Assignment 2 Economia monetaria

Supply and demand analysis of the market for reserves in Canada

1. Using the supply and demand analysis of the market for reserves in Canada, draw a diagram to indicate what happens to the overnight interest rate, borrowed reserves, and nonborrowed reserves, holding everything else constant, under the following situations.

• The economy is surprisingly strong, leading to an increase in the amount of chequable deposits.
• The Bank of Canada raises the target overnight interest rate.

Quantitative easing and credit easing

2. Briefly explain the difference between Quantitative Easing and Credit Easing.

Quantitative Easing consists in the expansion of central bank balance sheets which leads to a huge increase in the monetary base and therefore money supply. Nonetheless, there are a few reasons why it is not certain that it could work.

Firstly, the increase in monetary base just flowed into holdings of excess reserves. Furthermore, the expansion could lower short-term interest rates and could not stimulate the economy because the federal funds rate had already fallen to the effective zero lower bound. Lastly, an increase in monetary base does not necessarily imply there will be an increase in banks’ lending.

The Bank of Canada focuses more on Credit Easing which can be defined as altering the composition of the Bank of Canada’s balance sheet in order to improve the functioning of particular segments of the credit markets.

This action has multiple consequences. Firstly, providing liquidity to a particular segment of the credit market can help unfreeze the market which will become able to allocate capital to productive uses. In addition, securities become more attractive after they are purchased by the central bank, thus lowering the interest rates and stimulating spending.

Overnight interest rate and non-borrowed reserves targets

3. Draw diagrams to illustrate and explain why the Bank of Canada cannot achieve overnight interest rate target and non-borrowed reserves target simultaneously when the demand for reserves fluctuates.

Keynesian view of the demand for money

4. Why does the Keynesian view of the demand for money suggest that velocity is unpredictable?

Keynes developed a theory of money demand that highlights the importance of interest rates: the liquidity preference theory. There are three main reasons why velocity is not a constant.

Firstly, he recognized that payment technology (new methods of payment) could also affect the demand for money, thus as it advances, the demand for money would be likely to decrease relative to income.

Secondly, people hold money as a precaution against unexpected opportunities. Therefore, precautionary money balances is also proportional to income.

Lastly, people hold money as a store of wealth as money earns no interest and its opportunity cost is the nominal interest rate on bonds (i). An increase in i results in an increase in money’s opportunity cost and a decrease of th