The Bank of Canada’s Interest Rate Policy and Its Impact on Inflation (Essay Sample)

The Bank of Canada’s Interest Rate Policy and Its Impact on Inflation Name Institution Course Instructor Date Introduction Canada has been experiencing high levels of inflation. Inflation refers to the rise in the general price level in an economy and the process can reduce purchasing power, skew economic choices and cause uncertainty. To curb this, the Bank of Canada has sought to conduct a sequence of interest rate raises to achieve its inflation rate of 2%. This paper analyzes the Bank of Canada's Keynesian model of interest rate policy. The first part of the analysis presents how the Bank of Canada increases the interest rates and how, through this way, inflation is expected to be lowered through the reduction of aggregate demand. Mechanisms for Increasing Interest Rates The Bank of Canada being the central bank is expected to implement this monetary policy toward the achievement of price stability as well as economic development in the country. In a bid to manage inflation, the Banks employ various instruments to vary the interest rates in an attempt to manage the availability of money in the economic system hence the activity. There are three main instruments available at the disposal of the Bank and these are the open market operations the target for the overnight rate and adjustment of the bank rate. The nominal anchor is the specific interest rate for the overnight money market that is employed as the target. Overnight rate is the interest rate for one-day funds where the major financial institutions borrow and lend. The actualization of this rate indicates the stance of the Bank of Canada’s monetary policy through the setting of a target (Irvine et al., 2017, pp.264). If the Bank wishes to raise interest rates it increases the key of the overnight rate and this puts pressure on financial institutions to change their lending/borrowing rates. Consequently, there are high costs of borrowing throughout the economy that impact on consumer credit, mortgages and business financing. Figure SEQ Figure \* ARABIC 1: Money Supply Control and Interest Rate Graph (Irvine et al., 2017, pp. 261). Open market operations form one of the procedures through which the Bank of Canada control the money supply and interest rate. This process involves the purchasing of government securities through the open market and thus makes the bank withdraw money from the commercial banks, thus decreasing its employees. This lowers the level of reserves hence decreasing the levels of credit extended by banks as well as decreasing the money supply and increasing the interest rates. Higher interest rates are associated with the reduction in the quantity of borrowed funds due to the increased cost of purchasing reserves. This is important in accrediting short-term interest rates and in shaping the overall economic climate. Figure SEQ Figure \* ARABIC 2 Money Market and Interest and Expenditure Graph retrieved from (Irvine et al., 2017, pp. 241). The bank rate is known as the rate of interest which is charged by the central bank to the commercial banks that borrow money from the central bank (Onigah, 2024). Through the hike in the bank rate, the Bank of Canada puts pressure onto the commercial banks raising the cost, which is then reflected in high interest rates charged on borrowing products. It is particularly insightful in implementing changes in the volume of liquidity in the banking system and in interacting with the monetary policy direction of the central bank. Impact of Increased Interest Rates on Inflation Using Keynesian Model The Keynesian model gives a theoretical foundation for how changes in interest rates affect inflation and or aggregate demand. Aggregate demand (AD) represents the total demand for goods and services within an economy and is composed of four main components: For this purpose, the right side of the equation comprises consumption, investment, government spending and net exports abbreviated as C, I, G and NX respectively. From the Keynesian point of view, inflation is defined as a situation when aggregate demand outpaces the aggregate supply (AS) therefore putting upward pressure on the prices. Figure SEQ Figure \* ARABIC 3 Aggregate Demand and supply curve (Irvine et al., 2017, pp. 241). Reducing consumption is one of the major effects among the inflation-reducing effects caused by higher interest rates. When the interest rates rise, consumers cut down on their borrowing which leads to reduced purchases in homes, cars and other durable products. The decrease in consumer expenditure decreases total demand in the economy also known as aggregate demand. In addition, a high rate of inter...