THE ECONOMY AND YOU
KEY CONCEPTS – 1

INTEREST RATES ARE APPLIED TO MONEY THAT IS BORROWED (A COST) OR SAVED
(A GAIN)

HOW MUCH MONEY IS SAVED OR BORROWED DEPENDS ON WHETHER THE INTEREST
RATE IS SET HIGH OR SET LOW
Interest Rate
SET HIGH
SET LOW
Amount borrowed
Amount saved
DECREASES
– loans + major
credit purchases
are expensive
– sales of big ticket
items decrease
– prices of goods +
services fall
INCREASES
– low risk
investment (sits in
the bank +
collects interest)
– good for people
living off fixed
investments GICs,
bonds, etc.
INCREASES
– funds for major
purchases easily
affordable
– sales of homes,
cars, vacations
increase
– if supply <
demand prices
increase =
inflation
– “bubbles” may
burst (real estate)
DECREASES
– return on money
invested in a bank
is low
– stock market may
give a better
return BUT higher
risk
– living off
investments more
difficult
The interest rate can have an influence on how an economy performs by adjusting the supply and
demand of money.
Adjusting the short term interest rate to slow down or stimulate the economy is called MONETARY
POLICY.
FACTORS AFFECTING INTEREST RATES

global market forces
expected rates of INFLATION

o high interest rates usually follow a period of inflation to increase the cost of borrowing,
which decreases demand leading to lower prices
o higher rates are needed to cancel the effect of inflation for investors
o indexed pensions are protected from inflation – monthly payments are increased to
make up for the loss of purchasing power
monetary policy - as explained above

INFLATION + COST OF GOODS
Online source: http://www.tutor2u.net/economics/content/topics/inflation/what_is_inflation.htm
If a good in 2007 costs $1000 and inflation is at 2.5% then the cost to the buyer in 2008 will be
$1000 x 1.025 = $1025. Companies must pass on their increased costs (COST-PULL INFLATION) to
consumers.
Or, if a person earns $1000 in 2004 they will need to earn $1025 to maintain their lifestyle in 2005.
INFLATION + INVESTMENTS
Bank Rate
- set by the Bank of Canada
Prime Rate
- set by commercial banks and other lending institutions, which is higher
than the bank rate (rate given to most credit worthy customers)
Nominal Rate (N)
- posted rate for consumer lending/saving
Inflation rate (I)
- rate of inflation
On savings accounts:
Real interest rate (R)
= N–I
Example: If a savings account earns 5% interest but inflation is at 3%, the account is really only
earning 2% because 3% of the earned interest must be used to offset the increased cost of
purchased goods and services.
This is why investors will ask for much higher rates of return under inflationary conditions; or
investors may avoid investing in an economy where inflation is high and increasing steadily.
DEFLATION
– caused mainly by insufficient money in the economy to buy up the available goods and
services available
– lowered demand forces prices lower to increase demand, but only so far – company profits
suffer, which inevitably will lead to higher unemployment and lower consumer confidence
– Japan suffered from deflation for almost a decade – interest rates were set at 0% in an
attempt to stimulate borrowing to stimulate economic growth
–
Want to know more? Try http://www.inflationdata.com/inflation/Articles/Deflation.asp, or
http://www.guardian.co.uk/theissues/article/0,6512,959334,00.html#article_continue .