Question

Suppose you are the governor of the Bank of Canada and the economy is experiencing a sharp rise in the inflation rate. What actions would you take in:

a. open-market operations

• sell bonds

• buy bonds

• make advances to the chartered banks

• change the overnight lending rate

b. the bank rate

• raise the rate

• lower the rate

• set the rate at the lower bound of the Bank of Canada's operating band for the overnight lending rate

• set the rate lower than the publicized target on the overnight lending rate

c. The changes outlined above would affect chartered bank cash reserves and influence the money supply by

• reducing the lending ability of the banking system by reducing cash reserves and the money supply. The result would be to increase the real interest rate, reduce investment spending, reduce aggregate demand, and reduce inflation.

• increasing the lending ability of the banking system by increasing cash reserves the money supply. The result would be to increase the real interest rate, reduce investment spending, reduce aggregate demand, and reduce inflation.

• reducing the lending ability of the banking system by reducing cash reserves and the money supply. The result would be to decrease the real interest rate, decrease investment spending, decrease aggregate demand, and reduce inflation.

• increasing the lending ability of the banking system by increasing cash reserves and the money supply. The result would be to decrease the real interest rate, increase investment spending, increase aggregate demand, and increase inflation.

Answer 1

Answer A.

The correct option is - Sell Bonds

Answer B.

The correct option is - Raise the Rate

Answer C.

The correct option is - Reducing the lending ability of the banking system by reducing cash reserves and the money supply. The result would be to increase the real interest rate, reduce investment spending, reduce aggregate demand, and reduce inflation.

Explanation -

The policy outlined in the three answers is contractionary monetary policy by the central banks. When the central bank sells bonds in the open markets, banks buy the bonds and excess liquidity is absorbed by the central bank. Similarly, the bank rate is the rate at which the central bank lends money to the commercial banks. When the bank rate is increased, commercial banks borrow less from the central bank.

Both the policy actions translate into lower liquidity in the banking system and with less liquidity, the cost of money (interest rate) trends higher. As interest rates move higher, leveraged consumption and investment spending declines in the economy. The aggregate demand curve shifts to the left on a relative basis and this implies slightly lower output in the economy coupled with lower price levels. Therefore, inflation is curbed.