econ 1022 final Flashcards
Inflation Cycles
In the long run, inflation occurs if the quantity of money
grows faster than potential GDP.
In the short run, many factors can start an inflation, and
real GDP and the price level interact.
To study these interactions, we distinguish two sources of
inflation:
▪ Demand-pull inflation
▪ Cost-push inflation
Demand-Pull Inflation
An inflation that starts because aggregate demand
increases is called demand-pull inflation.
Demand-pull inflation can begin with any factor that
increases aggregate demand.
Examples are a cut in the interest rate, an increase in the
quantity of money, an increase in government expenditure,
a tax cut, an increase in exports, or an increase in
investment stimulated by an increase in expected future
profits
Initial Effect of an
Increase in Aggregate
Demand
Starting from full employment, an increase in aggregate demand
shifts the AD curve rightward
The price level rises, real GDP increases, and an inflationary gap arises.
The rising price level is the first step in the demand-pull inflation
Money Wage Rate
Response
The price level rises and
real GDP decreases back
to potential GDP.
Cost-Push Inflation
An inflation that starts with an increase in costs is called
cost-push inflation.
There are two main sources of increased costs:
1. An increase in the money wage rate
2. An increase in the money price of raw materials, such
as oil
A Demand-Pull Inflation
Process
Aggregate demand keeps increasing and the process just described repeats indefinitely
Several factors can increase aggregate demand to start a demand-pull inflation, …
but only an ongoing increase in the quantity of money can sustain it.
A demand-pull inflation occurred in Canada in the early 1970s when
inflation hit double digits by 1974.
Initial Effect of a Decrease
in Aggregate Supply
If oil producers cut
production and raise the
price of oil, short-run
aggregate supply decreases
and the SAS curve shifts
leftward.
Real GDP decreases and
the price level rises.
Aggregate Demand Response
The initial increase in costs creates a one-time rise in the
price level, not inflation.
To create inflation, aggregate demand must increase.
That is, the Bank of Canada must respond to the
unemployment and increase the quantity of money
persistently.
The Bank of Canada
stimulates aggregate
demand to counter the
higher unemployment.
Real GDP increases and
the price level rises again.
A Cost-Push Inflation
Process
If the oil producers raise the oil price to try to keep its relative price higher, …
and the Bank of Canada responds by increasing the quantity of money, …
a process of cost-push inflation continues.
The combination of a rising price level and a decreasing real GDP is
called stagflation.
Cost-push inflation occurred in Canada during the 1970s when the Bank responded to the OPEC oil price rise.
Expected Inflation
Aggregate demand increases, but the increase is expected, so its effect on the price level is expected.
The money wage rate rises in line with the expected rise in the
price level.
The price level rises as expected and real GDP remains at
potential GDP. The process repeats.
Forecasting Inflation
To expect inflation, people must forecast it.
The best forecast available is one that is based on all the
relevant information and is called a rational expectation.
A rational expectation is not necessarily correct, but it is
the best available.
The Quantity Theory and Deflation
Inflation rate = Money growth rate + Rate of velocity change
– Real GDP growth rate
Deflation occurs if
Money growth rate < Real GDP growth rate – Rate of
velocity change.
Inflation and the Business Cycle
When the inflation forecast is correct, the economy
operates at full employment.
If aggregate demand grows faster than expected, real
GDP moves above potential GDP, …
the inflation rate exceeds its expected rate and the
economy behaves like it does in a demand-pull inflation.
If aggregate demand grows more slowly than expected, …
real GDP falls below potential GDP, inflation slows, and
the economy behaves like it does in a cost-push inflation.
Deflation
An economy experiences deflation when it has a
persistently falling price level.
▪ What causes deflation?
▪ What are the consequences of deflation?
▪ How can deflation be ended?
The price level falls persistently if aggregate demand
increases at a persistently slower rate than aggregate
supply.
What are the Consequences of Deflation?/How can deflation be ended?
What are the Consequences of Deflation?
Unanticipated deflation redistributes income and wealth,
lowers real GDP and employment, and diverts resources
from production.
How can deflation be ended?
By increasing the growth rate of money.
Make the money growth rate exceed the growth rate of
real GDP minus the rate of velocity change.
The Phillips Curve
A Phillips curve is a curve that shows the relationship
between the inflation rate and the unemployment rate.
There are two time frames for Phillips curves:
▪ The short-run Phillips curve
▪ The long-run Phillips curve
The Long-Run Phillips Curve
The long-run Phillips curve shows the relationship
between inflation and unemployment when the actual
inflation rate equals the expected inflation rate.
The long-run Phillips curve (LRPC) is vertical at the natural unemployment rate.
Along LRPC, a change in the inflation rate is expected, so the
unemployment rate remains at the natural unemployment rate.
The Short-Run Phillips Curve
The short-run Phillips curve shows the tradeoff between
the inflation rate and unemployment rate, holding constant
1. The expected inflation rate
2. The natural unemployment rate
With a given expected inflation rate and natural unemployment rate: If the inflation rate is exceeds the expected inflation rate, the unemployment rate decreases.
If the inflation rate is below the expected inflation rate, the
unemployment rate increases.
The Federal Budget
The federal budget is the annual statement of the federal
government’s outlays and revenues.
The federal budget has two purposes:
1. To finance the activities of the federal government
2. To achieve macroeconomic objectives
Change in the Natural
Unemployment Rate
A change in the natural unemployment rate shifts both the long-run and short-run Phillips curves.
Fiscal policy
is the use of the federal budget to achieve
macroeconomic objectives, such as full employment,
sustained economic growth, and price level stability.
Budget Making
The federal government and Parliament make fiscal policy.
After a long, draw-out process of consultations, the
Minister of Finance presents a budget plan to Parliament.
Parliament debates the plan and enacts the laws
necessary to implement it.
Budget Balance
The federal government’s budget balance equals
revenues minus outlays.
If revenues exceed outlays, the government has a
budget surplus.
If outlays exceed revenues, the government has a
budget deficit.
If revenues equal outlays, the government has a
balanced budget.
Government revenues come from four sources:
Personal income taxes – largest revenue source
Corporate income taxes – smallest source
Indirect and other taxes – second largest source
Investment income
The government budget balance =
Revenues – Outlays
Government outlays are classified in three categories:
Transfer payments – largest outlay (by a large margin)
Expenditure on goods and services – appears as government expenditure in the circular flow chart
Debt interest
The Budget in Historical Perspective
During the 1960s, outlays and revenues increased.
During the late 1970s and through the 1980s, outlays
continued to rise but revenues fell and then remained
steady. A large budget deficit arose.
During the 1990s, expenditure cuts eliminated the budget
deficit, and after 1997, the budget returned to surplus.
A deficit re-emerged during the 2008–2009 recession, but
since 2014 the budget has been close to balanced.
Total revenues have no strong trends.
The main source in the fluctuations in revenues was personal income taxes
Transfer payments swelled drastically in the 1980’s and then were cut by a large amount in the 1990’s
Deficit and Debt
Government debt is the total amount that the government borrowing.
It is the sum of past deficits minus past surpluses.
Debt and Capital
Debt enables the holder to buy assets that will earn a
return that exceeds the interest paid on the debt.
Some government expenditure is investment—the
purchase of public capital (highways, universities, national
defence, etc.) that yields a social return that probably far
exceeds the interest rate the government pays on its debt.
But Canadian government debt, which is $709 billion, is
much larger than the value of the public capital stock.
This fact means that some government debt has been
incurred to finance public consumption expenditure
Supply-siders
Economists who believe that the effects of taxes on personal and corporate income are large.
Full Employment and Potential GDP
Income taxes change full employment and potential GDP.
The supply of labour decreases because the tax lowers the after-tax real wage rate.
An income tax reduces the incentive to work and thus reduces the supply of labour, then reducing labour hours, raising the wage rate, and reducing real GDP.
The vertical distance between the LS curve and the LS + tax curve determines the amount of income tax.
Tax wedge – The gap created between the before tax and after tax wage rate.
Taxes on Expenditure and the Tax Wedge
A tax on interest income reduces the incentive to save and drives a wedge between the after-tax interest rate earned by savers and the interest rate paid by firms.
Taxes on consumption expenditure add to the wedge.
A tax on capital income lowers the quantity of saving and investment and slows the growth rate of real GDP.
Taxes and the Incentive to Save and Invest
A tax on capital income lowers the quantity of saving and
investment and slows the growth rate of real GDP.
The interest rate that influence saving and investment is
the real after-tax interest rate.
The real after-tax interest rate subtracts the income tax
paid on interest income from the real interest.
Taxes depend on the nominal interest rate. So the true tax
on interest income depends on the inflation rate
A tax on interest income
A tax on interest income decreases the incentive to save and lend and thus decreases the supply of loanable funds (SLF).
In this case, the amount of tax payable is measured by the vertical distance between the SLF curve and the SLF + tax curve
A higher tax rate does not always bring greater tax revenue.
It brings in more revenue per dollar earned
Since a higher tax rate decreases the amount of dollars earned, two forces act in opposite directions on government revenues
Tax Revenues and the
Laffer Curve
The relationship between the tax rate and the amount of tax revenue collected is called the Laffer curve.
At the tax rate T, tax revenue is maximized.
If the current tax rate is less than T, then a rise in the tax rate will increase tax revenue.
If the current tax rate exceeds T*, then a rise in the tax rate will decrease tax revenue.
Supply-siders emerged through Ronald Reagan’s cabinet, specifically Arthur B. Laffer.
They correctly argued that tax cuts would increase employment and increase output
They incorrectly argued that tax cuts would increase tax revenues and decrease the budget deficit
Fiscal Stimulus
A fiscal stimulus is the use of fiscal policy to increase
production and employment.
Fiscal stimulus can be either
▪ Automatic or
▪ Discretionary.
Automatic fiscal policy is a fiscal policy action triggered
by the state of the economy with no government action.
Discretionary fiscal policy is a policy action that is
initiated by an act of Parliament.
Automatic Fiscal Policy and Cyclical and Structural
Budget Balances
Two items in the government budget change automatically
in response to the state of the economy.
▪ Tax revenues
▪ Outlays
Automatic Changes in Tax Revenues
Parliament sets the tax rates that people must pay.
The tax dollars people pay depend on tax rates and
incomes.
But incomes vary with real GDP, so tax revenues depend
on real GDP.
When the real GDP increases in an expansion, tax
revenues increase.
When real GDP decreases in a recession, tax revenues
decrease.
Outlays
The government creates programs that pay benefits to
qualified people and businesses.
These transfer payments depend on the economic state of
the economy.
When the economy is in an expansion, unemployment
falls, so unemployment benefits decrease.
When the economy is in a recession, unemployment rises,
so unemployment benefits increase.
Automatic Stimulus
In a recession, tax revenues decrease and outlays
increase.
So the budget provides an automatic stimulus that helps
shrink the recessionary gap.
In a boom, tax revenues increase and outlays decrease.
So the budget provides automatic restraint that helps
shrink the inflationary gap.
Cyclical and Structural Balances
The structural surplus or deficit is the budget balance
that would occur if the economy were at full employment
and real GDP were equal to potential GDP.
The cyclical surplus or deficit is the actual surplus or
deficit minus the structural surplus or deficit.
That is, a cyclical surplus or deficit is the surplus or deficit
that occurs purely because real GDP does not equal
potential GDP
Discretionary Fiscal Stimulus
Most discretionary fiscal stimulus focuses on its effects on
aggregate demand.
Fiscal Stimulus and Aggregate Demand
Changes in government expenditure and taxes change
aggregate demand and have multiplier effects.
Two main fiscal multipliers are
▪ Government expenditure multiplier
▪ Tax multiplier
Government expenditure multiplier
The quantitative effect of a change in government expenditure on real GDP.
The consensus is that the crowding-out effect that government deficits can have makes the government expenditure multiplier less than one
If this were the only consequence of the increase in
government expenditure, the multiplier would be >1.
If this were the only consequence of the increase in
government expenditure, the multiplier would be < 1.
Which effect is stronger?
The consensus is that the crowding-out effect dominates
and the multiplier is <1.
Tax multiplier
he quantitative effect of a change in taxes on real GDP.
Generally seen as less than one because the saving in disposable income will not always go towards aggregate demand, some will be saved
Also decreases investment because of the crowding-out effect
Graphical Illustration of Fiscal Stimulus
An increase in government expenditure or a tax cut increases aggregate expenditure.
The multiplier process increases aggregate demand.
Fiscal Stimulus and Aggregate Supply
Taxes drive a wedge between the cost of labour and the
take-home pay and between the cost of borrowing and the
return on lending.
Taxes decrease employment, saving, and investment and
decrease real GDP and its growth rate.
A tax cut decreases these negative effects and increases
real GDP and its growth rate.
The supply-side effects of a tax cut probably dominate the
demand-side effects and make the overall tax multiplier
larger than the government expenditure multiplier.
Time Lags
The use of discretionary fiscal policy is seriously
hampered by three time lags:
▪ Recognition lag—the time it takes to figure out that
fiscal policy action is needed.
▪ Law-making lag—the time it takes Parliament to pass
the laws needed to change taxes or spending.
▪ Impact lag—the time it takes from passing a tax or
spending change to its effect on real GDP being felt.
Monetary Policy Objectives
Objective of monetary policy is ultimately political, and it stems from the mandate of the Bank, which is set out by the Bank of Canada Act.
Objective of monetary policy is set out in the preamble of the 1935 Bank of Canada Act, and it is as follows:
To regulate credit and currency
To mitigate the fluctuation of production, trade, prices, and employment
In simple terms this means it is the bank’s job is to control the quantity of money and the interest rates to control inflation and where possible prevent excessive swings in real GDP growth and unemployment.
Joint Statement of the Government of Canada and the
Bank of Canada
The agreement of 2016 is
1. The target is defined in terms of the 12-month rate of
change in the total CPI.
2. The inflation target is the 2 percent midpoint of the
1 to 3 percent inflation-control range.
3. The agreement will run until December 31, 2021.
Such a monetary policy strategy is called inflation rate
targeting.
Inflation rate targeting
A monetary policy where the central bank commits to an explicit inflation target.
Uses the CPI as the measure of inflation
The core inflation rate is said to better predict future inflation rates and a consistent trend
Over the past 20 years, the core trend and CPI trends were very similar
The average of the three core inflation rates (CPI-common, CPI-median, and CPI-trim) has never left the target range.
Rationale for an Inflation-Control Target
Two main benefits flow from adopting an inflation-control
target:
1. Fewer surprises and mistakes on the part of savers and
investors.
2. Anchors expectations about future inflation.
Two reasons for an inflation-control target:
Policy actions are more clearly understood by financial market traders, which leads to fewer miscalculations by savers and investors
The target provides an anchor for future expectations about inflation
Controversy About the Inflation-Control Target
Critics of inflation targeting fear that
1. By focusing on inflation, the Bank might permit the
unemployment rate to rise or real GDP growth to slow.
2. The Bank might permit the value of the dollar rise on the
foreign exchange market and make exports suffer.
Supporters of inflation targeting respond
. Keeping inflation low and stable is the best way to
achieve full employment and sustained economic growth.
2. The Bank’s record is good. The last time the Bank
created a recession was at the beginning of the 1990s
when it was faced with double-digit inflation.
Responsibility for Monetary Policy
The Bank of Canada’s Governing Council is responsible
for the conduct of monetary policy.
The Governor and the Minister of Finance must consult
regularly.
If the Governor and the Minister disagree in a profound
way, the Minister may direct the Bank in writing to follow a
specified course and the Bank would be obliged to accept
the directive.
The Monetary Policy Instrument
The monetary policy instrument is a variable that the
Bank of Canada can directly control or closely target.
The Bank of Canada has three possible instruments:
1. The quantity of money (the monetary base)
2. The price of Canadian money on the foreign exchange
market (the exchange rate)
3. The opportunity cost of holding money (the short-term
interest rate)
The Conduct of Monetary Policy
The Bank of Canada can set any one of these three
variables, but it cannot set all three.
The values of two of them are the consequence of the
value at which the third one is set.
1. If the Bank decreased the quantity of money, both the
interest rate and the exchange rate would rise.
2. If the Bank raised the interest rate, the quantity of
money would decrease and the exchange rate would
rise.
3. If the Bank lowered the exchange rate, the quantity of
money would increase and the interest rate would fall.
The Overnight Loans Rate
The Bank of Canada’s choice of policy instrument (the
same choice made by most other major central banks) is a
short-term interest rate.
Given this choice, the exchange rate and the quantity of
money to find their own equilibrium values.
The Bank of Canada targets is the overnight loans rate,
which is the interest rate on overnight loans that chartered
banks make to each other.
When the Bank wants to slow inflation, it raises the
overnight loans rate.
When inflation is low and the Bank wants to avoid recession, it lowers the overnight loans rate.
The Bank’s Interest Rate Decision
To make its interest rate decision, the Bank of Canada
gathers data about the economy, the way it responds to
shocks, and the way it responds to policy.
The Bank must then process the data and come to a
judgement about the best level for the policy instrument.
After announcing an interest rate decision, the Bank
engages in a public communication to explain the reasons
for its decision.
Hitting the Overnight Loans Rate Target
Once an interest rate decision is made, the Bank of
Canada achieves its target by using two tools:
Operating band
Open market operations
Operating Band
The operating band is the target overnight loans rate plus
or minus 0.25 percentage points. So the operating band is
0.5 percentage points wide.
The Bank creates the operating band by setting:
1. Bank rate, the interest rate that the Bank charges big
banks on loans, is set at the target overnight loans rate
plus 0.25 percentage points.
2. Settlement balances rate, the interest rate the Bank
pays on reserves, is set at the target overnight loans
rate minus 0.25 percentage point.
Open market operations
If the overnight loans rate is above target, the Bank buys securities to increase reserves
Other short-term interest rates and the exchange rate also fall
The quantity of money and supply of loanable funds increases
The long-term interest rate falls
In the end, real GDP growth and inflation both speed up
If the overnight loans rate is below target, the Bank sells securities to decrease reserves
Same but opposite effects occur here with the process illustrated above
When the Bank of Canada lowers the overnight loans rate:
1.The Bank buys securities in an open market operation.
2. Other short-term interest rates and the exchange rate
fall.
3. The quantity of money and the supply of loanable funds
increase.
4. The long-term real interest rate falls.
5. Consumption expenditure, investment, and net exports
increase.
6. Aggregate demand increases.
7. Real GDP growth and the inflation rate increase.
When the Bank of Canada raises the overnight loans rate,
the ripple effects go in the opposite direction.
Monetary Policy Transmission
Short-term rates move closely together and follow the overnight loans rate.
Long-term rates move in the same direction as the overnight loans rate but are only loosely connected to the overnight loans rate.
These ripple effects stretch out for a period of one to two years.
The interest rate and exchange rate effects are immediate
Effects on money and bank loans follow in a few weeks and run for a few months
Real long-term interest rates change quickly and often in anticipation of the short-term interest rate changes
Spending plans change and real GDP growth changes after about a year
The inflation rate changes about one or two years after the change in the overnight loans rate
The three-month treasury bill rate
The interest rate paid by the Government of Canada on 3-month debt.
Identical to the overnight loans rate – a powerful substitution effect keeps the two rates close to each other
When they are close together like this there is no incentive for banks to choose one or the other – they are in equilibrium
Long-term bond rate
The interest rate paid on bonds issued by large corporations.
The interest rates are higher on these because they are riskier
When the Bank of Canada raises the overnight loans rate, the Canadian interest rate differential rises and the Canadian dollar appreciates.
The overnight loans rate also changes the quantity of money demanded and the quantity of loans and deposits created in the banking system.
Exchange Rate Fluctuations
The exchange rate responds to changes in the interest
rate in Canada relative to the interest rates in other
countries—the Canadian interest rate differential.
But other factors are also at work, which make the
exchange rate hard to predict.
Expenditure Plans
The ripple effects that follow a change in the overnight rate
change three components of aggregate expenditure:
▪ Consumption expenditure
▪ Investment
▪ Net exports
A change in the overnight loans rate changes in aggregate
expenditure plans, which in turn changes aggregate
demand, real GDP, and the price level.
So the Bank influences the inflation rate and output gap
Money and Bank Loans/Long-Term Real Interest Rate
Money and Bank Loans
When the Bank lowers the overnight loans rate, the
quantity of money and the quantity of bank loans increase.
Consumption and investment plans change.
Long-Term Real Interest Rate
Equilibrium in the market for loanable funds determines
the long-term real interest rate, which equals the nominal
interest rate minus the expected inflation rate.
The long-term real interest rate influences expenditure
plans.
The Bank of Canada
Fights Recession
If inflation is low and the output gap is negative, the Bank lowers the overnight loans rate target.
The Bank conducts an open market purchase to increase reserves …
and hit the new overnight loans rate target.
An increase in reserves increases the supply of money.
The short-term interest rate falls, and the quantity of money demanded increases.
The increase in the supply of money increases the supply of loanable funds.
The long-term real interest rate falls and investment increases
The fall in the real interest rate increases aggregate planned expenditure.
The multiplier increases aggregate demand.
The Bank of Canada
Fights Inflation
If inflation is too high and the output gap is positive, the Bank of Canada raises the overnight loans rate target.
The Bank conducts an open market sale to decrease reserves …
and hit the new overnight loans rate target.
A decrease in reserves decreases the supply of money.
The short-term interest rate increases, and the quantity of money
demanded decreases.
The decrease in the supply of money decreases the supply of
loanable funds.
The long-term real interest rate rises and investment decreases.
The rise in real interest rate decreases aggregate planned expenditure.
The multiplier decreases aggregate demand.
Loose Links and Long and Variable Lags
Long-term interest rates that influence spending plans are
linked loosely to the overnight loans rate.
The response of the real long-term interest rate to a
change in the nominal rate depends on how inflation
expectations change.
The response of expenditure plans to changes in the real
interest rate depends on many factors that make the
response hard to predict.
The monetary policy transmission process is long and
drawn out and doesn’t always respond in the same way.
The Anatomy of the Financial Crisis
The three main events that can put a bank under stress:
1. Widespread fall in asset prices
2. Large currency drain
3. Run on the bank
Financial Crisis: Cure and Prevention
Widespread fall in asset prices means banks suffer a
capital loss.
If the fall in asset price is large, the bank’s equity might fall
to zero, in which case the bank is insolvent.
The bank fails.
Large currency drain means that depositors withdraw
funds and the bank loses reserves.
The bank has a liquidity crisis and is short of cash
reserves.
Run on the bank occurs when depositors lose confidence
and make massive withdrawls. The bank’s equity shrinks.
The Key Elements of the Crisis
The three main events that put banks under stress were:
1. Widespread fall in asset prices
2. A significant currency drain
3. A run on the bank
Financial Crisis
The U.S. Fed’s Policy Actions
The Fed’s policy actions dribbled out for more than a year.
The Fed conducted massive open market operations to
keep the banks supplied with reserves.
Congress Crisis Policy Actions
▪ Extended deposit insurance
▪ Authorized the Treasury to buy “troubled” assets.
These actions provided U.S. banks with more reserves,
more secure depositors, and safe liquid assets in place of
troubled assets.
Macroprudential Regulation
Macroprudential regulation is financial regulation to
lower the risk that the financial system will crash.
The global financial crisis of 2007–2008 brought this type
of regulation to center stage.
Macro Versus Micro
Microprudential regulation seeks to lower the risk of failure
of individual financial institutions.
Macroprudential regulation focuses on the
interconnections among individual financial institutions and
markets and their shared exposure to common shocks.
The Tools
involves rules governing banks’ balance sheets, such as loan-to-net worth ratios, which adjust according to the macroeconomic climate. For instance, during a recession, minimum ratios might increase, while during an expansion, they might decrease. These regulations aim to stabilize the financial system by considering broader economic conditions, unlike microprudential regulations which focus on specific institutions.
Canadian Macroprudential Regulation
The Minister of Finance is responsible for maintaining
Canada’s financial stability, but the front line of Canada’s
macroprudential policy is performed by:
▪ The Bank of Canada
▪ The Office of the Superintendent of Financial Institutions
▪ The Canada Deposit Insurance Corporation.
The Bank of Canada’s specific duties to further support to
financial stability are.
Lender of last resort
2. Management of the payment system
3. Conductor of financial system stress tests
The Office of the Superintendent of Financial Institutions
regulates and supervises financial institutions.
The Canada Deposit Insurance Corporation insures the
deposits of banks and other depository institutions.
Policy Strategies and Clarity
In the short run, monetary policy creates a tradeoff
between inflation and unemployment.
But in the long run, monetary policy influences the inflation
rate and has no effect on the unemployment rate.
In the long run, the unemployment rate is determined by
the natural unemployment rate.
Inflation targeting is an attractive monetary policy strategy
because it manages inflation expectations, which makes
the best contribution to attaining full employment and
sustained growth.
Demand and supply in the loanable funds market determines the long-term real interest rate.
This rate influences expenditure decisions
In the short run, when the price level is not fully flexible, the supply of loanable funds is influenced by the supply of bank loans
A fall in the overnight funds rate increases the supply of bank loans and increases the supply of loanable funds
A rise in the overnight loans rate decreases the supply of bank loans and decreases the supply of loanable funds
The ripple effects of changes in the overnight loans rate then change three parts of expenditure plans:
Consumption expenditure
The lower the real interest rate the greater the consumption and the smaller the saving
Investment
The lower the real interest rate the greater the amount of investment
Net exports
The lower the interest rate, the lower is the exchange rate and the higher are exports and the lower are imports, thus increasing net exports
The Taylor Rule
A formula for setting the overnight loans rate.
Formula = 2 + INF + 0.5(INF-2) + 0.5GAP
INF = Inflation rate
GAP = Output gap
The Bank of Canada believes that since they use more information than just the inflation rate and the output gap they can set the overnight loans rate more intelligently than the Taylor Rule.
