Chapter 5 | Economic Policy

Question 1

FISCAL POLICY

Answer 1

Fiscal policy informs government decisions around the use of its spending and taxation powers.

A government’s fiscal policy influences economic activity, employment levels, and sustained long-term growth. Most fiscal policy is a balancing act between taxes and spending.

Question 2

NATIONAL DEBT

Answer 2

The national debt consists of accumulated past deficits minus accumulated past surpluses in the federal budget. When the government runs a deficit, it must borrow from the capital markets to finance the national debt.

Question 3

CROWDING OUT

Answer 3

Capital markets have a finite amount of capital. Therefore, when a government borrows significantly from the capital markets, less capital remains for businesses to borrow. This effect, referred to as crowding out, can have a negative impact on the economy.

The supply of capital may not be sufficient to meet the needs of the business community, and like any other market, when supply is less than demand, prices go up. In other words, interest rates rise, and it costs more to borrow money.

Question 4

KEY FISCAL POLICY TOOLS

Answer 4

The government’s key fiscal policy tools are spending and taxation.

Question 5

MONETARISTS

Answer 5

Monetarist theorists argue that governments should not use fiscal policy to influence the economy. They claim that changes to the money supply cause fluctuations in the economy. Therefore, the money supply and interest rates should be used to control economic instability and inflation. As the name suggests, monetary policy is the key economic tool that monetarist theorists propose should be used.

Monetarists believe that the central bank should expand the money supply at a rate equal to the economy’s longrun growth rate, such as 2% to 3% per year, for example. According to this view, the main policy goal is to control inflation, which creates a foundation for the economy to grow at its optimal rate. We look at monetary policy in the next section.

Question 6

BANK OF CANADA MAIN RESPONSIBILITIES

Answer 6

1. Monetary policy

2. The Canadian financial system

3 . Physical currency

4. Funds management

Question 7

BANK OF CANADA &
THE CANADIAN FINANCIAL SYSTEM

Answer 7

The Canadian financial system

The Bank works with a variety of agencies and market participants in Canada and abroad to promote and maintain the efficient operation of the financial system.

The Bank does this by overseeing the main clearing and settlement systems, working with domestic and international regulatory bodies, providing liquidity to the financial markets, and giving advice to the federal government. In its role as the nation’s central bank, the Bank is technically the ultimate source of liquidity in the financial system, and is referred to as the lender of last resort.

Question 8

GOAL OF MONETARY POLICY?

Answer 8

According to the Bank, the goal of monetary policy is to preserve the value of money in the economy by keeping inflation low, stable, and predictable. This goal helps to promote sustained economic growth and job creation. Since 1991, the Bank has acted to keep inflation between 1% and 3% by using inflation-control targets.

Question 9

The Bank can influence interest rates and the money supply through the following means:

Answer 9

The Bank can influence interest rates and the money supply through the following means:

• Target overnight rate

• Open market operations

• Drawdowns and redeposits

Question 10

WHEN ARE SPRAs USED?

Answer 10

SPRAs are used by the Bank when it wants to push interest rates down.

Question 11

TARGET OVERNIGHT RATE

Answer 11

TARGET OVERNIGHT RATE

The Bank conducts monetary policy primarily through changes to what it calls the target for the overnight rate. This action is the most important monetary policy tool the Bank uses. The Bank’s action can signal a policy shift towards an easing or tightening of monetary conditions to meet its inflation-control targets.

The overnight rate is the interest rate set in the overnight market, a marketplace wherein major Canadian financial institutions lend each other money in the form of one-day loans (called overnight loans). Changes in the target for the overnight rate influence other short-term interest rates, for such things as consumer loans or mortgages.

Question 12

OPEN MARKET OPERATIONS

Answer 12

The two main open market operations that the Bank uses to conduct monetary policy are Special Purchase and Resale Agreements (SPRA), commonly called Specials, and Sale and Repurchase Agreements (SRA).

Question 13

SPECIAL PURCHASE AND RESALE AGREEMENTS

Answer 13

An SPRA generally works as follows:

1. The Bank offers to lend on an overnight basis, that is, with an agreement that the loan be paid back one business day later.

2. The Bank essentially purchases Treasury bills from another financial institution on an overnight basis.

3. To complete the lending, the financial institution sells Treasury bills to the Bank on an overnight basis.

4. The Bank’s purchase of the Treasury bills gives the financial institution more money to lend out. This activity increases the money supply, causing the overnight rate to fall.

5. The next day, the transaction is reversed and the financial institution pays back the loan to the Bank.

Question 14

EXAMPLE / SPECIAL PURCHASE AND RESALE AGREEMENTS

Answer 14

The upper limit of the operating band is 2.0%, whereas overnight money is trending up and trading at 2.10%. The Bank enters into an SPRA and offers to lend at 2.0%, the top of the operating band.

This offer encourages financial institutions to borrow from the Bank at the lower rate, rather than from other institutions at the higher market rate of 2.10%. As a result, overnight rates remain within the operating band.

Question 15

SRA GOAL?

Answer 15

An SRA is similar to an SPRA, except that the goal is to increase the interest rate.

Question 16

SALE AND REPURCHASE AGREEMENTS

Answer 16

An SRA is similar to an SPRA, except that the goal is to increase the interest rate. If overnight money is trading below the target, the Bank may believe that inflationary pressures in the economy will rise because it becomes too inexpensive to borrow money.

To combat this pressure, the Bank intervenes and offers to borrow at a higher rate. For example, if the lower limit of the operating band is 1.5%, while overnight money is trading at 1.25%, financial institutions would much prefer the Bank’s rate.

Question 17

HOW AN SRA WORKS

Answer 17

An SRA generally works as follows:

1. The Bank offers to borrow money by selling treasury bills on an overnight basis.

2. The Bank essentially sells Treasury bills to other financial institutions.

3. To complete the deal, the financial institution buys Treasury bills from the Bank.

4. The transaction reduces the money supply because the financial institution must pay for the loan by drawing funds from its account. This action causes the overnight rate to rise. The next day, the transaction is reversed.

Question 18

DRAWDOWN

Answer 18

A drawdown is the transfer of deposits to the Bank from the chartered banks, which effectively drains the supply of available cash balances from the banking system. Financial institutions consequently have less money available to lend to consumers and businesses, which causes interest rates to increase. Consumers and businesses are less willing to borrow at these higher rates.

Question 19

REDEPOSIT

Answer 19

A redeposit is a transfer of funds from the Bank to the chartered banks. This increase in deposits and reserves increases the money supply, which in turn decreases interest rates.

Consumers and businesses are then more willing to borrow, and banks have more money to lend.

Question 20

BANK OF CANADA &
THE CANADIAN FINANCIAL SYSTEM

Answer 20

2. The Canadian financial system

The Bank works with a variety of agencies and market participants in Canada and abroad to promote and maintain the efficient operation of the financial system.

The Bank does this by overseeing the main clearing and settlement systems, working with domestic and international regulatory bodies, providing liquidity to the financial markets, and giving advice to the federal government.

In its role as the nation’s central bank, the Bank is technically the ultimate source of liquidity in the financial system, and is referred to as the lender of last resort.

Question 21

TRUE OF FALSE? In its role as the nation’s central bank, the Bank is technically the ultimate source of liquidity in the financial system, and is referred to as the lender of last resort.

Answer 21

ANSWER: TRUE

Question 22

DISCUSS THE BANK OF CANADA
&
FUNDS MANAGEMENT

Answer 22

FUNDS MANAGEMENT

The Bank is the fiscal agent for the Government of Canada. In this capacity, it has the following responsibilities:

It manages the government’s accounts through which virtually almost all money collected and spent by the government flows.

It manages the government’s foreign currency reserves, such as U.S. dollars, euros, gold, and silver.

It manages the government’s federal debt, which consists mostly of Treasury bills and marketable bonds. The Bank keeps track of this debt by ensuring that interest payments are made, tracking who owns the debt, and ensuring that the debt is paid back or refinanced in a timely manner.

It provides advice to the federal government regarding what debt can be issued, at what interest rate, and for what term, based on its assessment of the capital markets. The goal is to ensure stability of the capital markets.

Question 23

THE BANK RATE

Answer 23

The Bank Rate is the rate of interest that the Bank charges on oneday loans to the chartered banks and other major financial institutions who are members of Payments Canada.

The Bank Rate is the upper limit of the operating band. The Bank Rate and the operating band are adjusted simultaneously whenever the Bank changes the target for the overnight rate of interest.

Question 24

DISCUSS
CHALLENGES OF GOVERNMENT POLICY &
FUTURE CONSIDERATIONS

Answer 24

Expectations can cause a policy initiative to fail. For example, the government may announce that it will cut personal tax rates to stimulate the economy.

However, if the consensus is that the government is doing so only because it is near the end of its mandate, or if the tax cut is widely expected to be soon reversed, consumers may see it as a short-term action.

Therefore, consumers may choose to save the tax cut, instead of increase spending, and the policy initiative fails.

Question 25

DISCUSS
CHALLENGES OF GOVERNMENT POLICY
& TIME LAG

Answer 25

In economics, there are delays between recognizing an economic problem, deciding what policy action to take to solve the problem, implementing the policy, and ultimately seeing the benefit of the policy in action. These timing lags make monetary policy decisions more difficult and policy actions less effective.

For example, according to the Bank, such actions can take more than 18 months for the full effect on inflation to work its way through the economy.
Fiscal policy actions face similar delays, depending on parliament’s legislative cycle and the government’s budget position.

For example, the impact of lower consumer and corporate taxes is felt much more quickly than the impact from major infrastructure spending. A project to spend billions on a major new transit project could take many years to plan and implement.

Question 26

DISCUSS
CHALLENGES OF GOVERNMENT POLICY &
POLITICAL CONSIDERATIONS

Answer 26

Political

Politicians typically work towards re-election, which considerations creates what is known as a political business cycle.

While campaigning, they may advocate lowering taxes or spending on programs and infrastructure in their own riding. However, once they are elected, the national economic reality may call for lower spending.

Question 27

ADVANTAGES OF
MONETARY POLICY

Answer 27

ADVANTAGES OF MONETARY POLICY

The effect on the economy may be more immediate.

The initiative (e.g., lower or higher interest rates) can be reversed once the objective is achieved.

It is independent of political considerations.

Question 28

DISADVANTAGES OF MONETARY POLICY

Answer 28

DISADVANTAGES OF MONETARY POLICY

It can be difficult to target a specific region.

Lowering interest rates may not have any impact if the consumer doesn’t feel confident enough to spend.

If interest rates are already very low, lowering them even more may have no impact.

Question 29

ADVANTAGES OF FISCAL POLICY

Answer 29

ADVANTAGES OF FISCAL POLICY

Government spending can be targeted to specific regions.

Tax cuts and increased benefits are popular.

Consumers can more easily understand and experience the impact.

Question 30

DISADVANTAGES OF FISCAL POLICY

Answer 30

DISADVANTAGES OF FISCAL POLICY

Tax increases and government spending cuts are unpopular.

There are challenges in stopping a project once it has been implemented, even if the initiative is no longer necessary.

Higher government spending can raise debt levels and lead to a greater proportion of revenue going towards interest payments.

Question 31

NOTE ONLY / FISCAL POLICY

Fiscal policy is the use of government spending and taxation to pursue full employment and sustained long-term growth.

Governments pursue fiscal policy by spending more and taxing less when the economy is weak, and by spending less and taxing more when the economy is strong. In Canada, the federal budget is the key mechanism through which the government conducts fiscal policy.

Answer 31

NOTE ONLY / FISCAL POLICY

Fiscal policy is the use of government spending and taxation to pursue full employment and sustained long-term growth.

Governments pursue fiscal policy by spending more and taxing less when the economy is weak, and by spending less and taxing more when the economy is strong. In Canada, the federal budget is the key mechanism through which the government conducts fiscal policy.

Question 32

NOTE ONLY / BANK OF CANADA

The Bank’s role is to monitor, regulate, and control short-term interest rates and the external value of the Canadian dollar. The major functions of the Bank include issuing and removing bank notes, acting as fiscal agent and financial advisor for the federal government, and implementing monetary policy.

Answer 32

NOTE ONLY / BANK OF CANADA

The Bank’s role is to monitor, regulate, and control short-term interest rates and the external value of the Canadian dollar. The major functions of the Bank include issuing and removing bank notes, acting as fiscal agent and financial advisor for the federal government, and implementing monetary policy.