##le in his 1949 article on “ the nature of interest rates. ” describing a situation in which the central bank tries to bring interest rates down he states that [ p. 115 ] “ a consensus of market opinion can be swung, by words and deeds of the monetary authority or its masters ”. the structure of the basic new - keynesian model can be easily represented by three equations characterising the dynamics of the interest rate, output and inflation. the first equation can be related to the supply side, the second to aggregate demand, and the third specifies monetary policy behaviour. the equation representing aggregate supply captures the price - setting behaviour of firms, resulting from profit - maximisation under the obstacle of some sort of nominal price rigidity. owing to this rigidity, firms have to take into account the expected development of prices in the next period when setting their prices today. in its most basic form, this equation is known as the “ new - keynesian phillips curve ” which expresses current inflation πt as a function of currently expected inflation for the next period et ( πt + 1 ) and the current output gap xt : 4 πt = β · et ( πt + 1 ) + κ · xt. the latter stands for the amount of slack in the goods market and is defined as the difference between actual output and its natural level, that is, the production level which would prevail in the hypothetical situation of fully flexible prices. the demand equation ( ’ is curve ‘ ) is based on the assumption that households optimise their whole consumption stream over the present and the future. this leads to an expression relating the current output gap to the currently expected output gap of the next period et ( xt + 1 ) and an interest rate gap : xt = et ( xt + 1 ) – σ - 1 · ( it - et ( πt + 1 ) – rt * ) the natural real rate of interest comes in at this stage : the interest rate gap is the difference between the actual ex ante real interest rate it - et ( πt + 1 ) and the natural real rate of interest rt *. this variable turns out to be a key variable for the design of monetary policy in this class of models. within the newkeynesian paradigm it is defined as the one - period equilibrium real rate of return that would prevail in the hypothetical equilibrium with completely flexible prices, that is, in the absence of nominal price rigidities. as is evident from the

of policy rates, we do not outsource our monetary policy to the u. s. federal reserve. what happens in the united states obviously matters for canada, but this does not mean that our rates are tied to those of the americans. over the two decades of inflation targeting, the overnight rate in canada has been more than 200 basis points above, and more than 200 basis points below, the federal funds rate. these variations reflect differences in our respective economic outlooks. canadian monetary policy will be appropriate to canadian circumstances and consistent with achieving price stability in canada. canadians can also be assured that the bank will take the necessary steps to ensure that core financial markets remain liquid and operating. in the event of a major systemic shock, the bank has a wide range of tools to provide exceptional liquidity, consistent with a principles - based framework. this will help ensure that all canadians benefit from the strength of our financial system, in bad times as well as good. while we experience the fallout of events in europe and the united states, canada should also draw the lessons from these experiences. the european sovereign crisis reinforces the importance of sustainable government debt and the value of a flexible exchange rate. american difficulties underscore the risks of excessive household debt. should you wait out the storm? financial markets appear paralysed. you shouldn ’ t be. these events are like the waves on the sea. the underlying currents – those forces that affect the long - term outlook for our businesses and economy – are much stronger. today, the charts reveal three major currents : canadian firms are underexposed to the fastest growing parts of the global economy ; commodity prices can be expected to remain elevated relative to historic averages ; and our firms are not as productive as they could or need to be. regardless of what happens in the united states or europe, these challenges and opportunities need to be seized through sustained efforts here in canada. the world ’ s economic centre of gravity is shifting rapidly from advanced to emerging economies. the game in the united states will be more about taking market share ( something we have not been doing recently ) than participating in a growing market. to put it according to projections published since 1998 by the bank in our monetary policy report, this is the variance in the horizon over which inflation was projected to return to the 2 per cent target. bis central bankers ’ speeches bluntly, the u. s. economy can be expected to be relatively weak for some time as households repair balance sheets and governments wrestle with deficit