Question

2. Consider an open economy where the monetary authorities increase the money supply.

a) What are the instruments available for the Bank of Canada to conduct Monetary Policy? Discuss each of these in context and the practical applications thereof.

b) Explain how targeting the money supply and targeting the overnight rate work in practice. Why does the Bank of Canada prefer targeting the overnight rate?

c) Using an appropriate graphical representation, describe the monetary transmission mechanism as it pertains to the Bank of Canada lowering the overnight rate.

d) Why is it the case that it is better for monetary policy to work in tandem with fiscal policy than as a standalone policy?

Answer 1

a) a) The instruments available for the Bank of Canada to conduct Monetary Policy are open market operations - where the bank can choose the to purchase and sell government securities, reserve requirement ratio - amount which banks have to keep with the federal bank as obligation and discount rate - the minimum rate of interest at which central bank lend to other banks.

b) Overnight rate refer to the interest rate that banks use to borrow and lend from one another. Targeting money supply work through the instruments that central banks have in hand. The overnight rate is targeted by central banks by changing Bank's policy in someway or other.  

c) The monetary transmission mechanism works with increasing the amount of money with banks and leading to fall in interest rate with a rightward shift in investment curve with some time passing on the interest rate will rise up along the new investment curve as shown in the diagram.

d) It is important that monetary policy work in tandem with fiscal policy because a change in monetary policy lead to an increase or decrease in interest rate this increase or decrease in interest rate lead to fall or rise of investment and saving if monetary policy does not work in tandem with fiscal policy then all the effects of monetary policy can go away with a rise or fall in inestment in the economy.