Financial Institutions and monetary policy
Solution Assignment 3
Due March 27, 2017
Winter 2017,
Finainst_assign_3_win_2017,
30/03/2017 4:16 PM
Professor Hassouna Moussa
Instructions:
Attempt the following exercises. Justify you answers
Exercise 1
a)
Can the Bank of Canada BC influence economic activity and inflation by the mere control of the
overnight rate which is a very short run interest rate when investment in housing and in all
productive industries depend on long term borrowing?
Expectation theory of interest rates states
The yield (interest rate) on a longterm bond is equal to the average of the shortterm interest rates
that people expect to occur over the life of the longterm bond.
This implies that BC can control short and long nominal interest rates by merely controlling the very
short term overnight rate of the money market.
Since Expected inflation rate is steady = target inflation rate and Expected real interest rate =
nominal interest rate
–
Expected inflation rate, it follows that by controlling nominal interest rates BC
can also control expected real interest rates.
Housing investment and other investments in physical capital depend on long term real interest rates.
It follows that BC can influence investment and hence economic activity by simply controlling the
overnight rate if it can keep the inflation rate close to the target inflation rate so that the expected
inflation rate = target inflation rate.
b)
Compare the ways the Bank of Canada and the US Federal Reserve Board control inflation and
interest rates
BC has a 2% target for the inflation rate and its monetary policy consists in keeping the inflation rate
inside a twopercentage band centered at the target inflation rate. The FED (Federal Reserve Board)
has a target inflation rate of 2% but it has no commitment to keep the inflation rate within a band.
Associated with the target inflation both central banks estimate a target rate for the money market
rate (overnight rate for BC and federal funds rate of the FED. BC promise to keep the overnight rate
within 0.5% band centered on the target rate. The FED fixes the deposit rate as a lower bound for the
federal funds rate and its upper bound is the discount rate. BC does not change the width of the band
but the FED does by changing the discount rate.
They both rely on the expectation theory of the interest rates to control economic activity. High
economic activity is associated with a higher inflation rate. Both central banks try to control total
Money supply or lending by manipulating bank reserves or the monetary base and the overnight rate.
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 Monetary Policy

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