MANAGING THE ECONOMY WITH MONETARY POLICY
THE DEMAND FOR MONEY
The interest rate
The interest rate is the opportunity cost of holding wealth in the form of money rather than an interest-bearing asset.
Remember money is what doesn’t earn interest, like cash in your pocket. When you hold cash or a chequing account, you receive no (or very little) interest. The interest you could have earned is the PRICE of holding money.
Just as when the price of a good rises, people buy less of it, so when the interest rate rises, the price of money, people hold less of money.
Real GDP
An increase in real GDP increases the volume of expenditure, which increases the quantity of real money that people plan to hold.
An increase in real GDP acts like an increase in income. Real GDP rises, people wish to hold more money.
The effect is fairly strong, because the more goods and services people are buying, the more cash you need on hand they need to pay for them. The cash will be travelling from your bank account, to the cash register of the store, to the manufacturer and to the wages or workers and back to the cash registers of the stores. But if more goods are being bought and sold, more cash must be owned by someone as it flows through the economy.
Financial innovations, such as credit and debit cards and internet banking, have reduced the need for cash and have tended to reduce the demand for money. Working for cash under the table and other illegal activities would increase the demand for cash
THE SUPPLY OF MONEY
The supply of money is controlled by the Bank of Canada. The Bank of Canada is run by the federal government and is responsible for maintaining stable financial markets, stable markets for the Canadian dollar and for controlling inflation and reducing unemployment.
It can control the total amount of money in the economy and also control the interest rate.
At any point in time, the money supply of Canada is fixed in quantity. So the money supply of Canada is perfectly inelastic with respect to the interest rate.
(Key diagram to be able to use.)
The interaction of money demand and money supply sets the interest rate.
Reaching equilibrium:
If the interest rate is above equilibrium, say 6%, people will want to hold less money and more assets that earn interest. They will shift their cash out of chequing accounts and into short term bonds.
Firms may put their money for Friday’s payroll into short term bonds or Treasury bills until Thursday afternoon.
As firms buy bonds and Treasury bills, they push the price of them up. That pushes the interest rate down.
As the interest rate falls, firms and people are more willing to hold cash. The proportion of people’s assets they are willing to hold as chequing accounts increases. Equilibrium is reached.
If the interest rate is too low, say 3%, then people will sell bonds to have the convenience of cash. The bond prices will rise, and the interest rate will fall.
BOND PRICES AND INTEREST RATES
A Treasury bill in 30 days pays $10,000.
Their price today depends on the supply and demand for them.
If a firm buys it today for $9,950, then in 30 days the firm redeems it for $10,000.
$10,000-$9,950 = $50
$50/$9,950 = .005 or .5% in one month, one half a percent interest.
(If you have LOTS of money, it is worth the bother…)
At an annual rate, that is 12 * .005 = .06 = 6% interest.
If the price of bonds rises, the interest rate falls.
If the bond price rises to $9,975 and is redeemed in one month for $10,000, then the firm collects only $25.
$25/$9,975 = .0025, .25% a quarter of a percent.
At an annual rate, that is 12 * .0025 = .03 = 3% interest.
A big change in interest rate, for a little change in price.
The Bank of Canada can alter the interest rate by altering the money supply.
They alter the money supply by engaging in open market operations.
If they buy bonds in the open market they put money in the system and the money supply increases and interest rates fall.
If they sell bondsin the open market they take money out of in the system and the money supply decreases and interest rates rise.
If they increase the money supply, MS shifts to the right, and the equilibrium interest rate falls.
If they decrease the money supply, MS shifts to the left, and the equilibrium interest rate rises.
(shifts in the money supply and changing interest rates are the most important concepts.)
INTEREST RATES AND EXPENDITURES
Rising interest rates decrease expenditures
– shift AD in.
Falling interest rates increase expenditures
–shift AD out.
The changes in interest rates work on three categories of aggregate demand.
- Consumption expenditures.
If interest rates fall borrowing money to finance the purchase of consumer durables is less expensive. Car payments are lower. Credit card balances are easier to carry.
- Investment expenditures.
The expected profits from an investment (less an allowance for risk) must be greater than the interest rate. The lower the interest rate, the less profitable the investment may be and still be attractive to the firm. Lower interest rates make firms more willing to undertake investment.
- net exports
The interest rate alters exports and imports by changing the exchange rate.
- If the interest rate fallsin Canada relative to the world, people will sell Canadian bonds and treasury bills in order to buy foreign bonds.
- To buy foreign bonds, they must sell Canadian dollars and buy foreign currency.
- The decrease in the demand for Canadian dollars drives downthe price of Canadian dollars, the exchange rate.
If the interest rate rises, the reverse happens. foreigners want to buy Canadian bonds, so they buy the Canadian dollars needed to pay for them, driving up the exchange rate.
- The fall in the exchange rate reduces the cost of exports and increases the cost of imports. As a result, exports rise and imports fall.
AD shifts to the right, that is it increases.
MONETARY POLICY AND AGGREGATE DEMAND
If the Bank of Canada believes that there is a recessionary gap in the economy or about to appear, it increases the money supply and interest rates fall.
As a result, Consumption, Investment and Net Exports increase so that Aggregate Demand shifts to the right.
Equilibrium income rises, and the economy tends to expand.
If an inflationary gap were emerging, the bank would reduce the money supply and raise interest rates.
Higher interest rates would decrease Consumption, Investment and Net Exports and result in a shift in Aggregate Demand to the left, closing any inflationary gap and removing inflationary pressures.
The advantage of monetary policy is that it can be carried out quickly, and quietly with no need for a political discussion of changing government spending, taxes or transfer payments.
The Bank of Canada’s job is to constantly monitor the Canadian economy and make small continuous adjustments to keep it near equilibrium.
The disadvantage of monetary policy is that the process of changing interest rates changing spending can take a long time and it is hard to be precisely sure how much aggregate demand will shift as a result. This problem is a bigger problem, the further from equilibrium the economy has drifted.
Right now, David Dodge is making reductions in the interest rate to compensate for the decline in aggregate demand.
Aggregate demand has declined due to the decline in exports to the U.S.
Exports have declined because of a recession in the United States and because of the rise in the value of the Canadian dollar. The dollar has risen because people are investing much less in the U.S. stock market. (Not all changes in the value of the Canadian dollar are caused by interest rates.)
With good judgement, and doubtless a bit of luck, he will get just the right amount of increase in the money supply and decline in the interest rate to keep up on an even keel. Too much, and AD may shift too far to the right. Too little, and AD may shift too far to the left. Goldilocks policy is required.