CHAPTER 17 441 Tools of Monetary Policy Dollar goes down te Ra of fla In tio n Prices Decrease in target for the overnight interest rate Increase in demand $ Costs Interest rates go down F I G U R E 17- How the Bank of Canada Keeps the Rate of Inflation from Falling Below the Target Range Source: Bank of Canada website: www.bankofcanada.ca Reprinted with permission Hence, by changing the target and operating band for the overnight rate, the Bank of Canada sends a signal regarding the direction that it would like interest rates and the money supply to take A rise in the target and operating band, and thus the bank rate, is a signal that the Bank would like to see higher interest rates and less money in the economy A fall in the target and operating band is a signal that the Bank would like lower interest rates and more money Nominal Interest Rates and Monetary Policy The Bank of Canada uses the nominal overnight interest rate as its operating instrument, but as you will learn in Chapter 25, the effects of monetary policy on economic activity stem from how the real interest rate, ir, rather than the nominal interest rate, i, affects consumption and investment spending In fact, the current interest rate targeting approach is based on the belief that it is the real long-term interest rate, and not the real short-term interest rate, that affects consumer and business decisions How is it that changes in short-term nominal interest rates (such as the Bank of Canada s overnight rate) affect short- and long-term real interest rates? Under the new Keynesian assumption of sticky prices (that is, under the assumption that prices not adjust instantaneously to clear the markets), an expansionary monetary policy that lowers the short-term nominal interest rate will also lower the shortterm real interest rate, since the aggregate price level adjusts slowly over time and there is not much change in the inflation rate Moreover, according to the expectations hypothesis of the term structure of interest rates (discussed in detail in Chapter 6), the decline in short-term interest rates will also lead to a decline in long-term interest rates and ultimately to increases in consumer and investment spending