Economics: The Impact of Interest Rate on Economic Growth in Canada
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Literature Review
The economy consists of millions of consumers who interact with firms on a daily basis in order to determine the types of goods, which the firms must produce and what consumers must take and at what prices. In Canada, a market based economy; the government plays a crucial role in enacting taxation policies in order to collect revenue to be used in provision of services, such as security, health, housing and education (Bank of Canada, n.d.). Although the government may not tax directly certain products or services, their presence is often felt in form of regulatory policies such as quotas, licenses and minimum wages among others. The government can exercise control over its economy through monetary and fiscal policies it set forth.
Through the central bank, a government can set up decisions and regulations in order to determine the amount of money in circulation. In Canada, the Bank of Canada conducts the monetary policy (Masson, 2013). This is achieved through the adjustment of the very short-term interest rate in order to achieve a monetary expansion at relatively low and stable inflation rate. The monetary policy in Canada has a number of features that makes it unique. First, the independent government owned Bank of Canada, which is unswerable to the parliament, conducts the monetary policy. The Bank of Canada performs its functions independent from the federal government but all its policies are subject to the parliament considerations.
The other feature that defines the Canadian monetary policy is that the ease with which financial capital can move within Canada has made it possible for the creation of one monetary policy that applies all over Canada. In addition, Bank of Canada is the sole issuer of the bank notes in the country. Finally, the Bank of Canada has only one monetary policy regardless of the fact that many variable affect monetary decisions. Unlike the fiscal policy, the monetary policy has no direct influence on the taxation and spending at any level of the federal government. Similarly, it cannot regulate the labour and product markets in the country. However, it plays a limited role in the oversight and regulation of some parts of the financial system in Canada.
The big question would be, “what is the Bank of Canada’s policy instrument?” The policy instrument of the Bank of Canada is the overnight interest rate. The commercial banks in Canada borrow money from the Bank of Canada at a certain predetermined overnight interest rate and lend them to each other. The borrowing rates are market-determined and fluctuate on a daily basis. The Bank of Canada can keep the interest rate at a certain operating band by announcing the lending rate and the borrowing rates for a short while from the central banks in the country. When the Bank of Canada changes the overnight interest rates, it determines the rates at which the commercial banks can lend their money.
These actions of the Bank of Canada to determine the overnight interest rates, affects the economy as well as the money in circulation and at the same time controlling inflation rate in the country to a certain minimum (Frenkel, 1999). According to the study, the changes in the target for overnight interest rates also affects the 30-day treasury bills, 30-year government bonds, 10-year mortgage and the investment certificates that are guaranteed on three months. When the overnight interest rate target is reduced, the demand for credit increases due to a fall in the commercial banks lending rates. Conversely, when the target interest rates are increased, the quantity supplied falls and demand for credit reduces. Furthermore, a fall in the overnight interest rates results in greater demand for the bank notes due to increased demand for credit. The commercial banks responds by buying more government securities in order to be able to supply more bank notes to the commercial banks, who in the other hand, are forced to sell government securities in order to buy more bank notes and meet the money deficit.
The overall objective of the Bank of Canada monetary policy is to control the inflation rates in the country and maintains economic growth for the country. From above discussions, it is evident that the interest rates as set out by the Bank of Canada have a considerable influence on borrowing and investments in the country. Historically, it has been found that interest rates have had considerable impact on the inflation rates in Canada and as a result has affected unemployment rates in the country (Webber, 2000).
Between 1980s and 1990s, there has been a considerable rise in the interest rates in the country. The net effect was a fall in the profitability of businesses in the same erra, which ultimately affected Canadian economy. The short-term interest rates averaged 1% above inflation rates in 1950s-1980s and since 80s; it rose to 5% maintaining the average. This led to a fall in the average earning as share of GDP from 20% in 1950-1960s to about 15% in 1980-1990s (Webber, 2000). This provides a clear pointer of the impact that interest rates has had on the economy of the country. The objective of the raising of the interest rates from the beginning of the 1980s was to provide the necessary impetus in order to limit the rates of inflation and increase profitability of business interests in the country and boost economic growth.
According to (Harvey, 1997), a large component of the GDP of Canada consists of personal consumption expenditures. On the other hand, consumption patterns are influenced by the interest rates, which influence borrowings and savings. A change in the interest rates, can increase or lower savings and borrowings. As pointed earlier, the increase in the overnight interest rates, will lead to an overall increasing in the lending rates by the commercial banks. This affects borrowing, ultimately the consumption patterns, and the country’s economy. The pattern of the unusually high interest rates is a blessing to savers and a pain to the borrowers. Furthermore, higher interests rates create two important impacts on the economy. The phenomenon shifts the distribution of income into favoring the rentiers and increases the cost of servicing the debt of the government as described in (Drache, 2015, pg. 31). On contrary, the relative decrease in the interest rates spurs economic growth by reducing the federal debt. Between, 1997 and 2007, Canada experienced a successive decrease in the interest rates and an increase in the budget surplus (Roy-César, 2010). Consequently, there was a reduction in the federal debt from about 64 – 23% and a growth in the country’s GDP. The growth in GDP resulted from a reduc…………………………………………………………………………….
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about:blankAdd titleThe impact of interest rate on economic growth in Canada
Economics: The Impact of Interest Rate on Economic Growth in Canada
(Course Instructor)
(University Affiliation)
(Student’s Name)
June 24th 2015.
Literature Review
The economy consists of millions of consumers who interact with firms on a daily basis in order to determine the types of goods, which the firms must produce and what consumers must take and at what prices. In Canada, a market based economy; the government plays a crucial role in enacting taxation policies in order to collect revenue to be used in provision of services, such as security, health, housing and education (Bank of Canada, n.d.). Although the government may not tax directly certain products or services, their presence is often felt in form of regulatory policies such as quotas, licenses and minimum wages among others. The government can exercise control over its economy through monetary and fiscal policies it set forth.
Through the central bank, a government can set up decisions and regulations in order to determine the amount of money in circulation. In Canada, the Bank of Canada conducts the monetary policy (Masson, 2013). This is achieved through the adjustment of the very short-term interest rate in order to achieve a monetary expansion at relatively low and stable inflation rate. The monetary policy in Canada has a number of features that makes it unique. First, the independent government owned Bank of Canada, which is unswerable to the parliament, conducts the monetary policy. The Bank of Canada performs its functions independent from the federal government but all its policies are subject to the parliament considerations.
The other feature that defines the Canadian monetary policy is that the ease with which financial capital can move within Canada has made it possible for the creation of one monetary policy that applies all over Canada. In addition, Bank of Canada is the sole issuer of the bank notes in the country. Finally, the Bank of Canada has only one monetary policy regardless of the fact that many variable affect monetary decisions. Unlike the fiscal policy, the monetary policy has no direct influence on the taxation and spending at any level of the federal government. Similarly, it cannot regulate the labour and product markets in the country. However, it plays a limited role in the oversight and regulation of some parts of the financial system in Canada.
The big question would be, “what is the Bank of Canada’s policy instrument?” The policy instrument of the Bank of Canada is the overnight interest rate. The commercial banks in Canada borrow money from the Bank of Canada at a certain predetermined overnight interest rate and lend them to each other. The borrowing rates are market-determined and fluctuate on a daily basis. The Bank of Canada can keep the interest rate at a certain operating band by announcing the lending rate and the borrowing rates for a short while from the central banks in the country. When the Bank of Canada changes the overnight interest rates, it determines the rates at which the commercial banks can lend their money.
These actions of the Bank of Canada to determine the overnight interest rates, affects the economy as well as the money in circulation and at the same time controlling inflation rate in the country to a certain minimum (Frenkel, 1999). According to the study, the changes in the target for overnight interest rates also affects the 30-day treasury bills, 30-year government bonds, 10-year mortgage and the investment certificates that are guaranteed on three months. When the overnight interest rate target is reduced, the demand for credit increases due to a fall in the commercial banks lending rates. Conversely, when the target interest rates are increased, the quantity supplied falls and demand for credit reduces. Furthermore, a fall in the overnight interest rates results in greater demand for the bank notes due to increased demand for credit. The commercial banks responds by buying more government securities in order to be able to supply more bank notes to the commercial banks, who in the other hand, are forced to sell government securities in order to buy more bank notes and meet the money deficit.
The overall objective of the Bank of Canada monetary policy is to control the inflation rates in the country and maintains economic growth for the country. From above discussions, it is evident that the interest rates as set out by the Bank of Canada have a considerable influence on borrowing and investments in the country. Historically, it has been found that interest rates have had considerable impact on the inflation rates in Canada and as a result has affected unemployment rates in the country (Webber, 2000).
Between 1980s and 1990s, there has been a considerable rise in the interest rates in the country. The net effect was a fall in the profitability of businesses in the same erra, which ultimately affected Canadian economy. The short-term interest rates averaged 1% above inflation rates in 1950s-1980s and since 80s; it rose to 5% maintaining the average. This led to a fall in the average earning as share of GDP from 20% in 1950-1960s to about 15% in 1980-1990s (Webber, 2000). This provides a clear pointer of the impact that interest rates has had on the economy of the country. The objective of the raising of the interest rates from the beginning of the 1980s was to provide the necessary impetus in order to limit the rates of inflation and increase profitability of business interests in the country and boost economic growth.
According to (Harvey, 1997), a large component of the GDP of Canada consists of personal consumption expenditures. On the other hand, consumption patterns are influenced by the interest rates, which influence borrowings and savings. A change in the interest rates, can increase or lower savings and borrowings. As pointed earlier, the increase in the overnight interest rates, will lead to an overall increasing in the lending rates by the commercial banks. This affects borrowing, ultimately the consumption patterns, and the country’s economy. The pattern of the unusually high interest rates is a blessing to savers and a pain to the borrowers. Furthermore, higher interests rates create two important impacts on the economy. The phenomenon shifts the distribution of income into favoring the rentiers and increases the cost of servicing the debt of the government as described in (Drache, 2015, pg. 31). On contrary, the relative decrease in the interest rates spurs economic growth by reducing the federal debt. Between, 1997 and 2007, Canada experienced a successive decrease in the interest rates and an increase in the budget surplus (Roy-César, 2010). Consequently, there was a reduction in the federal debt from about 64 – 23% and a growth in the country’s GDP. The growth in GDP resulted from a reduc…………………………………………………………………………….
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