no bank lends below this

The overnight rate is trapped between the floor and ceiling — the corridor enforces the target.

Tool 3: Repos and Reverse Repos

• Repo (repurchase agreement): BoC lends money to banks in exchange for bonds temporarily → injects funds into the system → pushes overnight rate down
• Reverse repo: BoC borrows money from banks, temporarily taking bonds → withdraws funds → pushes overnight rate up

Tool 4: Open Market Operations

• BoC buys government bonds → injects money into system → rate falls
• BoC sells government bonds → withdraws money from system → rate rises

Remember

All four tools work through the same mechanism: changing the supply of funds available in the overnight market, which moves the overnight rate toward the target.

Ripple Effects of Monetary Policy

A change in the overnight rate ripples through the economy via three channels:

Channel 1: Other Interest Rates

• Banks pass the overnight rate change to prime rate, mortgage rates, car loans, and business loans
• Lower overnight rate → lower borrowing costs → more spending and investment

Channel 2: Consumption Timing (Intertemporal Substitution)

• Higher rates → saving is more rewarding → households delay consumption
• Lower rates → borrowing is cheaper → households bring forward consumption

Channel 3: The Exchange Rate

• Higher Canadian rates → foreign investors want C$assets\to \ast \ast demandforC$ rises** → C$ appreciates
• Appreciated C$ → Canadian exports more expensive → exports fall, imports rise → AD falls
• Lower rates → opposite → C$ depreciates → NX rises → AD rises

Exam Alert

Monetary policy affects AD through all three channels simultaneously. Raising the overnight rate: raises borrowing costs, discourages current consumption, and appreciates the dollar — all three reduce aggregate demand.

---

4. Unconventional Monetary Policy

When the overnight rate hits the zero lower bound (ZLB), conventional policy is exhausted. The BoC can then use unconventional tools.

Forward Guidance

• The BoC commits publicly to keeping rates low for an extended period
• Even though today’s rate cannot fall further, the commitment lowers expected future rates
• Lower expected future rates → lower long-term rates today → stimulates investment and spending
• Used aggressively in 2009 and 2020

Forward Guidance

“The BoC commits to holding the overnight rate at 0.25% until the economy reaches full employment, projected to be in 2023.” This lowers 5-year mortgage rates immediately, even though today’s overnight rate didn’t change.

Quantitative Easing (QE)

• The BoC purchases large quantities of long-term government bonds and other assets directly from financial markets
• QE injects money into the economy and pushes down long-term interest rates (which the overnight rate doesn’t directly control)
• Used in Canada during the COVID-19 pandemic (2020–2021)

How QE works:

1. BoC creates new money and buys government bonds
2. Bond prices rise → yields (long-term rates) fall
3. Lower long-term rates → cheaper mortgages, corporate borrowing → more investment and consumption

Downsides of QE:

• Losses: if long-term rates rise after QE, the BoC’s bond holdings lose value → central bank takes a loss
• Moral hazard: financial institutions may take on more risk knowing the BoC will purchase assets in a crisis

Lender of Last Resort

• When banks face a liquidity crisis (bank run), the BoC provides emergency short-term loans
• Prevents panic-driven runs from causing unnecessary failures
• Already covered in Chapter 15 - The Financial Sector
• Downsides: same as QE — potential losses on risky collateral, and moral hazard (banks may take on more risk knowing a backstop exists)

Common Mistake

Lender of last resort is for solvent banks with a liquidity problem. The BoC should not bail out banks that are fundamentally insolvent (i.e., liabilities exceed assets even in normal conditions).

---

Definitions

Bank of Canada (BoC) Canada’s central bank; conducts monetary policy, issues currency, and acts as lender of last resort.

Overnight Rate The interest rate at which major financial institutions lend to each other overnight; the BoC’s primary policy instrument.

Inflation Target The BoC’s goal of 2% CPI inflation (within a 1–3% band); the benchmark against which monetary policy is calibrated.

Neutral Real Interest Rate ($r^{\ast }$) The real interest rate consistent with the economy operating at full potential with inflation at target; neither stimulative nor restrictive.

Output Gap The difference between actual GDP ($Y$) and potential GDP ($Y^{\ast }$); positive gap → overheating; negative gap → recession.

Zero Lower Bound (ZLB) The practical floor of ~0% on nominal interest rates; beyond this, conventional monetary policy cannot further stimulate the economy.

Bank Rate The rate the BoC charges banks for overnight loans; sits 0.25% above the overnight rate target, forming the corridor ceiling.

Deposit Rate The rate the BoC pays on deposits held overnight; sits 0.25% below the overnight rate target, forming the corridor floor.

Repo (Repurchase Agreement) A transaction where the BoC lends money to banks by temporarily buying their bonds; injects funds into the overnight market.

Reverse Repo A transaction where the BoC borrows money from banks by temporarily selling bonds; withdraws funds from the overnight market.

Open Market Operations The BoC’s purchase or sale of government bonds to adjust the money supply and influence the overnight rate.

Forward Guidance A commitment by the BoC to keep interest rates at a stated level for a future period, influencing long-term rate expectations.

Quantitative Easing (QE) Large-scale purchases of long-term bonds and assets by the BoC to inject money into the economy and lower long-term interest rates when the overnight rate is at zero.

Moral Hazard The tendency of institutions to take on more risk when they know they will be bailed out or protected from the consequences of failure.