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

Answer to Part A)

When there is an inflationary gap in the economy, the prices of goods and services begin to increase way beyond it ideally should. This creates a situation wherein the overall demand for goods and services increases beyond the capacity of suppliers to be able to provide the same. When this happens, the need of the hour is to increase the interest rates, so that consumption can go down and suppliers can then supply their goods at a reasonable rate which is acceptable to the general markets.

We can thus conclude by saying, that during an inflation cycle, as consumption levels are high, it is essential for the Bank of Canada to reverse the actions during the Corona Virus crisis which it took and increase the interest rates from here to reduce the aggregate or total demand and ease the market situation respectively.

Answer to Part B)

As we look to control the inflation of Canada, the key is to reduce the supply of money in the economy which has a direct impact on the overall consumption of people. The net effect of the increase in interest rates is as described on the supply of money.

In the above graph, we see that the interest rates are revised from I to I2 as a result of which, the supply shifts from S1 to S2 and the Quantity also changes from Q1 to Q2. Further, the equilibrium position also changes from E1 to E2.

This indicates the net effect of an increase in interest rates is that the overall supply of money in the economy is reduced and it helps in keeping the state of economy in check.

Part C)

As far as the aggregate or total demand for goods and services is considered, the same also is reduced, this is because those people who purchase on loans would need to pay extra cash for availing the

In the above graph we see that the demand for goods and services reduces and the prices also fall as a result of the interest rate measures taken by the government which have been described in the sections above.

Further, the equilibrium of demand and supply also shifts towards the left which indicates a contraction in the economy which is the desired outcome of a counter inflation policy followed by the Bank of Canada.

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