Solution Finainst_assign_3_win_2017.pdf

Solution Finainst_assign_3_win_2017.pdf - Financial...

Info icon This preview shows pages 1–2. Sign up to view the full content.

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 long-term bond is equal to the average of the short-term interest rates that people expect to occur over the life of the long-term 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 two-percentage 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.
Image of page 1

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

Image of page 2
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern