ECON 318/2

Fall 2017 ASSIGNMENT 1

Answer key

Question #1.Inflation targeting and unemployment (15 marks)

a. Explain the Bank of Canadas short run conflict between inflation and
unemployment targeting.

If the Bank of Canada pursues an inflation rate target when the current rate of
inflation is above its target rate then the Bank will implement a contractionary
monetary policy that leads to decreases in aggregate demand (AD). AD shifts to the
left, the price level falls, Real GDP decreases, and the rate of unemployment rises.

b. Has the Bank of Canadas inflation targeting been successful, based on the levels
of inflation and unemployment experienced by Canadians, over the past two
decades?

The current inflation target has been in place since the mid-1990s.
Canada's performance (levels of inflation) has been close to target for the last couple
of decades. Inflation has stayed inflation low and stable, while the levels of
unemployed have also been somewhat stable and lower than that of the early
1990s.

c. Why might the Bank of Canada decide to keep the overnight loans rate at 1
percent for the rest of 2017?

The current inflation target of 2 % (target band between 1% and 3%)has been in
place since the mid-1990s. The rate on inflation has recently increased above the
higher bound, which led the Bank of Canada to increase the overnight lending rate
by 25 basis points twice, in the months of July and September of 2017. It currently
sits at 1%.

If the inflation rate stabilizes within the target band, the Bank of Canada may
consider keeping the rate at 1% in 2017 and beyond. The rate of unemployment is
also an important variable for the Bank of Canada.

Should the Canadian economy move into a recession (several reasons, including
changes in the world economy, can account for such a change) and the rate of
unemployment rate rises significantly, then the Bank of Canada may consider
lowering the overnight lending rate. The Canadian economy, as other economies,
can be impacted by world events. For example, 9-11 and the recent downturn in the
US economy.
Question #2.Canadas budget deficit and overnight rate policy (15 marks)

a. Explain the difference and connection between a government budget deficit and
government debt.

Government debt is the total amount of the government has borrowed. Government
debt equals the sum of past deficits minus the sum of past surpluses.

When the government budget is in deficit, government debt increases, and

decreases when the government budget is in surplus.

b. How did the Bank of Canadas low interest rate policy affect government debt
and budget deficits of Canadian governments?

Bank of Canada's low interest rate policy reduces governments debt interest
payments and the amounts governments spend, which in turn, causes the size of the
government budget deficit to fall and governments overall debt will also fall.

c. How are government debt and Canadian governments budget deficits affected by
the new Bank of Canadas higher interest rates?

The Bank of Canadas new higher interest rate will result in higher interest
payments on the governments debt. Hence, the budget deficit increases and so will
the governments overall debt.

Question #3.Milton Friedman, professor of economics at Chicago University and

considered by many the most influential Monetarist of his generation, has accused the
Fed for following an unstable Monetary Policy. He argues that although the Fed has
given lip service to controlling the quantity of money it has given its heart to
controlling interest rates. (10 marks)

a. The Bank of Canada conducts its policy by setting overnight interest

rates. Explain the short term effects of this monetary policy? What are the effects
in long term?

In the short term, a change in the overnight rate can be done to influence many important
economic elements such as the unemployment rate, income levels, and the rate of market
growth.

In the long term, effects from changing the overnight rate are overcome by market
adjustments in wages due to excess demand or supply. However keeping the overnight
rate low increases the rate of inflation.
 b. How does the Federal Reserve conduct monetary policy in United States? Is the
policy comparable to Canada? Explain the differences and similarities of
monetary policy instruments of both countries.

The Fed has 3 tools to influence monetary policy:

1. Open market condition

2. Discount rate

3. Reserve requirements

Bank of Canada has Open market condition and Reserve requirements to exercise
monetary policies. Canada has another tool to do its monetary policy, the overnight
interest rate. It is slightly different than the Discount Rate that the US uses.

Question #4. Fiscal Policy (10 marks)

a. Define and compare automatic and discretionary fiscal policy?

The government is not involved in current automatic fiscal policy. While

government action is required for the activation of discretionary fiscal policy. The
latter, initiated by an act of Parliament requires a change in tax law and government
spending.

b. How do taxes and transfer payments programs work as automatic fiscal policy to
dampen the business cycle?

Taxes, such as income taxes, and transfer payments, such as employment insurance,
can be considered automatic fiscal stabilizers, since they can decrease the effect of a
change in consumers' disposable income and consumption expenditures, which in
turn contribute to aggregate expenditure (AE) changes.

Decreases in income during recessionary times may cause disposable income as

well as consumption expenditures, aggregate expenditure (AE) and aggregate
demand (AD).

However, when incomes fall, income taxes decrease and transfer payments increase.
Therefore, disposable income will not fall by as much as income. The smaller
decrease in disposable income leads to a smaller decrease in consumption
expenditure, aggregate expenditure (AE) and aggregate demand (AD).
Question #5. Recession Threat Demands Immediate Action (15 marks)

The NDP called for immediate action to create jobs by investing in infrastructure and
green energy programs to give the economy a kickstart. Peggy Nash, the party's finance
critic, said experts are warning of another recession and that Canadians are worried about
rising unemployment and falling markets.

Source: CBC News, September 29, 2011

Assume that the Canadian economy is in a recession, and the recessionary gap is
large.

a. Describe how the recessionary gap will be affected with discretionary and
automatic fiscal policy actions.

Discretionary fiscal policy is a fiscal action initiated by an act of Parliament.

When the economy is facing a large recessionary output gap, the government will
use expansionary discretionary fiscal policy (i.e. increases in government spending
and or decreases in taxes, through a Parliament of Canada act). The economy will
see, with time, its aggregate demand (AD) increase and the economy will tend to
move back towards its level of potential GDP.

Automatic fiscal policy, without government involvement, is triggered by how the

economy performs. For example, when the economy contracts and performs well
below potential levels transfer payments will increase while and taxes will decrease.
Therefore, disposable income will not fall by as much as income. The smaller
decrease in disposable income leads to a smaller decrease in consumption
expenditure, aggregate expenditure (AE) and aggregate demand (AD).

b. Is the NDPs proposed infrastructure spending a fiscal stimulus? Would such

spending be a discretionary or an automatic fiscal policy?

The NDPs proposed infrastructure spending is a fiscal stimulus, a stimulus used to

increase production, real GDP, income and employment.

Government spending on infrastructure including green energy programs can lead

to a stronger performing economy. This may be the case of the latest government of
Canada spending on projects such as the new Champlain Bridge. Although, the NDP
strongly promoted this action to improve production, incomes and employment, the
current Liberal Government has been the one to act upon expansionary
discretionary fiscal policy.
 c. Explain whether, and if so how, investing in infrastructure and green energy
programs would create jobs Show graphically and explain your answer.

Government investment in infrastructure and green energy programs causes the

level of investment in the economy of Canada to increase. Since investment is a
component aggregate expenditure (AE) and aggregate demand (AD) both will
increase when investment increases. Not only that, but real GDP and incomes also
rise. Higher incomes make it possible for increases in consumption expenditure.
Keeping in mind the multiplier effect. The increase in real GDP could also indicate
that jobs would also be created.

Also, since the quantity of capital will also increase with the added investment in
infrastructure and green energy programs, potential GDP is also expected to rise.

In an AD-AS graph, the aggregate demand curve, short-run aggregate supply curve,
and the long-run aggregate supply curve all shift rightward. Equilibrium real GDP
increases.

Question #6. Finance Minister Morneau lowered the income taxes of the middle class in
the latest federal budget. Show graphically and explain how lowering taxes on
employment will create jobs and improve the economy.
(15 marks)

The Canadian economy moved into a recession several years ago. Canadians and
their government representatives insisted that the Government assist. Although the
economy could be assisted with current automatic fiscal policy the government also
stepped in with discretionary fiscal policy. One of the tools used to stimulate the
economy, the current government`s ``sunny ways`` rather than austerity measures
called for by competing ideas on how to address the difficulties of the most recent
great recession, was to reduce income taxes of the middle class. The explanation
given by the government for considering this policy was that the middle class would
spend the additional tax savings, boost disposable income, consumption
expenditure, aggregate expenditure (AE) and aggregate demand (AD).

In an AD-AS graph, the aggregate demand curve, short-run aggregate supply curve
would shift to the right. The expected result would be an increase in equilibrium
real GDP and more jobs and hopefully a lower rate of unemployment. Unfortunately
a rise in the price level, or an increase in inflation) would also be expected.