Economics 222
Sections A and C
Assignment # 3
Fall 1998
Instructors: Lawrence McDonough; Ryan Davies
1. To answer this question, you may want to refer to the Bank of Canada's website at:
http://www.bank-banque-canada.ca/english/bg-p-1.htm
a. Define the Bank Rate. (Careful! The Bank of Canada changed its definition of the Bank Rate in February 1996. The definition given in the textbook is not accurate.)
b. What is the relationship between the Bank Rate and the Prime Rate quoted by commercial banks?
c. Find the latest reported Bank Rate and Prime Rate in the Globe and Mail.
d. How does the Canadian Prime Rate compare with the U.S. Prime Rate?
2. Suppose Canada has the following balance of payments data (in billions):
Find the following (show all calculations):
a. Merchandise trade balance
b. Net exports
c. Current account balance
d. Official settlements balance
e. Statistical discrepancy
3. What happens to M1 and M2+ as a result of each of the following changes?
a. You take $500 out of your chequing account and put it into a passbook savings account.
b. You take $1000 out of your chequing account and put it into a current account.
c. You take $1500 out of your money market mutual fund and deposit into your chequing account.
d. You cash $2000 in savings bonds and invest the money in a certificate of deposit.
4. Define velocity. Discuss the role of velocity in the quantity theory of money.
5. Suppose the money demand function is given by Md / P = 1000 + 0.2Y - 1000 i.
a. Calculate velocity if Y = 2000 and i = 0.10.
b. If the money supply (Ms) is 2600, what is the price level?
c. Now suppose the nominal interest rate rises to 0.15, but Y and Ms are unchanged. What happens to velocity and the price level? So if the nominal interest rate were to rise from 0.10 to 0.15 over the course of a year, with Y remaining at 2000, what would the inflation rate be?
6. a. Discuss four possible problems with using leading indicators to forecast recessions.
b. Consumer expenditures on durable goods such as cars and furniture, as well as purchases of new houses, fall much more than expenditures on on non-durable goods and services during recessions. Why do you think that is?
7. a. From Statistics Canada (http://www.statcan.ca/english/econoind/indic.htm), report the latest monthly change in:
Be sure to include the month of the latest reported period, the value of the statistic, and the monthly change.
b. Describe each statistic (from part a) as leading, lagging, or coincident.
c. Based on these observations, what stage of the business cycle do you believe that we are presently in? (i.e. expansion, peak, recession, trough, or recovery). Defend your decision by referring to the data that you have collected.
Answers:
1. a) Define the Bank Rate. <10 points>
The Bank Rate is the main "lever" that the Bank of Canada uses to conduct
monetary policy.
The Bank Rate is adjusted from time to time to help ensure a low-inflation
environment favorable for long-lasting growth and job creation.
The Bank Rate is the rate of interest that the Bank of Canada charges on
short-term loans to financial institutions. The Bank Rate is an important
tool because it is seen as the trend-setter for other short-term interest
rates.
A fall in the Bank Rate signals that the Bank of Canada would like to see
lower short-term interest rates in the economy.
A rise in the Bank Rate is a signal in the other direction.
Changes in the Bank Rate often lead to changes in the prime rate, which
is the rate of interest that commercial banks charge to their lowest-risk
customers. Other rates that can be affected include those charged to borrowers
for mortgage, car, and business loans, as well as rates paid to
savers on deposits and investment certificates.
Higher interest rates mean that people are likely to borrow less, spend
less, and save more. This reduces the amount of money in circulation and
acts as a brake on inflation. Lower interest rates encourage borrowing and
spending, and increased economic activity.
Changes in the Bank Rate and other shorter-term rates are not always
reflected in longer-term rates. For example, the 1 October 1997 increase
in the Bank Rate was followed by declines in longer-term interest rates,
as well as in the 5-year mortgage rate. This was widely seen as a result
of strengthened confidence that inflation would remain low.
Setting the Bank Rate
The Bank Rate is related to the "overnight lending rate." This is the
rate at which major participants in the money market borrow and lend
one-day funds to each other.
For example, if a commercial bank needs funds to cover the transactions
at its branches during the day, it can borrow from the Bank of Canada at
the Bank Rate, or on the overnight financing market from a participant
that has excess funds. The rate charged for this one-day loan is the
overnight rate.
The Bank of Canada establishes a range -- called the operating band --
in which the overnight lending rate can move up or down. The band is half
a percentage point wide and the Bank Rate is always set at the upper limit
of this band. For example, when the operating band is from 3.00 to 3.50
per cent, the Bank Rate is set at 3.50 per cent. The upper and lower
limits are the rates at which the Bank of Canada will respectively offer
financing for investment dealers or borrow funds from financial
institutions to ensure that the overnight rate stays within the band.
By changing the operating band and thus the Bank Rate, the central bank
sends a clear signal about the direction that it would like shorter-term
interest rates to take.
<From the Bank of Canada Website, July 1998>
b) The Bank rate is the rate of interest that the rate of
interest that the Bank of Canada charges on short-term loans to financial
institutions. The prime rate is the basic rate that chartered banks and
trust companies charge on loans to their best customers. Both are
administered rates. <5 points>
c)
d)
2.
Merchandise trade balance <3 points>
= merchandise exports - merchandise imports
= 267 - 233 = 34
Net exports <3 points>
= (merchandise exports + foreign travel in Canada + foreign
purchases of Canadian services) - (merchandise imports + Canadian travel
abroad + Canadian purchases of foreign services)
= (267 + 12 + 27) - (233 + 15 + 33)
= 306 - 281 = 25
Current account balance (CA) <3 points>
= (267 + 12 + 27 + 18 + 1) - (233 + 15 + 33 + 33)
= 325 - 314 = 11
Capital account balance (KA)
= (30 - 36) = -6
Official settlements balance <3 points>
= 5 - 4 = 1
Statistical discrepancy: <3 points>
CA + KA + SD = 0
11 - 6 + SD = 0
SD = -5
3. What happens to M1 and M2+ as a result of each of the following changes?
a) You take $500 out of your chequing account and put it into a passbook savings account.
-- M1 falls $500, M2+ is unchanged. <2.5 points>
b) You take $1000 out of your chequing account and put it into a current account.
-- M1 and M2+ are both unchanged. <2.5 points>
c) You take $1500 out of your money market mutual fund and deposit into your chequing account.
-- M1 rises $1500, M2+ is unchanged. <2.5 points>
d) You cash $2000 in savings bonds and invest the money in a certificate of deposit.
-- M1 is unchanged, M2+ rises $2000. <2.5 points>
4. Define velocity. < 5 points >
Velocity measures how often the money stock "turns over" each period. Specifically, velocity is nominal GDP (the price level P times real output Y) divided by the nominal money stock M. If we let V represent velocity,
V = PY / M
If velocity rises, each dollar of the money stock is being used in a greater dollar volume of transactions in each period, if we assume that the volume of transactions is proportional to GDP.
Discuss the role of velocity in the quantity theory of money. < 5 points >
The concept of velocity comes from one of the earliest theories of money demand, the quantity theory of money. The quantity theory of money asserts that real money demand is proportional to real income, or
Md / P = kY
where Md / P is real money demand, Y is real income, and k is a constant. The real money demand function L (Y, r + pie) takes the simple form kY. This way of writing money demand is based on the strong assumption that velocity is a constant 1 / k, and doesn't depend on income or interest rates.
5.
a) V = PY/M = Y/(M/P). From the money demand function, M/P = 1300.
b) P = Ms / (Md / P) = 2600 / 1300 = 2 < 5 points >
c) Now Md / P = 1250. So V = 2000/1250 = 1.6. P = Ms / (Md / P) = 2600 /
1250 = 2.08.
6.
a) Although the leading indicators seems to be useful for forecasting the future state of the economy, there are a number of problems in using them. First, the data is usually revised, sometimes substantially, so a signal from the leading indicators may be reversed later. Second, they sometimes give incorrect signals. Third, they don't provide much information on the severity or exact timing of the coming recession. Finally, structural changes in the economy mean the set of indicators must be revised periodically. <10 points>
b) Expenditure on durable goods is more sensitive to the business cycle than expenditure on non-durable goods and services, because people can more easily change the timing of their expenditure on durables. When economic activity is weak, and people face the danger of losing their jobs, they avoid making durable goods purchases. Instead, they may drive their cars a little longer before buying new ones, get the old washing machine repaired instead of buying a new one, and put off buying new furniture until a new expansion indicates greater income security. So in a recession, durable purchases decline a lot, but when an expansion begins, durable purchases pick up substantially. <5 points>
7. a) and b) <10 points>
Composite Index of Leading Indicators:
September 1998 207.2 +0.0% <leading>
U.S. Composite Index of Leading Indicators:
August 1998 225.8 +0.0% <leading>
Business Investment (Machinery and equipment):
2nd quarter 1998 62.3 +5.4% <coincident>
New motor vehicle sales:
August 1998 120.1 -1.2% <coincident>
Housing Starts:
August 1998 137.3 11.6% <leading>
Gross Domestic Product (at market prices):
Nominal: 2nd quarter 1998 887.6 +0.6% <coincident>
Real: 2nd quarter 1998 826.9 +0.3%
Toronto Stock Exchange 300 Index:
September 1998 5,614.12 1.51% <leading>
Consumer Price Index:
September 1998 108.6 -0.2% <lagging>
Unemployment rate:
September 1998 8.3 0.0% <coincident>
Participation rate:
September 1998 65.2 0.3% <coincident>
c) Any reasonable answer will be accepted. Your answer should be defended by referring to the data collected above. <5 points>