Question

Describe the steps from the time Bank of Canada lowers the bank rate to the time real GDP and the price level will increase or decrease. In order to earn full marks, each description must fit the correct order of the steps.

Answer 1

The bank rate is the interest rate at which commercial banks borrow from the Central Bank.

When the Central Bank lowers the bank rate, it means now central banks can borrow funds at a cheaper rate. Thus, they respond by borrowing more.

As commercial banks borrow more, they are now abundant with liquidity.

This excess liquidity means now they can lower their interest rates - the rate at which commercial banks offer loans to consumers and producers. (As a side effect, the interest rate on savings is also reduced)

Now that consumers and producers are able to borrow more money at cheaper rates, this gives them an incentive to do so. This increases the level of consumption and investment in the economy.

Now, at equilibrium, Y = AD = C + I + G + NX

Here, Y refers to GDP, AD is aggregate demand, C is consumption, I is investment, G is government expenditures and NX is net exports.

In reality, lower interest rates makes borrowing easier for the government as well as the export-import activities.

So, consumers, producers and the government, start borrowing more, and spending more money. Economic activity begins to rise. In effect, GDP gets increased, due to all these factors.

At the same time, lower interest rates raise AD, while AS may not increase simultaneously. It takes time for the supply side factors to increase.

This leads to a phase where demand exceeds supply, and thus the price level will begin to rise.

In summary, due to the lowering of the bank rate, AD rises, GDP rises, and price level also rises.