Monetary Policy: Theory, Mechanisms, and Pandemic Response (ECON-1020H Chapter 15 Study Notes)

Monetary Policy

Introduction

Monetary policy is a key tool for economic stabilization, especially in response to recessions and financial crises. It is primarily conducted by central banks, which use policy interest rates and money supply adjustments to influence aggregate demand and inflation.

• Stabilization Policy: Monetary policy is often preferred over fiscal policy due to fewer political barriers and its direct impact on financial markets.

• Policy Interest Rate: The main instrument of conventional monetary policy, closely linked to the money supply.

• AD-AS Lens: The effects of monetary policy are best understood through the Aggregate Demand-Aggregate Supply (AD-AS) framework.

The Demand for Money

Modeling the Demand for Money

The demand for money arises from the need to facilitate transactions and resolve the lack of double coincidence of wants. In macroeconomics, money is treated as a primitive, consisting of currency in circulation and demand deposits.

• Money: Includes both physical currency and demand deposits held at banks.

Liquidity Preference Theory

John M. Keynes introduced the concept of liquidity preference, which explains why people hold money instead of other assets.

• Medium of Exchange: Money is held to make payments.

• Liquidity: The demand for money reflects the desire for liquidity.

• Opportunity Cost: The cost of holding money is the short-term nominal interest rate, typically the rate on short-term government bonds.

The Money Demand Curve in the Short Run

The money demand curve shows the relationship between the quantity of money held and the short-term nominal interest rate, holding other factors constant.

• Downward Slope: As the interest rate rises, people hold less money; as it falls, they hold more.

Shifts of the Money Demand

Changes in the price level or real GDP shift the money demand curve.

• Dollar Value of Transactions: $\text{Dollar Value} = \text{Price Level} \times \text{Quantity of Goods}$

• Higher Price Level: Increases demand for money.

• Higher Real GDP: Increases demand for money.

• Lower Price Level or GDP: Decreases demand for money.

Money and Nominal Interest Rate

The Money Supply

The central bank determines the money supply, which consists of currency in circulation and demand deposits. The money multiplier links the monetary base to the total money stock.

• Central Bank Control: The central bank sets the monetary base and, through the money multiplier, influences the money stock.

• Money Market: The equilibrium between money demand and supply determines the interest rate in the short run.

Equilibrium in the Money Market

Interest rates adjust to balance the quantity of money demanded and supplied.

• Below Equilibrium Rate: Excess demand for money leads to lower bond prices and higher interest rates.

• Above Equilibrium Rate: Excess supply of money leads to higher bond prices and lower interest rates.

Bond Price and Interest Rate Relationship:

• Bonds have a face value (e.g., $100).

• Bond interest rate formula: $i = \frac{100}{P_b} - 1$

• Example: If bond price falls from $95 to $90, interest rate rises from 5.26% to 11.11%.

Nominal vs. Real Interest Rate

• Nominal Interest Rate: Determined in the money market.

• Real Interest Rate: $\text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Expected Inflation Rate}$

• In the short run, expectations are stable, so real and nominal rates move together.

Money Market vs. Loanable Funds Market

• Money Market: Interest rate balances money demand and supply at a given price level.

• Loanable Funds Market: Interest rate balances savings and investment at a given output level.

Monetary Policy and Interest Rate

Central Bank Control of Interest Rate

The central bank can influence the short-term nominal interest rate by adjusting the money supply.

• Increase Money Supply: Lowers nominal interest rate.

• Decrease Money Supply: Raises nominal interest rate.

• Policy Tools: Open-market operations and adjusting the bank rate.

Open-Market Operations

• Purchasing Bonds: Central bank buys short-term government bonds, raising bond prices and lowering interest rates.

• Selling Bonds: Central bank sells bonds, lowering bond prices and raising interest rates.

• Open-market operations are the primary tool for achieving target interest rates.

Effects of Monetary Policy

Monetary Policy in a Closed Economy

Monetary policy affects aggregate demand (AD) through changes in interest rates.

• Expansionary Policy: Increase in money supply lowers interest rates, increases AD, raises price level, real GDP, and lowers unemployment.

• Contractionary Policy: Decrease in money supply has the opposite effects.

• Properly timed expansionary policy can help end recessions.

Monetary Policy in a Small Open Economy

In economies with perfect capital flow and flexible exchange rates, monetary policy has additional effects via exchange rates and net exports.

• Lower Interest Rate: Leads to capital outflow, currency depreciation, and increased net exports.

• Aggregate Demand: Further increases due to higher net exports.

• Equilibrium: Domestic interest rate returns to world interest rate; currency depreciates; price level and real GDP rise; unemployment falls.

Fixed Exchange Rate Regime

• Central bank loses ability to change money supply independently.

• Any increase in money supply must be offset to maintain fixed exchange rate.

The Zero Lower Bound (ZLB)

There is a limit to how low nominal interest rates can go; they cannot fall below zero.

• Zero Lower Bound: Limits effectiveness of conventional monetary policy.

• Example: Post-2008 crisis, U.S. and Canadian policy rates approached zero.

Quantitative Easing

When conventional policy is constrained by the ZLB, central banks use unconventional tools.

• Quantitative Easing: Central bank purchases long-term bonds to inject liquidity.

• Direct Lending: Central bank may lend directly to non-financial businesses.

• Example: In 2009, the Federal Reserve purchased mortgage-backed securities (MBS).

Appendix: Monetary Policy and the Pandemic

Bank of Canada's Corridor and Floor Systems

During the COVID-19 pandemic, the Bank of Canada shifted from a corridor system to a floor system for setting interest rates.

• Corridor System: Target rate is set between deposit and bank rates.

• Floor System: All rates converge at the lower bound during crisis periods.

Interest Rates and Inflation During the Pandemic

Interest rates and inflation fluctuated significantly during and after the pandemic, reflecting central bank interventions.

• Interest Rate Trends: Policy rates dropped to near zero, then gradually increased post-pandemic.

• Inflation: Rose sharply during the recovery phase.

Bank of Canada Balance Sheets

The Bank of Canada expanded its assets and liabilities during the pandemic, primarily through bond purchases and liquidity provision.

Assets	Liabilities
Bonds (3-year and under, over 3-year)	Currency in circulation
Securities under repurchase agreements	Deposits of banks and government

Useful Links

• BoC Assets and Liabilities

• Framework for market operations and liquidity provision

• Annual Reports and Quarterly Financial Reports

• Annual Reports 2021: Financial Statements

Summary

• Money Demand: Driven by liquidity preference.

• Interest Rate Determination: Set by equilibrium in the money market.

• Monetary Policy: Adjusts money supply via open-market operations.

• Short-Run Effects: Vary between closed and open economies.

• Pandemic Response: Included unconventional policies and changes to central bank operating frameworks.