Question

As an independent governmental agency, the Bank of Canada is in charge of implementing monetary policies to achieve its major objectives. What are those objectives, and what policy tools does the Bank exercise to meet them? Explain the transition mechanisms through which changes in policy variables affect the economy. (You are welcome to “chose” the state of the economy – slumping or fast growing with a threat of inflation, and progress your policy recommendations and analysis based on your scenario. You should mention how you understand contractionary/expansionary monetary policies, the tools in the hand of the Central Banks to use, methods (OMO, inflation targeting, interest rate setting, etc. as well as the channels those changes may impact the economic indicators such as GDP, unemployment and inflation. You do not need to discuss all possible transmission mechanisms channels, just stick with one that you think is the most plausible and develop your logic.)

Answer 1

Suppose the economy is currently facing problem high price level implying a high inflation rate. Thus, the objective of Bank of Canada is to reduce high inflation through monetary policies.

For this scenario and to correct the condition of economy the bank will use contractionary monetary policy through implementing various tools which are as follows -

1) It will increase the bank rate - The rate at which commercial banks take loans from central bank. With increase in this rate, the banks will also increase their loan interest rates, which will reduce the demand for loans and hence lesser investments and consumptions will be made reducing AD. This will shift the AD lower and hence the price level will also reduce. The consequences include, reduction in investments, consumption and production growth.

2) Selling in open market operation - The bank will start selling government securities at lower prices in open market. This will make people invest in these securities and hence will left with lesser purchasing power. This will reduce the AD and thus price level.