Question

Explain the economics of: i) how and why the equilibrium Canadian interest rate (R_$) changes in response to the change in monetary policy adopted by the Bank of Canada; and ii) how and why that change in interest rate brings the Canadian money market (shown in the bottom panel) back into equilibrium.                             

Answer 1

Bank of Canada is the Central bank of the country, responsible for formulating country's monetary policy.

The Central Bank is mandated to keep prices stable by keeping inflation in check ( mostly below 2% ) and ensuring a condition that helps economic growth in the country.

Interest rate is the main instrument available with the central bank to change money supply in the economy. When supply of money increases interest rate decraeses as cost of borrowing goes down, and when supply of money decreases interest rate rises leading to higher cost of borrowing.

Let us take an example:-

If the inflation or price level right now in Canada is -0.2%. However, due to pandemic people are not spending money. Current benchmark interest rate is 0.25%. In order to encourage increase in spending by consumers across the country, the Central Bank may further decrease the main policy rate of interest from 0.25% to 0%. Main policy rate is the policy rate at which central bank lends money to the commercial banks, or it is the interest rate that a bank charges on overnight credit facility to another bank. Fall in borrowing cost due to fall in interest rate will encourage people to borrow more money than before leading increase in consumer spending. As consumers spend more than before prices will increase as well leading to an increasing inflation rate.

Therefore, it is the interest rate which the central bank uses to control money supply in the economy.