Question

Due to Covid – 19 Pandemic that caused economics crisis, Bank of Canada had cut interest rates; and it is likely to announce further cuts even if interest rates went into negative territory;

If we assume that, because of the actions of Bank of Canada, the economy is fully recovered to the extent that it developed an inflationary gap.

1. After this recovery that developed an inflationary gap, is Bank of Canada going to increase or decrease the interest rates?

2. Based on your answer to (a) above, and with the aid of an appropriate labeled diagram, show the effect on the money supply.

3. With your understanding of the monetary transmission mechanism and assuming an open economy, explain how the Central Bank of Canada’s actions affect the various components of Aggregate Demand, and, ultimately the equilibrium price level and real GDP?  Use the appropriate labeled diagrams to help explain your answers.

Answer 1

Introduction:-

Rate cuts or interest rate reductions are made, primarily with a view of increasing liquidity in a country which takes place during a recession. During a recession, the total demand for goods and services remains low as is widely seen in the economy due to the Corona Virus crisis. As establishments remain shut, people are shying away from consuming more goods and services and are looking to rather not spend more money in this environment. To control the same, the Bank of Canada which is the supreme banking agency looks to overturn the same by interest rate reductions.

Once, the recession is over, and in return inflation increases and the prices of goods and services begin to increase, the following steps need to be taken to ensure economic stability and are explained in detail as follows:-

Case Specifics:-

A)

After the recovery is over and inflation takes over the economy, the flow of money in circulation is high. This leads to an increase in the aggregate or total demand for goods and services which must be reduced to maintain economic stability. For this it is essential to increase the interest rates and ensure that these are not reduced any further.

An increase in the interest rates, discourages spending as loans become more expensive for mass population and this ensures that the inflation can remain in check.

When the Central Bank increases interest rates for banks, the same is passed over to the end consumer. Then, the consumers incentive to take a loan is relatively lowered down and he becomes reluctant to demand more which corrects the inflationary gap in the economy.

Part B)

As inflation in the economy which is the rise in prices of all goods and services increases, the Central Bank looks to revise interest rates to have a direct reduction in the supply of currency and control markets, prices and total supply in the country as much as possible. This is illustrated in the following diagram for money supply:-

In the above graph, we see that the interest rates are increase and the initial equilibrium shifts to the new equilibrium and the quantity of money supply is reduced. Due to the same, the demand also reduces and the economy returns back to its normal state over a period of time.

Part C)

Due to the above correction in Interest Rates, the Aggregate demand for goods and services begins to decline sharply. This pushes the prices to be lower than they used to be and corrects the inflation that exists in the economy. A graph which will help in explaining the same is as follows:-

In the graph above, we see that the initial price is reduced due to a shift in the Initial Demand to the Reduced Demand. As a result of which the quantity demanded is lesser and the supply also shifts downwards from the intersection between Initial Price and Demand to Reduced Price and Reduced Demand respectively.

This happens, as loans become expensive and it is difficult for people to be able to consume more during this time period.  

Please feel free to ask your doubts in the comments section.