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Monetary Conditions

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.