Monetary Policy

The term monetary policy refers to the actions of a regulatory committee, current board, or central bank, which determine the rate of growth and size of the money supply. These actions have impact on interest rates. Institutions maintain the monetary policy of the country through certain actions, including regulations on bank reserves (the amount of money financial institutions are required to keep) and increasing the rate of interest.

The supply of money is controlled through interest rates and other means in order to promote stability and economic growth. The aim is to achieve low unemployment rates and stable prices. To this, monetary policy is either contractionary or expansionary, with contractionary policy shrinking the money supply or expanding it more slowly. With expansionary policy, the money supply increases at a more rapid pace than usual. Contractionary policy aims to slow down inflation so that no deterioration of asset values and distortions are observed. Then, expansionary policy aims to lower interest rates so that businesses have access to easy credit and expand their operations. The goal of expansionary policy is to prevent recessions and reduce unemployment levels.

The Bank of Canada aims to keep inflation predictable, stable, and low as to raise the living standard of Canadians by contributing to stable economic performance. The monetary policy of the country is built on two pillars and namely, inflation-control target and flexible exchange rate. A flexible
exchange rate allows the country to develop an independent monetary policy, which is a ‘shock absorber’ and meets the needs of the economy. Stable and low inflation contributes to making a well-functioning and productive economy. Then, fluctuations in the key interest rate have impact on interest rates in general, affecting the spending decisions of Canadians.

A cornerstone of Canada’s monetary policy, inflation-control targeting was introduced in 1991. The current target range is between 1 and 3 percent, while the Bank of Canada aims to keep inflation at 2 percent. Inflation-control targeting contributes to making the monetary policy of Canada more understandable to the general public and the financial markets. It measures the effectiveness of the country’s monetary policy and anchors predictions for future inflation. This helps government structures, businesses, and individuals make decisions in a way that contributes to non-inflationary economic growth. When inflation is kept at low levels, this reduces the cost of borrowing and encourages people to purchase durable goods.

There are other types of monetary policy besides the cornerstones of Canada’s monetary policy. These include fixed exchange rate, money aggregates, and price level targeting. A system of fixed rates is in place when the authorities declare fixed exchange rate but do not trade currency actively as to maintain the rate. Another approach is money targeting, based on a continuous expansion of the country’s supply of money. This type of monetary policy is referred to as monetarism. Price level targeting is a similar mechanism to inflation-control targeting. The difference is that growth of the consumer price index in one year, under or over the long-term price level targets, is offset in the next years. The aim is to reach a targeted price level over a certain period of time, which gives consumers a degree of certainty about future price levels. The gold standard is another type of monetary policy under which units of gold bars are used to measure the price of the national currency. The promise of the government to sell and buy gold at a fixed price keeps the price of the currency constant. In general, the gold standard may be classified as a variety of commodity price level targeting or a variation of fixed exchange rates.