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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 14: The AD-AS Model and Monetary Policy Prepared by: Kevin Richter, Douglas College Charlene

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Text of © 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 14: The AD-AS Model and...

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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 14: The AD-AS Model and Monetary Policy Prepared by: Kevin Richter, Douglas College Charlene Richter, British Columbia Institute of Technology
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 2 Introduction Monetary policy is one of the two main traditional macroeconomic tools to control the aggregate economy. While fiscal policy is controlled by the government directly, monetary policy is controlled by the central bank in Canada.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 3 Introduction Monetary policy influences the economy through changes in the money supply and availability of credit.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 4 Effect of Monetary Policy on the Macro Policy Model Expansionary monetary policy shifts the AD curve to the right. Contractionary monetary policy shifts the AD curve to the left.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 5 Effect of Monetary Policy on the AD/AS Model The effect of monetary policy on equilibrium income and the price level depends on whether inflationary pressures are set in motion. That in turn depends on how close the economy is to its potential income.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 6 Effect of Monetary Policy on the AD/AS Model The supply conditions of the economy are central to the effect one believes monetary policy will have on the economy.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 7 Effect of Monetary Policy on the Macro Policy Model Expansionary monetary policy increases nominal income. Its effect on real income depends on how the price level responds. % Real Income = % Nominal Income % Price Level
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 8 Effect of Monetary Policy on the AS/AD Model In Keynesian range, real income will rise with expansionary monetary policy and decline with contractionary monetary policy. The price level is unaffected.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 9 Monetary Policy When Prices are Fixed P0P0 SAS Y2Y2 Y0Y0 Y1Y1 Price level Real output Expansionary monetary policy Contractionary monetary policy AD 0 AD 1 AD 2
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 10 Monetary Policy in Intermediate Range In the intermediate range, both real income and price level change.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 11 Real output Price level Expansionary Monetary Policy in the Intermediate Range Y1Y1 P0P0 P1P1 Y0Y0 AD 1 Short-run aggregate supply AD 0
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 12 Real output Price Level YPYP LAS AD 0 SAS 0 AD 1 SAS 1 A B Expansionary Monetary Policy in the Classical Range
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 13 Duties and Structure of the Bank of Canada A central bank conducts monetary policy and acts as financial adviser to the government. Central bank a type of bankers bank.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 14 Duties and Structure of the Bank of Canada In some countries the central bank is a part of the government. In Canada the central bank is not part of the government it is a Crown corporation, not under direct day-to-day control of the federal government.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 15 Structure of the Bank The head of the Bank of Canada is the Governor of the Bank. So far the Bank of Canada has had seven governors.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 16 Structure of the Bank Monetary policy is set by the governor with the advice of his senior advisers. The Bank has a Board of Directors made up of 12 non-specialists in monetary policy.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 17 Structure of the Bank Price stability has often been the goal of monetary policy. Price stability is interpreted to mean a low and stable rate of inflation.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 18 International Considerations The design and implementation of monetary policy is affected by international considerations. Exchange rates play a critical role in the process.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 19 International Considerations An exchange rate expresses the value of one currency in terms of the value of another It tells us how many units of one currency is needed to buy one unit of another. Exchange rate can be expressed in two ways Can$1.18 can buy US$1. US$0.85 can buy Can$1.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 20 International Considerations Exchange rates matter because international trade is an important part of every economy. Monetary policy is important because it will affect international trade through changes in the money supply.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 21 International Considerations The exchange rate depends on how much of that currency is in circulation. Therefore, monetary policy cannot be set without consideration of international issues.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 22 Duties of the Bank The Bank of Canada is responsible for: Conducting monetary policy Providing central banking services Issuing bank notes Administering public debt.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 23 Duties of the Bank of Canada Conducting monetary policy is the most important job the Bank of Canada has to do. Monetary policy influencing the supply of money and credit in the economy.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 24 The Bank of Canada supervises and regulates financial institutions. It serves as a lender of last resort to financial institutions. It provides banking services to the Canadian government. Duties of the Bank of Canada
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 25 The Bank of Canada issues the nations paper currency. It provides financial services such as cheque clearing to financial institutions, such as chartered banks. Duties of the Bank of Canada
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 26 Importance of Monetary Policy Monetary policy is the Bank of Canadas most important job, and is the most-used policy in macroeconomics. The Bank of Canada conducts and controls monetary policy.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 27 Importance of Monetary Policy Actual decisions about monetary policy are made by the Governor of the Bank of Canada, with consultation with senior staff.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 28 Conducting Monetary Policy Monetary base vault cash, deposits at the Bank of Canada, plus currency in circulation. Bank reserves either vault cash or deposits at the Bank of Canada. Bank reserves are IOUs of the Bank of Canada.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 29 Conducting Monetary Policy The Bank of Canada influences the amount of money in the economy and the activities of chartered banks by controlling the monetary base.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 30 Conducting Monetary Policy Monetary policy affects the amount of reserves in the banking system. The amount of reserves affects interest rates.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 31 Conducting Monetary Policy Other things being equal, as reserves decline, interest rates rise. As reserves increase, interest rates fall.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 32 Tools of Monetary Policy The tools of monetary policy include: Changing the target range for the overnight financing rate. Cash management operations.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 33 Overnight Financing Rate All chartered banks are members of the Canadian Payments Association. Among other things, this association runs an electronic funds transfer system called the Large Value Transfer system (LVTS), where payments clear and settle daily.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 34 Overnight Financing Rate If 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 position. These loans occur in the overnight market.
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  • 2006 McGraw-Hill Ryerson Limited. All rights reserved. 35 Overnight Financing Rate The overnight financing rate is the rate of interest associated with these very short-term loans in the overnigh