Canadian Securities Course (CSC) Level 1 Practice Exam

How would the Bank of Canada implement monetary policy if inflation was rising?

1. Reduce the money supply

2. Lower interest rates

3. Increase interest rates

4. Implement quantitative easing

The correct answer is: Increase interest rates

When inflation is rising, the Bank of Canada typically responds by increasing interest rates. This is a strategy aimed at cooling down an overheated economy. Higher interest rates lead to more expensive borrowing costs for consumers and businesses. As loans become pricier, spending tends to decrease, which can help to lower the demand for goods and services. With less demand, businesses might hold back on raising prices, thereby helping to reduce inflationary pressures. The rationale behind this approach is grounded in the relationship between interest rates and both consumer spending and investment. By increasing rates, the bank is signaling an intention to tighten monetary policy to combat rising inflation, working to stabilize prices over time. The other strategies mentioned, such as reducing the money supply or implementing quantitative easing, would typically be used in a different economic context, such as when trying to stimulate growth during a slowdown or when inflation is very low. Thus, increasing interest rates is the appropriate response to rising inflation, as it is designed to mitigate excessive price increases in the economy.