Canada Policy Analysis Taxes & Economics

The Economic Importance of Policy Interest Rates

Every month and a half, the news is flooded with reports on the Canadian Central Bank’s most recent policy interest rate decision. What is lacking in these reports is the importance and meaning behind these rate decision. The policy interest rate is extremely important to the economy, with effects ranging from the price of stocks, to the cost of putting food on the table.

First off, it is important to understand the importance of interest rates on the economy, and in our individual lives. In short, when interest rates are lower, people can afford to take on loans. This means instead of having to save up to make a purchase, they can do it on credit. What this results in is an increase in consumer spending, as people can make almost any purchase at any time.

For instance, when purchasing real estate, consumers will factor in the added cost of completing the transaction now, on credit, instead of waiting to save up there money; this cost is the interest rate that the bank charges. Recently, interest rates have been low, which has been a factor in the corresponding larger than usual volume of housing purchases. Secondly, interest rates determine how much businesses can expand and buy new materials.

The Bank of Canada in Ottawa

When interest rates are low and businesses can afford to take out loans, they will expand their business practises, which results in efficiency due to a concept called economies of scale, which means that as a business or economy expands, the amount of resources required per unit produced goes down. This is what allows us to have mass amounts of products such as pencils, pens and even cellphones; if businesses hadn’t been able to invest and expand, the cost of many of our goods would be much higher.

Hopefully, you now comprehend the importance of the interest rate. The interest rate is, in part, determined by the Policy Interest Rate. The Policy Interest Rate is the Central Bank’s target for the interest rate in which banks make one day loans to one another. Despite what one may think, the big Canadian banks rely upon making loans with one another to maintain there outflow of cash to clients and to perform their daily operations. Naturally, the banks pay much less to loan from one another than it costs for us to loan from them, and since the market for loans between banks is very small, it is easy for the Bank of Canada to manipulate the interest rate.

One might ask how the rate a bank has to pay another bank for a loan impacts the general interest rate. When the Bank of Canada lowers its policy interest rate, this results in a decrease in borrowing costs for the banks, which results in a decrease in the cost of borrowing for consumers as a whole; when the interest rate decreases, businesses, homeowners and individuals will be encouraged to borrow money. This will result in the stimulation of the economy, as more people have money and are spending it. The opposite will occur when the government raises the policy interest rate: the cost of borrowing (the interest rate) will increase, resulting in less loans being distributed to businesses and individuals, resulting in less consumption and hence dampening economic growth.

This begs the following question: why doesn’t the Bank of Canada maintain low interest rates indefinitely? Unfortunately, like in many things in life, the positives of lowering interest rates also comes along with many negatives. Lowering interest rates will result in rising rates of inflation, which makes goods more expensive. The little known fact about inflation is that its true cost doesn’t lie in the fact that it rises prices; this rise in price corresponds with rising wages. Instead, inflation punishes those who lend money to others; if someone were to give someone a $100 loan and inflation was 3%, in one year, there money is suddenly worth $97. Moreover, fluctuations in price result in something called menu costs, which is the cost for stores and restaurants to reprint and adjust all there menus and advertisements to fit the new prices.

Bank of Canada Governor Stephen Poloz speaks during a news conference upon the release of the Monetary Policy Report in Ottawa January 22, 2014. Chris Wattie/Reuters

To sum up the cost of inflation quite simply in three words: it causes inefficiency. This is the reason why the Bank of Canada doesn’t maintain low rates indefinitely. Moreover, if they left the interest rates untouched, after a while they would rise on their own. This is because the banks charge something called a nominal interest rate. Essentially, the banks recognize that there is a cost associated with inflation, so they will take the interest rate they want to earn (the real interest rate) and add it with the cost of inflation to get the nominal interest rate which is what one will see on a credit card statement, mortgage or any other loan. When inflation rises, this results in an increase in the nominal interest rate; the banks do not earn any more money, but they have to charge more to negate the cost of inflation on their assets.

The rate decisions that the Central Bank, and specifically the governor of the Central Bank Stephen Poloz makes are based on a deep understanding of Canada’s economy, and through thorough analysis of the underlying, vital statistics pertaining to the Canadian economy. With this being considered, the fundamental ideas behind the Bank of Canada’s rate decisions are relatively easy to comprehend. Essentially, the bank can take expansionary and contractionary approaches to the economy. If the economy is in recession, like in 2008, the Bank of Canada will lower its rates and try to add money into the economy, to try and help the economy gain its footing. On the opposite end of the spectrum, if inflation is relatively high, in Canada usually around 2 percent, the Bank of Canada will do the opposite. It will raise interest rates and try to take some money out of the economy, which will slow economic growth, but will also limit the effects of inflation.

Overall, the importance of interest rates to an economy cannot be overstated. Every individual experiences the effects of interest rates in one way or another on a daily basis. This extremely important economic indicator is in large part determined by the Bank of Canada, who manipulates it using its Policy Interest Rate. Next time you see the Policy Rate in the news, hopefully you’ll have some notion as to what that number means, and will have  a little bit of knowledge about the reasoning behind the decisions that the Bank of Canada makes.

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