Friday, December 20, 2013

Interest Rates, Money Supply Growth, and Inflation in Canada

Monetary policy aims at promoting economic growth and curbing inflation through the control of the supply of money and the protection of the national currency. The Bank of Canada is the authority responsible for its implementation in Canada. How does the control of money supply relate to inflation? Basically, according to the quantity theory of money, over the long-run, money supply is directly proportional to the general level of prices. A change in the growth rate of money supply should therefore cause an equal change in inflation, the growth rate of price level.
In Canada, since 1991, the Bank of Canada has the mission of keeping inflation between 1 and 3 percent per annum. To achieve this target commonly referred to as the inflation-control target, it adjusts its key interest rate, which in turn influences other interest rates such as the consumer loan and mortgage rates. Changes in interest rates affect money demand and consequently money supply and inflation. The Bank of Canada’s key interest rate also known as key policy rate is the overnight rate, which basically is the interest rate applied to interbank lending.
In this article, I show the relationship between interest rates, money supply growth, and inflation in Canada.

The Relationship between Various Interest Rates in Canada
In Figure 1, below, I have plotted over the time period January 1983-November 2013 (1) the overnight rate, (2) the bank (or discount) rate, (3) Chartered banks’ consumer loan rate, (4) the Government of Canada’s two-year bond yields, (5) Chartered banks’ conventional 1-Year Fixed mortgage rate, and (6) the 1-month treasury bill rate.  
Figure 1: The Overnight and various other Interest Rates in Canada, 1983:1-2013:11, Data Source: Statistics Canada.

One can observe from Figure 1 the co-movement between the six interest rates. This means the chartered banks and the government adjust their interest rates to the overnight rate. When the Bank of Canada, say, increases its key interest rate, it becomes costly for chartered banks to borrow money overnight. They then pass on the increase in the overnight rate on the interest rates on consumer loan, mortgage, and other bank rates.
  
The Relationship between Interest Rates and Money Supply Growth
How does money supply react when chartered banks and other financial institutions pass an increase in the overnight rate on their various interest rates? To answer for this question, I have used the money supply measure called M2++. M2++ is made up of cash, checking and saving deposits, money market mutual funds held by all agents. Over the period 1969-2012, the correlation coefficient between the growth rate of M2++ and bank rate is .56 in Canada.

The Relationship between Money Supply Growth and Inflation
I have plotted in Figure 2, below, the growth rate of M2++ and inflation over 1969-2012.
 
Figure 2: M2++ Growth Rate and Inflation, Canada, 1969-2012, Annual Averages of Data Sampled Monthly, Data Source: Statistics Canada
 

Clearly, one can observe from the above figure that inflation follows the movement of the growth rate of M2++. The correlation coefficient between the two variables is .81.

To sum up,
  • Changes in the overnight rate influence the interest rates applied by financial institutions in Canada.
  • An increase in the growth rate of money supply can cause inflation. So does an increase in interest rates. The correlation coefficient between interest rate and inflation is .75.