As Canadians weather inflation amidst economic uncertainty, many are asking a fundamental question about the Bank of Canada鈥檚 policy strategy: how do increased interest rates tame inflation?
The answer comes down to spending behaviour.
鈥淗igher interest rates encourage saving and discourage borrowing and, in turn, spending,鈥 the Bank of Canada (BoC) explains on its website. 鈥淚n response, companies increase their prices more slowly or even lower them to encourage demand.鈥
In order to achieve the inflation target, the BoC will adjust the policy rate, prompting banks to increase interest rates on their deposits, loans and mortgages, and initiating a chain reaction in the exchange of goods and services.
In an effort to measure inflation each month, Statistics Canada tracks the prices of consumer goods and services, all contributing to what鈥檚 called 鈥渢he consumer price index鈥 (CPI). This measurement represents 鈥渂ig picture鈥 spending across Canada, and the data is commonly considered by businesses, institutions and governments to understand financial trajectories.
Expectation is a key component of inflation troubles.
鈥淚f people expect that prices will rise, on average, by about 2 per cent each year, employers and workers are more likely to agree to a 2 per cent wage increase to compensate for the higher cost of living,鈥 the Bank of Canada said. 鈥淎nd since wages affect the cost of producing goods and services, and the cost affects their prices, this cycle helps the Bank keep inflation on target.鈥
Simply put, if the cost of goods outweigh people鈥檚 income, people will buy less and the economy will slow. General purchasing power will decrease throughout the economy.
鈥淗igh inflation can mean that people who have saved for their retirement may find themselves with less money than they expected,鈥 says the BoC. 鈥淏usinesses and consumers must spend time and effort trying to protect themselves from the effects of rising costs.鈥
But as bad as high inflation is, deflation 鈥 where prices plummet 鈥 isn鈥檛 much better.
鈥淎 drop in some prices can boost demand for those items,鈥 says the BoC. 鈥淏ut a general, persistent fall in prices is usually a symptom of deep problems in an economy.鈥
Because of this, the BoC also leverages interest rates when it comes to enabling more spending.
鈥淟ower interest rates work in the opposite way and can help increase inflation if it is too low.鈥
It all comes down to purchasing power 鈥 and the fuel behind it, the BoC explains. When people lose their jobs, they have less money to spend. As a result of this, when a business is experiencing fewer sales, they may drop their prices 鈥 but that鈥檚 a result of lowered demand.
鈥淎s more money is saved, less money is spent, prices fall further, and economic activity shrinks.鈥
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