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Chapter 5- Economic Policy

What are the Different Economic Theories?**
Rational Expectations Theory
Suggests that firms and workers are rational thinkers and can evaluate all the consequences of a government policy decision, neutralizing its intended impact.
Example:
Suppose the government decides to cut taxes temporarily in order to boost consumer spending and improve economic conditions.

If consumers behave rationally, they will realize that the tax cut will crete a deficit that eventually has to be repaid with higher taxes.

Instead of spending the tax cut, they save it to repay future taxes, and the government’s move has no impact.

Keynesian Economics
advocates the use of direct government intervention to achieve economic growth and stability.

Keynesians believe the use of active fiscal policy, through government spending and taxation, is necessary to stabilize the business cycle.

Example:
Consider the case when the economy enters a recession. Keynesians advocate an increase in government spending or lower taxes to raise consumer income. With more money in their pockets, consumers increase their spending on goods and services. To meet the higher consumer demand for their products, businesses hire more workers to expand production and unemployment falls. Lower unemployment leads to a further increase in consumer income and spending. The increase in income and spending may continue for some time. However, once policymakers believe that spending is rising too quickly, policy will change to reflect lower government spending and higher taxes.
Monetarist Theory
suggests that the economy is inherently stable, with its own self-adjusting mechanism that automatically moves the economy to a stable growth path.

Monetarists argue against the use of active monetary/fiscal policy and believe the central banks should simply expand the money supply at a rate equal to the long-term growth rate.

Believe that instability in the money supply is the major cause of fluctuations in rGDP, and rapid money supply growth is the major cause of inflation.

Friedman coined the phrase “inflation is always and everywhere a monetary phenomenon.”

Example:
Monetarists believe that instead of pursuing active monetary or fiscal policy, the central bank should simply expand the money supply at rate equal to the economy’s long-run growth rate- somewhere in the neighbourhood of 2% to 3% per year, for example.

According to this view, controlling inflation as the main policy goal creates a foundation for the economy to grow at its optimal rate.

Supply-Side Economics
suggests that to foster an environment of prosperity, the market should be left alone and government intervention should be minimal (only changes in tax rates).

This theory maintains that lower government spending and lower taxes provide stimulus for expansion

Example:
This view advocates that changes in tax rates exert important effects over supply and spending decisions in the economy.

They maintain that reducing both government spending and taxes provide the stimulus for economic expansion. Reducing taxes and the size of the government would help to fuel the economy for economic expansion. According to supply-siders, a reduction in marginal tax rates stimulates investment in the economy and ultimately leads to a higher level of output.

What is Fiscal Policy?**
Fiscal Policy
the use of government spending and taxation to pursue full employment and sustained long-term growth.

Governments pursue this goal by spending more and taxing less when the economy is weak, and spending less and taxing more when the economy is strong.

Both the Federal and Provincial Governments play a role
While provincial is responsible for health care, education, and welfare, most of their funding comes from the federal government.

When the fed cuts spending on programs, there is upward pressure on provincial deficits.

The Federal Budget*
Federal Budget
In Canada, the federal budget is the key mechanism through which the government conducts fiscal policy.

The budget contains projections for the coming year for spending, revenue, and the amount of the projected surplus or deficit.

Budget Surplus
If the revenue collected during the year exceeds spending for the year
Budget Deficit
If total spending during the year is higher than the revenue collected

When the gov runs a deficit, it borrows by selling gov bonds and T-bills.

National Debt
The accumulation of total gov borrowing over time- the sum of past deficits minus the sum of past surpluses
The projected deficit may differ from what the government actually borrows because:
Bonds that mature and need to be refinanced are not included in the projected financials.

The government has access to several special-purpose accounts, which reduce their dependence on debt markets- The most important of such funds is the civil service pension fund. main reason why financial requirements are less than the deficit.

How Fiscal Policy Affects The Economy*
Spending
by the governments includes purchasing goods and services, such as a new highway, or transferring money directly to citizens.

Only the first type is recorded as G in GDP.

Taxes
Raising or lowering taxes to change the level of disposable income for consumers.

Can change:

Direct taxes
Sales taxes
Payroll taxes
Capital taxes
Property taxes

Taxes discourage the activity being taxed- income taxes reduce the incentive to work, payroll taxes reduce the incentive to hire, and sales taxes reduces the incentive to spend.

Debt-to-GDP Ratio
is regarded as a sound measure of a nation’s overall debt burden because it measures the debt relative to the ability of the government and the nation to finance it.

In Canada, the debt-to-GDP is about 35%, down from 70% in the mid ’90s.

What is the Role of the Bank of Canada?**
Role of the Bank of Canada
to monitor, regulate and control short-term interest rates and the external value of the Canadian dollar.
Functions of the Bank of Canada*
The major functions of the BoC include:
-The issuance and removal of bank notes
-Acting as a fiscal agent and financial advisor for the Federal Government
-The implementation of monetary policy (i,e., managing the supply of the nation’s money).
As a Fiscal agent to the Government, the BoC:
-Administers the Governments deposit accounts and funds,

including deposit account with the BoC and chartered banks in which government cash is held and;

The Exchange Fund Account, which holds the Government’s foreign exchange reserves.

The BoC also manages:
Canada’s official international currency reserves

The Bank of Canada Act empowers the Bank to:

buy/sell gold and silver, maintaing deposits with other banks

Acts as a depository for gold held by the Exchange Fund Account

Debt Management- minister of finance is responsible, but relies on the BoC for advice and implementation.

As a financial advisor to the government, the BoC advises:
The timing of new federal securities issues, and the price, yield and other features the securities should carry to make them marketable.

Advises on where securities should be sold (domestically, US, offshore)

The goal of monetary policy
is to improve the performance of the economy by regulating growth in the money supply and credit.

BoC achieves this through its influence over its short-term interest rates.

What is Monetary Policy?**
Monetary Policy
In Canada, it involves following specific inflation-control targets that establish a range within which to contain annual inflation.

Currently, the target range is 1% to 3%.

The BoC keeps inflation within this range by:
Increasing short-term rates if inflation approaches the top of the target range (which indicates that the demand for goods and services is rising too strongly).

If inflation falls towards the bottom of the range, it indicates that economic growth is slowing and support is needed through a decrease in interest rates.

In the long run, inflation is linked to the growth of money and credit- through its influence over rates, the BoC affects their supply and demand.

Monetary policy needs to be forward looking, because their is usually a time lag of one to two years.
Implementing Monetary Policy*
The bank uses the target for the overnight rate to implement changes in the direction of monetary policy.
Overnight Rate
is the interest rate set in the overnight market- where major Canadian financial institutions lend each other money on an overnight basis.

When the Bank changes the target for the overnight rate, other short-term interest rates also tend to change.

The overnight rate operates within a 50 basis points (or 1/2 of a percentage point) wide operating band- each day, the bank targets the midpoint of the operating band as its monetary policy objective
For example, if the band is 5.0% to 5.5%, the target is 5.25%.
Bank Rate
is the minimum rate at which the BoC will lend money on a short-term basis to the chartered banks and other members of the Canadian Payments Association (CPA).

Its role is a lender of last resort- the bank rate is the upper limit of the overnight target operating band- given the above example, 5.5%.

The BoC will provide secured loans at the bank for one business day to the chartered banks and members of the CPA
This plays a useful role in providing them a safety valve and assuring liquidity.
Open Market Operations*
Special Purchases and Resale Agreements (SPRAs) and Sale and Repurchase Agreements (SRAs) are the two main open market operations used by the BoC to conduct monetary policy.
SPRAs
are used to relieve undesired upward pressure on the overnight rate.

If overnight money trades above the target of the operating band, the BoC intervenes and offers to lend at the upper limit of the band.

This action reinforces the upper limit of the overnight target.

Example:
If the upper limit is 4.25% and overnight trading money is trading at 4.50%, financial institutions will borrow at the lower rate offered by the BoC.
The SPRAs work as follows:
The BoC offers to purchase securities from a dealer (bank) with an agreement to sell them back the next day at a predetermined price.

The BoC pays the institution with cash- it is essentially a very short-term loan.

When the securities are resold to the institution, the BoC receives money.

This operation is used to reinforce the upper limit or top end of the overnight target and is closely watched by market participants.
Sale and Repurchase Agreements (SRAs)
are used to offset undesired downward pressure on the overnight rate

If overnight money is trading below the target of the operating band, the BoC offers to borrow at the lower limit of the band.

This reinforces the lower limit of the overnight target.

Example:
The lower limit is 3.75% and overnight money is trading at 3.5%, financial institutions would get more interest on their deposits from the BoC.
The SRAs work as follows:
The BoC offers to sell government securities to chartered banks with an agreement to repurchase them the next day at a predetermined price.

They receive money- they are essentially borrowing.

The next day, the BoC repurchases those securities in exchange for cash (repayment).

Since financial institutions know that the BoC will always lend money at the upper limit and borrow money at the lower limit, it makes no sense to trade outside of the band.
Cash Management Operations*
The BoC established the Large Value Transfer System (LVTS) to facilitate its cash management operations
System allows participating financial institutions to conduct large cash transaction with each other through an electric wiring system.

This system provides an important setting to conduct monetary policy.

At the end of each day, all of the transactions are added up, and some financial institutions may end up needing to borrow funds while others may have some left over.

The BoC can also influence interest rates by transferring the government’s deposits:
From its chartered banks account to its BoC account (drawdown)

From its BoC account to its chartered banks account (redeposit)

Drawdown
is the transfer of deposits to the BoC from chartered banks, which drains the supply of available cash balance from the banking system.

This decreases deposits and reserves available to the banks to utilize in their business.

This causes a contraction in the availability of loan to consumers and businesses, which places upward pressure on interest rates.

Redeposit
is a transfer of funds from the BoC to the chartered banks, which increases deposits and reserves and availability of funds in the banking system.

Adding money to the system places downward pressure on interest and gives banks an incentive to increase loans to consumers and businesses.

What are the Challenges of Government Policy?**
One challenge the government faces is that the economy may be slow to react to policy changes
Interventionist policy may not be effective or even essential in guiding the economy.
A second challenge is the view that the economy makes it way quickly to its natural equilibrium, and the no need exists for policy other than to constrain policy
This difference is central to the controversy surrounding the role of money growth.
Monetary policy has proved effective in the short-run, but how long is the short-run?
Government policy is relevant in two contexts:
Counter-cyclical initiatives in the short-run (managing the business cycle)

The development of human capital and enhancement of tech advances (long-term)

The Consequences of Failed Fiscal Policy*
Interest payments on the national debt were the federal government’s single biggest expenditure through the 90s
However, successive budget surpluses in the lat 2000’s helped to lower the gov’s debt
Fiscal and Monetary policies are often unsynchronized, increasing the cost to the economy
80s saw rising deficits at a time when the economy was growing very strongly and inflationary pressure was building.

The BoC responded by raising interest rates, which resulted in higher debt servicing costs for governments.

A large national debt constrains the ability of government to run counter-cyclical fiscal policy
When debts are large, moves to increase the deficit upset investors, who sell bonds and drive up interest rates- this reduces the beneficial impact on the economy

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