ECON 110 Chapter Notes - Chapter 29: Monetary Policy, Prime Rate, Monetary Transmission Mechanism

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29. 1 how the bank of canada implements monetary. The monetary transmission mechanism describes how changes in the demand for or supply of money cause changes in the interest rate: this then leads to changes in aggregate demand, real gdp, and the price level. It therefore chooses not to implement its monetary policy in this way. Bank chooses to target the interest rate directly: the bank can more easily communicate its policy actions to the public by targeting the interest rate than by targeting the level of reserves in the banking system. The bank of canada and the overnight interest rate. Economists refer to the overall pattern of interest rates corresponding to government securities of different maturities as the term structure of interest rates. The interest rate corresponding to the shortest period of borrowing or lending is called the overnight interest rate: this is the interest rate commercial banks charge one another for an overnight loan.

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As we observed in this chapter, central banks, rather than purposefully setting the level of the money supply, usually set a target level for a short-term interest rate by standing ready to lend or borrow whatever money people wish to hold at that interest rate. (When people need more money for a reason other than a change in the interest rate, the money supply therefore expands, and it contracts when they wish to hold less.)

A. Describe the problems that might arise if a central bank sets monetary policy by holding the market interest rate constant. (First, consider the flexible-price case, and ask yourself if you can find a unique equilibrium price level when the central bank simply gives people all the money they wish to hold at the pegged interest rate. Then consider the sticky-price case.)

B. Does the situation change if the central bank raises the interest rate when prices are high, according to a formula such as R - R₀= a(P - P₀), where a is a positive constant and P₀a target price level?

C.Suppose the central bankâs policy rule is R - R₀= a(P - P₀) + u, where u is a random movement in the policy interest rate. In the overshooting model shown in Figure 15-12, describe how the economy would adjust to a permanent one-time unexpected fall in the random factor u, and say why. You can interpret the fall in u as an interest rate cut by the central bank, and therefore as an expansionary monetary action.

13. As we observed in this chapter, central banks, rather than purposefully setting the level of the money supply, usually set a target level for a short-term interest rate by standing ready to lend or borrow whatever money people wish to hold at that interest rate. (When people need more money for a reason other than a change in $4,010 $570.3 $641.0 CHAPTER 15 Money, Interest Rates, and Exchange Rates 383 the interest rate, the money supply therefore expands, and it contracts when they wish to hold less.) a. Describe the problems that might arise if a central bank sets monetary policy by holding the market interest rate constant. (First, consider the flexible-price case, and ask yourself if you can find a unique equilibrium price level when the central bank simply gives people all the money they wish to hold at the pegged interest rate. Then consider the sticky-price case.) b. Does the situation change if the central bank raises the interest rate when prices are high, according to a formula such as where a is a positive constant and a target price level? c. Suppose the central bankâs policy rule is where u is a random movement in the policy interest rate. In the overshooting model shown in Figure 15-12, describe how the economy would adjust to a permanent one-time unexpected fall in the random factor u, and say why. You can interpret the fall in u as an interest rate cut by the central bank, and therefore as an expansionary monetary action. Compare your story with the one depicted in Figure 15-13. Figure 15-12: http://gyazo.com/3d32377d42b5c9584e17b3c5e40aafaa

Figure 15-13: http://gyazo.com/1fa467e253e320f61da17532fa8d2b58

Consider an economy with a money demand curve given by Dm = 10,000 - 4000r.

a) If the money supply in the economy is 6,000, then what is the equilibrium interest rate and quantity of money?

b) If (gross) investment demand is given by ID = 20,000 - 200r, then what is the equilibrium level on investment?

c) In a private closed economy, where AE = C + Ig and C = 10,000 + 0.8 Y, what is the equilibrium level of real GDP in the immediate short run?

d) In the immediate short run, how much does real GDP change when the Bank of Canada increases the money supply from 6,000 to 7,000? Is this monetary policy contractionary or expansionary?

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ECON 110 Chapter Notes - Chapter 29: Monetary Policy, Prime Rate, Monetary Transmission Mechanism

ECON 110 Full Course Notes

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