Monetary Policy

Money Fact Sheet #14

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Monetary Policy

MONETARY POLICY IS ABOUT ensuring that money can play its vital role in helping our economy run smoothly. To do this, the Bank of Canada focuses monetary policy on protecting the value of Canadian money by keeping inflation low and stable. 

The ultimate objective

Keeping inflation low and stable is essential to keeping the economy on the smoothest possible track for long-lasting growth and job creation. The Bank's focus on inflation means that the output gap between the potential and actual performance of the economy is kept as narrow as possible. Monetary policy aims at avoiding inflationary "boom-and-bust" cycles that lead to painful recessions and rising unemployment.

Keeping inflation low and stable allows people to make spending and investment plans with a greater sense of confidence about the future. This helps to encourage the long-term investment that contributes to long-lasting growth and job creation, and leads to productivity growth that brings real improvements in our standard of living.

Low inflation creates many other direct benefits in its own right—such as protecting the purchasing power of pensioners and other Canadians on fixed incomes.

The elements of monetary policy

At the heart of monetary policy is the inflation-control target that the Bank of Canada and the federal government have established for Canada. The target range for inflation is from 1 to 3 per cent, as measured by the consumer price index.

The Bank of Canada carries out monetary policy mainly through changes to its Target for the Overnight Rate. A change in the target influences other interest rates and may lead to movement in the exchange rate of the Canadian dollar. The level of interest rates and the exchange rate determine the monetary conditions in which the Canadian economy operates; it affects the level of spending and economic activity in the country.

The transmission of monetary policy occurs as changes in monetary conditions affect the demand for goods and services. Lower interest rates, for example, tend to increase spending and reduce savings, and a lower dollar can boost exports and hold back imports. Conversely, higher interest rates tend to curb domestic spending and a higher dollar tends to curb exports and encourage imports. Strong demand for Canadian goods and services puts upward pressure on prices if it exceeds the economy's capacity.

But changes to the Bank Rate do not immediately affect the economy in a manner that is readily predictable. The transmission mechanism of monetary policy has long and variable lags because the economy takes time to adjust to changes in monetary conditions.

There are lags of from 18 months to 24 months between monetary policy changes and their effects on inflation and the economy. A chain of events is set in motion that affects consumer spending, sales, production, employment, and other economic indicators. This means that monetary policy must always be forward-looking. It must anticipate the monetary conditions needed today to help keep the economy on track for growth and job creation in the future.

A dynamic process of adjustment takes place in the economy in the following stages:

  • changes in interest rates lead to changes in spending and sales;
  • changes in spending and sales lead to changes in production (and employment); and
  • changes in production lead to changes in prices and, thus, to changes in inflation.

 

Each of these stages lags behind the previous one, and the length of the lags can vary. Because the effect of monetary policy actions on prices can have a long lag, the Bank of Canada must recognize, as early as possible, any signals that indicate the emergence of upward or downward pressure on prices down the road and take corrective measures well in advance of the time the impact of these pressures will be felt.

Bank adjusts monetary conditions

If the Bank estimates that the economy will be exceeding its capacity at some point in the future, the Bank may need to adjust monetary conditions ahead of time in order to prevent inflation pressures from building. Conversely, if the economy was expected to slow down, the Bank would take action to ease monetary conditions (by lowering interest rates) so that inflation would not fall below the target range.

Various economic indicators are used to judge what inflation is likely to be 18 to 24 months in the future. These include the intensity of credit demand, the pace of monetary expansion, and developments in prices and costs.

Timely, measured steps are necessary to ensure that the economy can grow on a sustainable basis—that is, without generating inflation pressures.

Because of the lag, monetary policy must focus on the future, rather than the present. By always acting in a forward-looking manner, the Bank of Canada aims to pre-empt future inflation and keep it within its inflation-control target range.

July 2001

 

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