Question

Recently the Bank of Canada has come under significant pressure to not raise interest rates in order to “help” the economy. Hint: Assume Canada is a closed economy.

a) For these groups, including some Canadian chartered banks, to request this action, what must these parties be assuming about the present economic performance of Canada? Explain in words only. Your answer should focus on the present level of real GDP, employment & unemployment.

b) Suppose the Bank of Canada listens to some of this advice and it decides to lower the interest rate. This means that part b is a continuation of part a. Using words and one IS/LM diagram explain how the bank would do this and what impact this impact this would have on real GDP, consumption, investment, the real interest rate, employment, unemployment, and the real money supply in the short-run.

c) If the Bank of Canada were to undertake this change of policy (in part b) what would the long-run impact of this be on inflation and/or deflation for the economy? That is would the rate of inflation (or deflation) go up, down or stay the same in the longer term as a result of this policy? Use one AS/AD diagram to help answer this sub-question – on this diagram clearly label the initial short-run and new long-run equilibria.

d) Assuming the Bank of Canada has a policy goal of keeping the rate of inflation within the range between 1% to 3% per year would this policy change help meet this goal or to move away from this goal? Explain in words only how/why you feel this is so. Aside: The Bank of Canada really does have an inflation target like described above.

Answer 1

a) For these groups, including some Canadian chartered banks, to request this action(not to raise interest rates), what must these parties be assuming about the present economic performance of Canada? Explain in words only. Your answer should focus on the present level of real GDP, employment & unemployment.

Interest rates increase is a part of contractionary monetary policy which is aimed at controlling inflation in an economy. This is generally used when economy is overheating due to more aggregate demand. If present price levels are in control but real GDP is not growing at expected rate and unemployment is higher due to less aggregate demand then it will be expected that interest rates do not go up. If interest rates are low then more aggregate demand will be expected boosting investors and business people confidence and hence more goods.services will be produced decreasing unemployment and achieving a good rate of GDP growth.

b) Suppose the Bank of Canada listens to some of this advice and it decides to lower the interest rate. This means that part b is a continuation of part a. Using words and one IS/LM diagram explain how the bank would do this and what impact this impact this would have on real GDP, consumption, investment, the real interest rate, employment, unemployment, and the real money supply in the short-run.

If interest rates are lower then it makes borrowing less expensive, and results in more consumer spending and a rightward shift in the AD curve. As shown in the diagram below, as Aggregate demand shifts to right due to less interest rates, real GDP will go up from Yf to Ye. Consumption, investment, employment and money supply will be more in an economy as people will save less and consume more due to less interest rates. Unemployment will go down.

c) If the Bank of Canada were to undertake this change of policy (in part b) what would the long-run impact of this be on inflation and/or deflation for the economy? That is would the rate of inflation (or deflation) go up, down or stay the same in the longer term as a result of this policy? Use one AS/AD diagram to help answer this sub-question – on this diagram clearly label the initial short-run and new long-run equilibria.

Assumption: Monetarists model : In the long run economy will come back to LRAS (Long run aggregate supply). As discussed in part a and b, Shift in aggregate demand to right also took price levels up from Pf to Ple. This will raise prices of factors of production and suppliers will supply less in an economy and aggregate supply(AS) 1 will shift to AS2 taking prices to new level at PL2 but on LRAS which is a long run equilibrium. Inflation is likely to go up as price levels now settle at PL2

d) Assuming the Bank of Canada has a policy goal of keeping the rate of inflation within the range between 1% to 3% per year would this policy change help meet this goal or to move away from this goal? Explain in words only how/why you feel this is so. Aside: The Bank of Canada really does have an inflation target like described above.

Bank of Canada aim t keep inflation at 1-3% goal may be missed as price levels are likely to go up if we consider monetarists AD-AS model. if there is still unemployment and firms have spare capacity then price levels may not go up as increasing aggregate demand will employ this spare capacity and production will go up without change in price levels. If aggregate supply also increases along with aggregate demand then price levels will not go up.