Monetary policy is concerned with how much money circulates in the economy, and what that money is worth.
The cornerstone of the Bank's monetary policy framework is its inflation-control system, the goal of which is to keep inflation near 2 per cent — the mid-point of a 1 to 3 per cent target range. This system provides a clear measure of the effectiveness of monetary policy, and increases the predictability of inflation.
The Bank is equally concerned with significant movements in the inflation rate, both above the 2 per cent mid-point and below it. When demand is strong, it can push the economy against the limits of its capacity to produce. This tends to raise inflation above the midpoint, so the Bank will raise interest rates to cool off the economy. When demand is weak, inflationary pressures are likely to ease. The Bank will then lower interest rates to stimulate the economy and absorb economic slack.
See The Output Gap for more information about the impact of demand and production on inflation.
The Bank carries out monetary policy by influencing short-term interest rates. It does this by raising and lowering the target for the overnight rate. (The "overnight rate" is the interest rate at which major financial borrow and lend one-day (or overnight) funds among themselves.) In November 2000, the Bank introduced a system of eight "fixed" dates each year on which it announces whether or not it will change the target for the overnight rate.
Changes in the target for the overnight rate usually lead to changes in other interest rates, and so affect people's spending decisions. This, in turn, influences the level of demand for goods and services. When demand exceeds supply, prices will rise.
Low, stable and predictable inflation is the best contribution that monetary policy can make to a productive, well-functioning economy. It allows Canadians to make spending and investment decisions with more confidence. This encourages longer-term investment in Canada's economy, and contributes to sustained job creation and greater productivity. This in turn leads to real improvements in our standard of living.