Gary Rabbior is the president of the Canadian Foundation for Economic Education. This is the fourth of a six-part series on understanding how the economy works and why it matters to investors.
Using the analogy, we can see why it is so important for the Bank of Canada to try to create the appropriate monetary conditions for the economy. How does the Bank of Canada affect monetary conditions?
First, if the Bank wants to try and reduce spending levels - that is, if it thinks spending levels are likely to push up the rate of inflation - it can help push up interest rates. If interest rates rise, people and businesses tend to borrow and spend less and can reduce the pressures pushing up the inflation rate.
The Bank can also reduce interest rates if it wants to try and boost spending. It can also put more money on deposit with the commercial banks. This gives the banks more money to lend and invest. The Bank can also withdraw money from the commercial banks if it wants to decrease the amount of money in circulation.
Third, the Bank can also influence the exchange rates of the Canadian dollar. If it wants to reduce spending, a higher valued dollar will tend to reduce our export sales - that is, reduce spending on Canadian goods and services. Similarly, if the Bank wanted to try and boost spending, a lower valued Canadian dollar should help boost our export sales.
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An Investor's Guide to Understanding the Economy:
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The Bank's goal is to try and generate the "right" monetary conditions to keep the economy on a smooth growth path with relatively stable prices. That's the objective - but it's not easy. If monetary and credit conditions are "too loose" (that is, they generate too much spending in relation to what the economy is producing) then the higher spending levels that occur will cause higher prices and higher levels of inflation.
But if monetary and credit conditions are "too tight," that is, if interest rate levels, the quantity of money, and the exchange rate are such that they discourage and reduce spending too much, then output will remain unsold, business inventories will accumulate, companies will cut back on production and lay off workers, and incomes will be lost. Tight monetary conditions can reduce spending, and the falling spending and reduced sales will slow down production activity and the economy.
Our economy has two sides to it. There is the real side (the actual goods and services that are produced and distributed using our available resources) and the money or nominal side (the money in our financial system that exists to help our economy with the process of production, exchange, and distribution).
In the long run, the quantity of money in our economy will affect the prices paid for available output and the average price level in the economy. The quantity of money will ultimately not affect the level of output.
The money side exists to help the real side. If the money supply and monetary conditions are managed well, they can help to support real, productive economic activity that creates goods, services, jobs, and incomes in our economy. They can help to keep the economy on a stable path.
Canada has had a pretty good record over recent years in terms of financial management. The Bank of Canada has played a big part in that. The Bank of Canada has not always managed to get things "quite right" - and there will always be debates over monetary policy and the actions and policies implemented - but, by and large, Canadians can be pretty pleased with the quality of financial management expertise the Bank of Canada has demonstrated. There are many other countries that envy our record. Let's hope the same holds true for our future.
In summarizing, the key point is that our economic world does not revolve around money. We could turn on the printing presses and give everyone lots and lots of money, and that money would fail to make the people in our society better off. We saw this in our game. The extra money may even make some people worse off if they can't afford the higher prices that result. Inflation creates problems, and the economy, as a whole, functions less well during inflationary times.
Our Auction Block game didn't reveal all the possible costs of inflation. For instance, inflation creates uncertainty regarding the future. Inflation makes it more difficult for people to make economic decisions and increases the risk that some decisions may turn out to have negative consequences. Inflation forces businesses and households to spend more time, and often more money, trying to protect themselves from the effects of rising prices. Inflation can also mean particular hardship for those whose incomes don't keep pace with the rising level of prices. For these and other reasons, price stability in the economy is preferred over higher rates of inflation, and we hope that our economy will move along a nice, stable path accompanied by high levels of employment.
Our economy-the economic engine to produce goods and services-is not driven by money. The economic engine is driven by the labour, ingenuity, capital, and other resources that are put to productive use. Money is the oil that lubricates the engine and can keep it running smoothly and efficiently. However, as with any lubricant, if not used properly, it can damage the engine, slow it down, and cause a host of complications. And the Bank of Canada is the primary "mechanic" that tries to keep the engine well, and appropriately, lubricated.