Economic Policy

Question 1

What is fiscal policy, what does the federal budget consist of in revenue and debt – how does a surplus or deficit impact the capital market?

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.
• The government’s revenue comes primarily from different forms of taxation. The government’s budget balance is equal to that revenue less total spending. The federal budget contains projected spending, revenue, surplus or deficit, and debt for the coming fiscal year, which runs from April 1 to March 31, plus at least one subsequent year.
• 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. The amount of the surplus or deficit each year, along with the current national debt, are the most important numbers in the budget. These amounts indicate the extent to which the government will be borrowing in the coming year and the impact it will have on the capital markets. Governments finance deficits by issuing debt instruments such as bonds and Treasury bills in the capital markets.
• 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.

Question 2

Dive deeper into the government’s two key fiscal policy tools of spending (how does spending less or more impact the economy) and taxation (how do higher or lower taxes affect the economy)?

Answer 2

• When the government provides funding for new infrastructure, the government spending component of the GDP obviously increases, but that is not all. To build a new highway, for example, workers must be hired and materials must be bought. The newly employed workers have more money to spend, which may increase the consumer spending component of GDP. As consumers spend more, business revenues also increase. Some companies may expand their operations to meet increased demand for their products. Therefore, the business spending component of the GDP may also increase. In this way, government spending on infrastructure can have a stimulative effect on the whole economy.
• Several types of taxes provide the revenue for government spending. Some taxes are imposed on businesses; others are imposed on consumers. If the government wants to stimulate the economy, it can lower personal taxes, in which case consumers have more money to spend. It can also lower business taxes, in which case businesses have more money to spend and invest. And when businesses expand operations and hire more workers, this can lead to a drop in the unemployment rate. As with spending, the government may increase taxation to lower inflation, making it more difficult for consumers and businesses to spend.

Question 3

Now into the area of monetary policy, talk about the Bank of Canada’s four main areas of responsibility, with reference to monetary, the financial system, currency, and funds management:

Answer 3

• Monetary policy is designed to preserve the value of the Canadian dollar by keeping inflation low, stable, and predictable. The Bank makes use of inflation control targets to influence interest rates and a flexible exchange rate when conducting monetary policy.
• 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.
• The Bank is responsible for designing, printing, and distributing Canadian bank notes.
• The Bank is the fiscal agent for the Government of Canada. A fiscal agent is an institution appointed to advise in, and conduct, various financial matters of another. In the capacity of fiscal agent, the Bank has the following responsibilities:
  o It manages the government’s accounts through which virtually almost all money collected and spent by the government flows.
  o It manages the government’s foreign currency reserves, such as U.S. dollars, euros, gold, and silver.
  o It manages the government’s federal debt, which consists mostly of Treasury bills (short-term securities issued at discount rate and redeemed at full face value) and marketable bonds (long-term debt securities that pay regular interest). 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.
  o 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 4

Discuss how the Bank of Canada sustains value in the economy by keeping inflation low and predictable using the target overnight rate:

Answer 4

• Setting an official interest rate is the most noticeable and most important monetary policy tool the Bank uses. The Bank conducts monetary policy primarily through changes to what it calls the target for the overnight rate. By changing its target, the Bank can signal a policy shift toward 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.
• The overnight rate operates within an operating band that is 50 basis points wide. A basis point equals 1/100th of a percentage point. Each day, the Bank targets the mid-point of the operating band as its key monetary policy objective. For example, if the operating band is 1.5% to 2.0%, then the target for the overnight rate is 1.75%.
  o How the Operating Band Works: The lower bound is the deposit rate (the interest rate banks earn when they deposit money at the Bank of Canada). The upper bound is the bank rate (the interest rate banks pay when they borrow from the Bank of Canada). The target overnight rate is right in the middle of this band.
  o Example Scenario: Let’s say the Bank of Canada sets the operating band at 1.50% to 2.00%. Lower bound (1.50%) → If banks have extra cash, they can deposit it at the Bank of Canada and earn 1.50% interest. Target overnight rate (1.75%) → This is where the Bank of Canada wants overnight borrowing/lending to happen between banks. Upper bound (2.00%) → If a bank needs money, it can borrow directly from the Bank of Canada but will pay 2.00% interest.
  o How Banks Use This System: A bank that has extra cash won’t lend it out for less than 1.50%, because that’s what the Bank of Canada would pay them. A bank that needs cash won’t pay more than 2.00%, because they could just borrow from the Bank of Canada instead. As a result, most overnight lending between banks happens near the 1.75% target rate.

Question 5

Discuss how the Bank of Canada sustains value in the economy by keeping inflation low and predictable using the open market operations:

Answer 5

• The overnight rate can fall outside the Bank of Canada’s target range due to imbalances in supply and demand for short-term borrowing. Here’s why:
  o If the overnight rate is too high (above the target)
  o Borrowing is expensive, which can slow down the economy.
• The Bank of Canada lowers rates by offering overnight repos—essentially lending money to banks at a lower rate to increase the money supply and push rates down. If the overnight rate is too low (below the target) Borrowing is too cheap, which can lead to excessive spending and inflation. The Bank of Canada raises rates by using overnight reverse repos—essentially borrowing money from banks at a higher rate to absorb excess cash and push rates up.
• In a healthy market, banks will always choose the cheaper option—the Bank of Canada’s lending rate (upper bound). But in cases of urgency, credit risk, or liquidity shortages, some banks might get stuck borrowing at higher rates.