MONETARY CONDITIONS IS THE
TERM used to describe the combined effect of the
level of short-term
interest rates and the exchange rate for the
Canadian dollar.
With an open economy like Canada's, and a
flexible
exchange rate, changes in the dollar's
external value have a big influence on the
demand for goods and services. For example, a
considerably lower dollar can result in more
goods being exported, increased tourism, and
higher import prices, leading to fewer goods
being imported. Higher import prices also affect
consumer prices.
This
means that the Bank must consider the exchange
rate when changing the
Target for the Overnight Rate because it is
the combined effect of interest rates and the
exchange rate that determines monetary
conditions and helps keep the economy on a
smooth course.
It is sometimes mistakenly
said that the Bank of Canada changes its
monetary policy by moving the Overnight Rate
Target up or down.
What is really happening is
that the Bank is moving the Overnight Rate
Target to adjust monetary conditions. It does
this to ensure a sound, low-inflation climate
for long-lasting growth and job creation—the
ultimate objective of monetary policy.
Tracking monetary conditions
To carry out monetary policy,
the Bank of Canada tracks monetary conditions
with the monetary conditions index, a tool
developed by the Bank and published in its
Weekly Financial Statistics.
This index incorporates interest rates and the
exchange rate—a 3 per cent change in the
exchange rate is equivalent to a 1 percentage
point change in interest rates, a relative
weighting of three for interest rates and one
for the exchange rate.
The
information provided by the index helps to guide
the monetary policy decisions of the
Bank—particularly decisions on when to adjust
the Overnight Rate Target in response to
changing economic developments.
When the Bank needs to change
monetary conditions directly, it adjusts its
Overnight Rate Target, which in turn can affect
the exchange rate. Higher Canadian interest
rates attract funds to this country, leading to
a stronger Canadian dollar. Lower interest rates
tend to bring a lower exchange rate.
However, the Bank does not respond to short-term
movements in the exchange rate and in monetary
conditions. It attempts, instead, to maintain
monetary conditions in a range consistent with
the long-term objectives of monetary policy.
The
Bank must also take account of the lag in the
transmission of monetary policy. This is the 18
to 24 months required for the sequence of events
that transmits a change in monetary conditions
through the economy to ultimately affect the
inflation rate.
