Question

You are asked to analyze the effect of the Bank of Canada's new interest rate policy on housing prices. Using a comparative static experiment, describe the steps you need to follow to produce a sound theoretical macroeconomic analysis.

Answer 1

The decision of bank of Canada to keep interest rate at a historical record level of 0.25% can have a significant impact on housing market in Canada.

The interest rate are single most important factor that determine the demand for housing. Since buyers usually finance their houses through loans and on which they have to pay interest rate. So a higher interest rate means higher cost of buying a house and similarly low interest rate would mean lower cost of buying a house.

So the decision of bank of Canada to keep interest rate at 0.25% can significantly increase the demand for housing.

In the above diagram we have the supply and demand for housing in price and quantity space. The supply curve for housing is upwards sloping as we should expect since higher price would motivate builders to provide more houses. And the demand curve is downwards sloping means lower price means higher demand.

The original supply and demand curve is represented by SS and D(r) curves as shown, and the equilibrium is at point A. Where the equilibrium housing price is at P* and equilibrium number of houses is at Q*.

But after the decline in interest rate r to historical low level represented by r' we should expect the demand curve for housing to shift to the right to D'(r') which is representing higher demand at lower interest r' < r. And note the new equilibrium is at point B, where the new equilibrium price is at P' which is higher than P*, P' > P* and the new equilibrium quantity of housing or equilibrium number of housing is at Q' which is also higher than Q' > Q*.

So this is what is most likely effect of bank of Canada's new interest rate policy on housing prices.