10: Central Banking and Monetary Policy

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On January 21, 2015 Stephen Poloz, the Governor of the Bank of Canada, announced a cut in the Bank's key monetary policy rate, the overnight rate, from 1.00% to 0.75%. The Bank wanted provide monetary stimulus to offset the negative growth rate and inflation rate effects of the sharp drop in oil prices. A further cut in the overnight rate to 0.50% followed on July 15, 2015. The Bank's forecast for growth and inflation in Canada had been revised downward based on weakness in the international economy, particularly the slowdown in growth in China and declining commodity prices. Although growth in real GDP was stronger in 2016 the output gap remained at an estimated 1.25% to 0.25% based on estimation procedures. The Bank of Canada in its April 2017 Monetary Policy Report, expecting slow economic growth and stable inflation beyond the first half of 2017, maintained the 0.50% overnight rate. These are recent examples of monetary policy decisions by the Bank of Canada to defend its inflation rate target and support the economy's growth rate.

This chapter examines the role of the central bank. The central bank is responsible for monetary policy. Its monopoly control of the supply of cash, or monetary base, gives it a powerful influence in financial markets. Sometimes the central bank controls the monetary base to control the supply of money. Other times it controls short-term interest rates. In either case, central bank actions are designed to affect inflation, output, and employment. They work through the transmission mechanism that links monetary policy to aggregate demand, as we discussed in the last chapter.