Question

Again, on March 27th, 2020, The Bank of Canada decreased its target for the overnight interest rate to 0.25 percent "to provide support to the Canadian financial system and the economy during the COVID-19 pandemic." The decrease in interest rates is an example of an expansionary monetary policy. Assume a closed economy.

In three steps, describe the channels, the monetary transmission mechanism, through which this change in policy leads to a shift of the aggregate demand curve (Hint: AD-AS model)

Explain what happens to aggregate demand, real GDP, and the price level?

Answer 1

The lowering of the interet rate by The Bank of Canada is meant to add a boost to the aggregate demand in the closed economy in the following mechanism:

1. The lowering of interest rate will reduce the cost of borrowing in the economy

2. This will add incentive to the investors to take more loans and increase the amount of investment; consumption demand will also rise due to the cheaper loans available to the consumers, enabling them to buy from the market in credit

3.The amount of liquidity in the system will increase with a multiplier effect ; which can help the economy in times of reduced economic activity due to the epidemic.

The money held has deposits with the bank will go back to the investors and through multiplier effect, it will create a surge of liquidity in the system. This increased liquidity will then add to the purchasing power of the public.

This means that the aggregate demand will rise. Considering an AD-AS model, the downward sloping aggregate demand curve will shift to the right. As a result the real GDP, which is a measure of real economic output will increase. However, the injection of liquidity in the system will result in an increase in the price level in the economy.

OUTPUT (Y) = C + I + G

C and I (private investment) will increase leading to higher output.

However, a word of caution:
In this scenario it may so happen that the increase in money supply from the liquidity injected into the system might not be able to push the level of real output in the economy due to the constraints placed by the epidemic and thus, it can cause a demand pull inflation resulting in increase in the price level.