Chapter 4 Part 2 Flashcards
Explain how Demand & Supply of Capital
Influences Interest Rates?
ANSWER: A large government deficit or a boom in business investment raises the demand for capital and forces interest rates to rise.
Therefore, unless there is an equivalent increase in the supply of capital, the price of credit also rises. In turn, higher interest rates may encourage government, companies, and households to save more.
An increase in savings may reduce demand for borrowing, which in turn may reduce interest rates.
Explain How Foreign Rates & The Exchange Rate
Influences Interest Rates?
ANSWER: Because Canada has an open economy, investors are free to move their money between Canada and other countries. Therefore, foreign interest rates and financial conditions can also influence Canadian interest rates.
For example, a rise in the U.S. interest rate increases returns on U.S. investments. Investors holding Canadian dollars wishing to invest in the United States must sell their Canadian dollars to purchase U.S. dollar-denominated securities.
This activity increases the supply of Canadian dollars on the foreign exchange market and places downward pressure on the value of the Canadian dollar. If the Bank of Canada decides to slow or reduce this fall in value, it can intervene and raise short-term interest rates, even if underlying conditions in Canada are unchanged.
This measure encourages investors to continue holding Canadian investments rather than switch to U.S. dollar-denominated securities.
List 3 ways that higher interest rates may impact the economy?
ANSWER:
They reduce business investment.
They encourage saving.
They reduce consumption.
Explain how higher interest rates reduce business investment?
ANSWER: An investment should earn a greater return than the cost of the funds used to make the investment.
Higher interest rates raise the cost of capital for investments and reduce the possibility of profitable investments. Therefore, businesses are less likely to invest.
Explain how higher interest rates encourage saving?
ANSWER: By increasing the cost of borrowing, higher interest rates discourage consumers from buying on credit, especially high-priced items such as houses, cars, and major furniture articles. Instead of choosing to borrow and pay off debt, they are content to put their money in savings.
Explain how higher interest rates reduce consumption?
ANSWER: Higher interest rates increase the portion of household income that is needed to service debt, such as mortgage payments, thereby reducing the income available to spend on other items. This effect is offset somewhat by the higher interest income earned by savers.
Explain: Nominal Rates?
ANSWER: The nominal interest rate is one where the effect of inflation has not been removed. The rate charged by a bank on a loan is the nominal interest rate, as is the quoted rate on an investment such as a guaranteed investment certificate or Treasury bill. Other things being equal, the higher the rate of inflation, the higher the nominal interest rate.
EXPLAIN: Real Interest Rates?
ANSWER: Real interest rates is the nominal interest rate minus the expected inflation rate.
What is deflation?
In economics, deflation is a decrease in the general price level of goods and services.
Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). Inflation reduces the value of currency over time, but deflation increases it. This allows more goods and services to be bought than before with the same amount of currency.
Deflation is distinct from disinflation, a slow-down in the inflation rate, i.e. when inflation declines to a lower rate but is still positive.
NOTE ONLY
A one-time jump in prices caused by an increase in the price of oil or by the introduction of a new sales tax, for example, is not true inflation. The true definition of inflation requires that prices continue to increase. Likewise, a rise in the price of one product is not in itself inflation; it may merely reflect the increased scarcity of that product.
Inflation occurs when prices follow a sustained rising pattern. As prices rise, money begins to lose its value, and a larger amount of money is needed to buy the same amount of goods and services.
NOTE ONLY
A one-time jump in prices caused by an increase in the price of oil or by the introduction of a new sales tax, for example, is not true inflation. The true definition of inflation requires that prices continue to increase. Likewise, a rise in the price of one product is not in itself inflation; it may merely reflect the increased scarcity of that product.
Inflation occurs when prices follow a sustained rising pattern. As prices rise, money begins to lose its value, and a larger amount of money is needed to buy the same amount of goods and services.
Four costs of inflation on the economy?
It can erode the standard of living of Canadians, particularly of people on a fixed income, for example retired individuals who rely on a monthly government pension. Canadians who are able to increase their income in response to inflation, either through increased wages or changes to their investment strategy, are less affected.
It reduces the real value of investments, such as fixed-rate loans, because the loans must be paid back in dollars that buy less. A borrower whose income rises with inflation will not be affected. However, lenders are likely to demand a higher interest rate on the money they lend during inflationary times.
It distorts the price signals sent to market participants. As we discussed earlier, prices are set by supply and demand. When inflation is high, it is difficult to determine whether a price increase is simply inflationary or a genuine relative price that reflects a change in supply or demand.
Accelerating inflation usually brings about rising interest rates and a recession. Therefore, high-inflation economies usually experience more severe expansions and contractions than low inflation economies.
DEMAND PULL INFLATION
If demand for all goods and services is higher than what the economy can produce, prices will increase as consumers compete for too few goods.
This typically occurs as we move from an expansion towards the peak phase of the business cycle. In such cases, output expands and consumer income rises, which leads to strong consumer demand for goods and services.
If businesses have trouble meeting this higher demand, prices begin to rise. In this way, higher and continued consumer demand pushes inflation higher. This state of affairs is called demand-pull inflation.
COST PUSH INFLATION
Inflation can also rise or fall due to shocks from the supply side of the economy—that is, when the costs of production change. When faced with higher costs of production from higher wages or increases in the price of raw materials, firms respond by raising prices or producing fewer products. The higher costs push inflation higher. This state of affairs is called cost-push inflation.
DISFLATION
Disinflation is a decline in the rate at which prices rise (i.e., a decrease in the rate of inflation). Prices are still rising, but at a slower rate.
DEFLATION
Deflation is a sustained fall in prices, where the annual change in the CPI is negative year after year. Deflation is simply the opposite of inflation. Falling prices are generally preferred over rising prices. Goods and services become cheaper, and our income has more buying power than it used to. Although this is true in the short term, there are negative consequences of deflation.
