Chapter 22 - Notes

22.1 - The Bank of Canada

What the Bank of Canada Does

• Canada's central bank — determines monetary policy (setting interest rates to influence economic conditions)
• Created by Parliament in 1934, opened in 1935
• Goal from the Bank of Canada Act: "promote the economic and financial welfare of Canada" by calming fluctuations in production, trade, prices, and employment
• Since 1991, primary focus has been low and stable inflation
• The Bank can't change inflation, output, or unemployment directly — it uses interest rates as its tool to nudge spending up or down

The Bank's Balancing Act

• Too-high interest rate → economy produces below potential → unemployment rises
• Too-low interest rate → output exceeds potential → sparks inflation
• Goal: keep output close to potential output, which achieves stable inflation

Central Bank Independence

• The Bank operates with significant independence from the government — free from short-term political pressures
• Why independence matters: politicians might overheat the economy for short-term gain (boost output before an election), which causes long-run inflation with no lasting output benefit
• Research shows: more central bank independence → lower inflation on average

Government Oversight (Independence ≠ Zero Accountability)

• Board of Directors chosen by the government
• Governor and deputy governor ultimately approved by the Finance Minister
• Bank must publish annual reports, governor appears before Parliament's Finance Committee
• Transparency: everything published openly so anyone can evaluate decisions
• If they disagree: the Finance Minister can issue an official "directive" that the governor must follow — but this has NEVER been used
• The Coyne Affair (1961): Governor Coyne resigned over a dispute with the government about interest rates → led to changes in the Bank of Canada Act allowing the directive power

Monetary Policy in Five Steps

Step 1: Economic Projections (~2.5 weeks before decision)

• Economists run computer models of the economy (C, I, G, NX, commodity prices, US economy, international developments)
• Project inflation, unemployment, GDP growth

Step 2: Major Briefing (~1.5 weeks before)

• Updated data: business outlook survey, bank loan officer survey, financial market data from around the world
• Ground-level intelligence: housing market activity, auto loans, stock markets, bond yields, foreign inflation

Step 3: Policy Recommendations (Thursday before decision)

• Economists and Governing Council discuss final recommendations
• Key tool: the real interest rate (opportunity cost of spending)
  • Raise r → spend less → lower output → lower inflation
  • Lower r → spend more → higher output → higher employment
• Ongoing process — each meeting builds on previous decisions (was the last rate change enough? too much?)
• Everyone voices a recommendation except the Governing Council members

Step 4: Making the Decision (weekend deliberation)

• Governing Council meets alone, discusses, works through disagreements
• Sleep on it over the weekend → meet again Tuesday for final decision

Step 5: Communication (Wednesday 10 AM)

• Press release, website posting, social media
• Wording is extremely carefully chosen — even small word changes can move markets
• 4 times a year: governor gives live statement and takes media questions
• Governor makes speeches around the country; appears at Parliament's Finance Committee twice a year
• Communication is strategic: the Bank is trying to shape expectations — if people believe inflation will be stable, it's more likely to actually be stable (self-fulfilling, from Chapter 19)

8 monetary policy decisions per year

22.2 - The Bank’s Policy Goals and Decision-Making Framework

The Bank's Mandate: 2% Inflation Target

• Bank formally targets 1% to 3% inflation range with 2% as the midpoint
• Since 2021, the Bank also aims for maximum sustainable employment — but only as long as inflation stays within the 1-3% range
• Inflation remains the primary target; employment is secondary
• By announcing the target publicly, the Bank tries to create a virtuous cycle: if people believe inflation will be 2%, they set prices accordingly, and inflation actually stays at 2% (self-fulfilling from Chapter 19)

Why Target Inflation Instead of Unemployment?

1. Inflation is primarily determined by monetary policy → easy to target directly
   • Unemployment is affected by frictional/structural factors (minimum wage, unions, efficiency wages) that have nothing to do with monetary policy
2. Inflation and unemployment are interdependent — keeping inflation at target also keeps unemployment near its lowest sustainable level
   • Unemployment too high → excess capacity → inflation falls below target
   • Unemployment too low → capacity constraints → inflation rises above target
   • So targeting inflation effectively targets unemployment too — no long-run trade-off

Why NOT Target 0% Inflation? (Four Reasons)

1. Inflation greases the wheels of the labour market

• Employers hate cutting nominal wages (workers resent it)
• With 2% inflation, employers can cut REAL wages by simply not giving a raise — workers don't notice as much
• At 0% inflation, real wage cuts require actual nominal wage cuts → employers avoid them → lay off more workers during recessions instead

2. The Bank can lower real interest rates more when inflation is above zero

• Zero lower bound: the Bank can't set nominal interest rates below ~0% (people would just hold cash)
• Real interest rate = nominal rate − inflation
• If inflation = 2% and nominal rate = 0% → real rate = −2% (stimulative)
• If inflation = 0% and nominal rate = 0% → real rate = 0% (can't go lower)
• Higher inflation target gives more room to cut real rates during recessions

3. A 0% target risks deflation

• Bank sometimes undershoots its target → if target is 0%, undershooting means negative inflation (deflation)
• Deflation is dangerous: falling prices → people delay spending → less demand → prices fall more → vicious cycle
• Deflation also raises the real interest rate (nominal rate minus negative inflation = higher real rate) → further depresses spending

4. Measured inflation may be overstated

• CPI biases from Chapter 12 (quality improvements, new products, substitution bias)
• 0% measured inflation might actually mean ~−1% actual inflation (mild deflation)

How the Bank Chooses the Interest Rate — Four Factors

Factor 1: Start with the neutral real interest rate

• Neutral real interest rate: the real rate when the economy is at potential — neither overheating nor underperforming
• Used to be thought of as ~2%, but may now be well below 2% due to secular stagnation (from Chapter 14)
• Setting r above neutral → output below potential; setting r below neutral → output above potential

Factor 2: The Bank targets the nominal rate to influence the real rate

• Bank controls the overnight rate (nominal rate banks charge each other for overnight loans)
• Nominal rate = real rate + inflation → Bank adds inflation to its desired real rate to get the nominal rate it sets

Factor 3: Compare inflation with the target

• Inflation > 2% target → set real rate ABOVE neutral to cool spending and reduce inflationary pressure
• Inflation < 2% target → set real rate BELOW neutral to stimulate spending and boost inflation
• Bank also looks at inflation FORECASTS to get ahead of problems

Factor 4: Look at the output gap

• Positive output gap → economy overheating → set r above neutral to cool it
• Negative output gap → unemployment too high → set r below neutral to stimulate
• Bank also looks at output gap FORECASTS

The Policy Rule-of-Thumb (Taylor Rule)

Real interest rate = Neutral real rate + (1/2 × inflation gap) + output gap

Overnight rate - Inflation = Neutral real rate + (1/2 × inflation gap) + output gap

Where:

• Inflation gap = actual inflation − 2% target
• Output gap = (actual output − potential output) / potential output

Then: Nominal overnight rate = Real interest rate + Inflation rate

Example: neutral real rate = 1%, inflation = 1.5%, output gap = +0.5%

• Real rate = 1% + (1/2 × (1.5% − 2%)) + (1 × 0.5%) = 1% + (−0.25%) + 0.5% = 1.25%
• Nominal rate = 1.25% + 1.5% = 2.75%

Key Points About the Rule:

• The Bank responds half a percentage point for each percentage point of inflation gap
• The Bank responds 1 percentage point for each percentage point of output gap
• The rule is a good predictor of actual Bank decisions but the Bank doesn't follow it mechanically
• Decisions are systematic (reliable pattern) but not automatic (judgment still matters)
• Also called the Taylor Rule after the economist who described it

Rules vs Discretion Debate

• Rules: remove temptation to overheat economy, make policy predictable
• Discretion: allows Bank to get ahead of problems and respond to unusual situations (e.g., 2007 rate cuts before the recession, zero lower bound concerns, financial instability)
• In practice: Bank starts with what the rule suggests, then uses judgment to adjust

22.3 - How the Bank Sets Interest Rates

The Overnight Market

• Banks lend out most of the money you deposit (that's how they make money)
• But they need to keep some cash on hand (reserves) to make payments (e.g., when you write a cheque to your landlord)
• Some days banks are short on cash → need to borrow overnight from other banks
• Some days banks have excess cash → willing to lend overnight
• The overnight rate is the interest rate on these overnight interbank loans
• The Bank of Canada runs this market on a computer platform called Lynx

Four Tools the Bank Uses to Hit Its Target Overnight Rate

Tool 1: Standing offers to lend and borrow

• Bank of Canada offers to accept deposits from banks at the deposit rate → sets the FLOOR (why lend to another bank for less when you can always deposit at the Bank of Canada?)
• Bank of Canada offers to lend to banks at the bank rate → sets the CEILING (why borrow from another bank for more when you can borrow from the Bank of Canada?)
• The range between the deposit rate (floor) and bank rate (ceiling) = the operating band
• The Bank controls this band — just adjust the deposit rate and bank rate to move the whole band up or down

Tool 2: Injecting or withdrawing funds

• The Bank of Canada is the banker to the federal government → tax receipts and government paycheques flow through its accounts daily
• To nudge the overnight rate UP: put less of the government's funds in the overnight market → less supply → rate rises
• To nudge the overnight rate DOWN: leave extra government funds in the overnight market → more supply → rate falls

Tool 3: Repos and reverse repos

• Repo (repurchase agreement): Bank buys a bond from a financial institution, agrees to sell it back next day at a slightly higher price → effectively a short-term loan → injects cash into the market → pushes overnight rate DOWN
• Reverse repo: Bank sells a bond, agrees to buy it back next day → withdraws cash from the market → pushes overnight rate UP

Tool 4: Open market operations (buying and selling government bonds)

• Bank buys bonds → pays cash to banks → banks have more reserves → less need to borrow, more ability to lend → overnight rate goes DOWN
• Bank sells bonds → banks pay cash → less reserves → more need to borrow, less ability to lend → overnight rate goes UP
• This is the traditional central banking tool, but the Bank of Canada doesn't typically use it for regular policy anymore
• Quantitative easing is a special version of this used in unconventional circumstances (covered later)

How the Overnight Rate Affects the Rest of the Economy

Step 1: Overnight rate → other interest rates

• When overnight rate changes, banks adjust rates on credit cards, mortgages, business loans, student loans, savings accounts, auto loans
• Variable rates (credit cards, some student loans) move almost immediately with the overnight rate
• Longer-term fixed rates also adjust because a long-term loan is like a series of short-term loans → banks price it based on expected future short-term rates
• How much long-term rates move depends on how long the Bank is expected to keep the new rate

Step 2: Interest rates → spending decisions

• Lower rates → lower opportunity cost of spending → more consumption and investment
• Lower rates → government pays less interest on debt → potentially more room for government purchases
• The IS curve logic from Chapter 18

Step 3: Interest rates → exchange rate → net exports

• Lower Canadian interest rates → Canada less attractive for foreign investors → less demand for C$ → Canadian dollar depreciates
• Cheaper C$ → Canadian exports cheaper for foreigners → exports rise
• Cheaper C$ → imports more expensive for Canadians → imports fall
• Net exports rise
• The reverse happens when rates rise: C$ appreciates → net exports fall

Full chain: Bank changes overnight rate → other rates adjust → C, I, G, NX all change → aggregate expenditure changes → output changes → inflation changes

Practical Warning

• When the Bank cuts rates, it seems like a good time to borrow — but the Bank cuts rates because the economy is weakening
• You should factor in the risk of losing your job before taking on new debt
• Young people are most vulnerable to unemployment during downturns

22.4 - Unconventional Monetary Policy

The Problem: What Happens When Interest Rates Hit Zero?

• The Bank's main tool is the overnight rate, but it can't go below ~0% (the zero lower bound)
• If the economy still needs stimulus after rates hit zero, the Bank needs other tools
• Goal of unconventional tools: push longer-term interest rates down even when short-term rates are already at zero

Two Unconventional Tools

1. Forward Guidance

• The Bank promises to keep rates low for a long time in order to push down longer-term interest rates today
• Logic: long-term rates are based on expected future short-term rates → if the Bank commits to low short-term rates for years, long-term rates fall
• Example: Governor Macklem in July 2020: "interest rates are very low and they're going to be there for a long time"
• Lower long-term rates → more mortgages, car loans, business investment → more spending
• Only works if people believe the Bank will follow through — credibility is essential

2. Quantitative Easing (QE)

• The Bank buys large quantities of longer-term government bonds to push down long-term interest rates
• In 2020-2021, Bank of Canada bought ~$350 billion in government bonds (asset holdings quadrupled)
• How it works: Bank buys long-term bonds from investors → increases the supply of long-term loans → long-term interest rates fall
• Similar to open market operations but targets long-term rates instead of the overnight rate
• Also signals commitment to keeping rates low (reinforces forward guidance)
• Result: historically low mortgage rates, cheaper long-term business borrowing

Lender of Last Resort

What it is: the Bank of Canada stands ready to lend to financial institutions that need cash immediately but can't get loans elsewhere

• Uses the Emergency Lending Assistance program at the bank rate (higher than overnight rate — only used in emergencies)
• Purpose: prevent bank runs and financial panics

Why it matters:

• Bank runs are contagious (Chapter 15) — one bank failing makes depositors at other banks panic
• During the Great Depression, the US central bank chose NOT to bail out banks → 5,000+ banks failed → deepened the depression
• During 2007-2009, central banks learned from this and acted aggressively → provided massive loans to prevent panic from spreading
• In 2007-2009, the problem extended beyond regular banks to shadow banks (like Lehman Brothers) → central banks expanded their reach to these institutions too

The "Too Big to Fail" Problem:

• Large financial institutions know the central bank will bail them out because their failure would cause widespread chaos
• This creates moral hazard — incentive to take on extra risk (if bets pay off they profit, if they don't the central bank rescues them)
• Bailouts may prevent the current crisis but make future crises more likely
• Solution: regulation — require banks to maintain sounder financial positions so they're less likely to need bailouts

The Bailout Trade-off:

• Using public money to save private companies is controversial — benefits shareholders of failing companies
• But also prevents broader financial chaos that would hurt everyone
• In the 2008 crisis, the US central bank was eventually fully repaid with interest — but there were real risks involved

Questions

1. In an effort to maintain inflation at its targeted level the Bank of Canada designs its policies, in the short run, to
   Keep real GDP close to potential output
2. Suppose that the inflation rate is at 5%, but the Bank of Canada does not implement contractionary monetary policy. Which of the following is the most likely explanation?
   The Bank of Canada knows that there is a lag in the effects of monetary policy and expects inflation to fall before monetary policy would have an effect.
3. Starting in long-run equilibrium, which of the following scenarios would be most likely to cause the Bank of Canada to implement expansionary monetary policy?