Question

The bank of Canada is concerned about the current COVID-19 financial crisis and decided to decrease its key interest rate to 0.25%.

a) with the aid of an appropriate diagram show the change in money supply

b) with your understanding of the monetary transmission mechanism and assuming an open economy how the bank of Canada actions effect the various components of AD and ultimately the equilibrium price level and real GDP ?

use the appropriate diagram to help explain your answers

can someone answer this question ?

Answer 1

The Current Corona Virus crisis is causing deep distress among economists as well as planners alike. As establishments remain shut, and consumers have stopped demanding for goods other than essential commodities. The net outcome expected from the same is a spike in unemployment and a serious reduction in the gross domestic product, which is the final value of goods and services produced by a nation over a period of a year usually. This would happen for Canada as well as the rest of the world.

With a view to correct what is happening in Canada, the Interest Rates which are charged from the commercial banks have been reduced to 0.25% which in turn would mean that the interest rates charged by commercial banks would also decrease drastically. Its net effects on the Aggregate Demand and Supply of currency in the market place is as described.

Part A)

The following graph depicts what would happen to the supply curve for money as the interest rates are lowered.

In the above graph, we see that the Interest Rates have reduced from initial to reduced interest rates. The currency in circulation has thus increased from Initial Quantity to Increased Quantity and the equilibrium has also shifted from Initial Equilibrium to Increased Equilibrium. The shift in the supply curve has also been indicated which clearly depicts an increase.

Further, the New Equilibrium suggests that the demand for money has also grown. As interest rates are revised and reduced, the incentive of people to borrow from banks increases. This has a huge impact on the state of the economy, as consumers start purchasing more goods and services at a cheaper rate, whereas producers begin to expand operations at a lower interest rate respectively.

Part B)

As explained above, consumers begin to demand more goods and services as the interest rates are lowered down. This leads to an increase in Aggregate Demand for goods and services which can be indicated through the help of the following graph: -

In the above graph, we see that the aggregate demand rises and shifts the equilibrium towards the right. The Price also increases as a result from the initial price to the increased price and the quantity has also been shown to increase respectively.

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