The AD-AS Model and Monetary Policy

1 The AD-AS Model and Monetary PolicyChapter 142 IntroductionnMonetary Policy is one of the two main traditional macroeconomic tools to control the aggregate fiscal Policy is controlled by the government directly, Monetary Policy is controlled by the central bank in policyinfluences the economy through changes in the money supply and availability of of Monetary Policy on the Macro Policy ModelnExpansionary Monetary Policy shifts the AD curve to the Monetary Policy shifts the AD curve to the of Monetary Policy on the AD/AS ModelnThe effect of Monetary Policy on equilibrium income and the price level depends on whether inflationary pressures are set in depends on how close the economy is to its potential of Monetary Policy on the Macro Policy ModelnExpansionary Monetary Policy increases nominal

2 Effect on real income depends on how the price level Real Income = % Nominal Income % Price Level6 Effect of Monetary Policy on the AS/AD ModelnIn Keynesian range, real income will rise with expansionary Monetary Policy and decline with contractionary Monetary price level is Policy When Prices are FixedP0 SASY2Y0Y1 PricelevelReal outputExpansionary Monetary policyContractionary Monetary policyAD0AD1AD28 Monetary Policy in Intermediate RangenIn the intermediate range, both real income and price level outputPrice levelExpansionary Monetary Policy in the Intermediate RangeY1P0P1Y0AD1 Short-run aggregate supplyAD010 Monetary Policy in Classical RangenOnly the price level will change since the economy is at outputPrice LevelYPLASAD0 SAS0AD1 SAS1 ABExpansionary Monetary Policy in the Classical Range12 Duties and Structure of the Bank of CanadanA central bank conducts Monetary Policy and acts as financial adviser to the bank a type of bankers and Structure of the Bank of CanadanIn some countries the central bank is a part of the Canada the central bank is not

3 Part of the government it is a Crown corporation , not under direct day-to-day control of the federal of the BanknPrice stability has often been the goal of Monetary stability is interpreted to mean a low and stable rate of ConsiderationsnThe design and implementation of Monetary Policy is affected by international rates play a critical role in the ConsiderationsnAn exchange rateexpresses the value of one currency in terms of the value of anotherqIt tells us how many units of one currency is needed to buy one unit of rate can be expressed in two waysCan$ can buy US$ $ can buy Can$ ConsiderationsnExchange rates matter because

4 International trade is an important part of every Policy is important because it will affect international trade through changes in the money ConsiderationsnThe exchange rate depends on how much of that currency is in , Monetary Policy cannot be set without consideration of international of the BanknThe Bank of Canada is responsible for:qConducting Monetary policyqProviding central banking servicesqIssuing bank notesqAdministering public of the Bank of CanadanConducting Monetary Policy is the most important job the Bank of Canada has to Policy influencing the supply of money and credit in the Bank of Canada supervises and regulates financial serves as a lender of last resort to financial provides banking services to the Canadian of the Bank of Canada22nThe Bank of Canada issues the nation s paper provides financial services such as cheque clearing to financial institutions.

5 Such as chartered of the Bank of Canada23 Importance of Monetary PolicynActual decisions about Monetary Policy are made by the Governor of the Bank of Canada, with consultation with senior Monetary PolicynMonetary base vault cash, deposits at the Bank of Canada, plus currency in reserves either vault cash or deposits at the Bank of reserves are IOUs of the Bank of Monetary PolicynThe Bank of Canada influences the amount of money in the economy and the activities of chartered banks by controlling the Monetary Monetary PolicynMonetary Policy affects the amount of reserves in the banking amount of reserves affects interest Monetary PolicynOther things being equal, as reserves decline, interest rates reserves increase, interest rates of Monetary PolicynThe tools of Monetary Policy include.

6 QChanging the target range for the overnight financing management Financing RatenAll chartered banks are members of the Canadian Payments other things, this association runs an electronic funds transfer system called the Large Value Transfer system (LVTS), where payments clear and settle Financing RatenIf financial institutions have surplus balances resulting from the clearing process at the LVTS, they can loan them on a very short term basis to those members who are in deficit loans occur in the overnight Financing RatenThe overnight financing rateis the rate of interest associated with these very short-term loans in the overnight Financing RatenThe Bank of Canada has a target range for the overnight financing rate it falls between the bank rate (maximum)

7 And the rate at which the Bank will pay the LVTS participants who want to leave their surplus funds with the Bank of Canada (minimum).33 Overnight Financing RatenChanges in the overnight financing rate influence all other rates through the term structure of interest rates the structure of yields on financial instruments with similar characteristics, but different terms to Financing RatenArbitrage the buying and selling of similar goods and services across different markets provides the link between interest rates on dissimilar Financing RatenThe bank rate is the interest rate charged on advances from the central Financing RatenThe main tool of Monetary Policy in Canada is the target range for the overnight financing the target range for the overnight financing rate is increased, Aggregate Demand will decreasing the target range.

8 Aggregate Demand will the Target RangenAn increase in the target range makes it more expensive for banks to borrow from the Bank of decrease in the target range makes it less expensive for banks to borrow from the Bank of Management OperationsnCash management is the second major tool of Monetary Policy in Management OperationsnCash management techniques include:qvarious open market operations -buying and selling of government bonds and transfer of government deposits between chartered banks and the Bank of Market OperationsnOpen market operationsare the Bank of Canada s buying and selling of federal government Market OperationsnTo expand money supply, the Bank of Canada buys contract money supply, the Bank of Canada sells Market PurchasenAn open market purchase is an example of expansionary Monetary Monetary policyis a Monetary Policy that tends to reduce interest rates and raise Market PurchasenWhen the Bank of Canada buys bonds.

9 It deposits the money in federal government accounts at a cash reserves rise, encouraging banks to lend out the money supply Market SalenAn open market sale is an example of contractionary Monetary Monetary policyis a Monetary Policy that tends to raise interest rates and lower Market SalenIn return for the bond, the Bank of Canada receives a cheque drawn against a bank s reserve assets are reduced and money supply Prices and Interest RatesnThe Bank of Canada raises the demand for bonds when it buys bonds in an open market purchase. nBond prices rise and interest rates , bond prices and bond interest rates are inversely of a bond0 Quantity of bondsOpen Market Purchase48 Bond Prices and Interest RatesnThe Bank of Canada increases the supply of bonds when it sells bonds in the open prices fall and interest rates of a bond0 Quantity of bondsOpen Market SaleS150 government DepositsnA transfer of government deposits from the chartered banks and other financial institutions to the Bank of Canada reduces the amount of liquidity in the banking puts upward pressure on interest DepositsnA transfer of government deposits from the Bank of Canada to the chartered

10 Banks and other financial institutions increases the amount of liquidity in the banking puts downward pressure on interest Policy in the AD/AS ModelnIn AD/AS Model , Monetary Policy works primarily through its effect on interest Monetary PolicynThe Bank of Canada decreases the money interest rates go interest rates go up, the quantity of investment goes Monetary PolicynAs investment goes down, aggregate demand goes aggregate demand and income go down by a multiple of the decrease in Monetary PolicynThe AD curve shifts to the left by a multiple of the shift in and output i I Y 56 Contractionary Monetary Policy When Prices are FixedM i I Y AD1AD0Y1Y0P0 SASP rice level0 Real income IInitial shiftMultiplier effect57 Expansionary Monetary PolicynExpansionary Monetary Policy works in the opposite i I Y 58 Expansionary Monetary Policy When Prices are FixedM i I Y AD0AD1Y0Y1P0 Aggregate supplyPrice level0 Real incomeMultiplier effect IInitial shift59 Emphasis on the