Digging a little deeper into the issue of inflation, today we look at how the Bank of Canada uses interest rates to manage inflation.

Managing inflation goes back to basic economics, and the theory of supply and demand. If something is in good supply, prices go down. If supply is low, an item is hard to get and prices go up. For example, if you live in a “one-horse town” everyone wants to own that one horse (demand is high), and will pay a lot of money for it. If a newcomer arrives with 10 horses to sell, supply has increased, and prices will go down. Imagine the same horse seller visits a town where everyone already owns a horse. Demand is low. The seller will have to drop prices even more to convince people to buy his horses.

Interest rates are essentially the price of money. If interest rates go up, money is more expensive to borrow. It costs more to borrow money for your house, car or vacation. Fewer people will borrow, thus demand for goods goes down. If demand goes down, prices go down. This keeps inflation low.

If low inflation is good, then why not always have high interest rates? Well, if money is too expensive, and people aren’t borrowing, then people are not buying cars or houses, or going on vacation. This is naturally not good for the economy. In a recession, interest rates are often lowered (as in the previous few years in Canada) to encourage people and business to spend more and stimulate the economy.

The Bank of Canada sets the overnight interest rate in Canada with these goals in mind. They are constantly seeking a balance between stimulating the economy, and keeping inflation under control. If rates are too low for too long, inflation can get out of control, and the prices of goods and services can rise dramatically, which is also not good for the economy.

As investors, we like high interest rates, as our deposits and bonds make more money over time. As borrowers, we prefer low rates, so our mortgages and car loans are cheaper. The rate of interest and the rate of inflation will influence your financial plan and your investing strategy. Have you discussed inflation with your adviser? Do you know how it might affect your plan?

For more on the Bank of Canada and monetary policy, read about the monetary policy transmission mechanism.