Running head: BANK OF CANADA’S REACTION TO OIL PRICE SHOCK 1

Bank of Canada’s Reaction to Oil Price Shock

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Bank of Canada’s Reaction to Oil Price Shock

Despite the fall in consumer price index inflation in the country according to the article

Bank of Canada maintains overnight rate target at 3/4 per cent, the Bank of Canada decided to

maintain an overnight lending rate at 3/4 percent and for the bank and deposit rates the rates

were set at 1 and 0.5 percent respectively. This paper discusses the action of the bank using the

IS-LM model.

Oil is an important export for the Canadian economy. This implies that the decline in the

prices of the commodity directly affects the economic activities in the country. However, as

highlighted in the article, core inflation remained lower due to the boost of sector-specific factors

especially the stronger growth in the non-energy sector over the previous year. The fall in oil

prices had affected the aggregate demand and income but the bank anticipated the most impact of

the oil price shock to appear in the mid-2015. As a result, the bank of Canada decided to ease the

Canadian financial conditions by reducing overnight lending rates by one quarter from 1% in

January 2015 to stimulate non-energy export and investment. Prior to the monetary easing, the

overnight lending rates had been maintained at 1% for 4 years since mid-2010. This action can

be demonstrated using the IS-LM model as shown in figure 1 below.

 BANK OF CANADA’S REACTION TO OIL PRICE SHOCK 3

r LM (M/P)

LM1(M1/P > M/P)

1% A

0.75%
B

IS

Y Y1 Output (Y)

Figure 1. Summary of Bank of Canada’s action

The diagram above summarizes the action of the Bank of Canada. By maintaining the

overnight lending rates at 0.75% as opposed to the original rate of 1 % increase, the money

supply in the economy causes the LM curve to shift outwards and to the right from LM to LM1.

The reduction in the overnight lending rate also causes a downward movement along the IS

curve from point A to point B and increases the level of output from Y to Y1. A decline in the

overnight lending rates is spread throughout the economy. When banks are borrowing money

cheaply from the central bank, they will, in turn, offer cheap loans to members of the public thus

increasing the money supply in the economy. Availability of money enhances demand for goods

and investment in the non-energy sector thus increasing the level of output to Y1. The movement

along the IS curve from point A to point B is attributable to decline in interest rates by the

financial institutions, high rate of investment, high demand, and consumption for goods and

services in the non-energy sector and increase in the level of output.

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Since the Bank of Canada expected the impact of low oil prices to intensify in the

preceding months, it decided to maintain the low-interest rates to increase the money supply.

With low-interest rates, individuals are motivated to borrow and invest. Consumers are also

likely to consume more at this time. Increased investment and consumption favor economic

growth.

In Summary, the bank maintained a high level of money supply to stimulate investment

and consumption in the non-energy sector with the aim of mitigating the negative effects of the

oil price shock. The monetary policy stimulus was meant to facilitate financial stability and

maintain a balanced inflation profile.