CSC101

Section 2: The Canadian Investment Marketplace

Chapter 5: Economic Policy

Volume 1 Sections, Chapters – Topics Covered
 Section 2: The Canadian Investment Marketplace
4.Overview of Economics
 Defining Economics
 Measuring Economic Growth
 Business Cycle
 The Labour Market
 The Role of Interest Rates
 The Impact of Inflation
 International Finance and Trade
5.Economic Policy
 Fiscal Policy
 The Bank of Canada
 Monetary Policy
 The Challenges of Government Policy

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Learning Objectives
1. Describe the components of fiscal policy and their impact on economic
performance.
2. Explain the roles and functions of the Bank of Canada.
3. Analyze how the Bank of Canada implements and conducts monetary policy.
4. Summarize the challenges governments face when implementing fiscal and
monetary policy.

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Fiscal Policy
 Fiscal policy informs government decisions around the use of it spending and taxation
powers
 The federal government is responsible for services including national defense,
employment insurance, pension income for seniors and the disabled, veterans’ affairs,
foreign affairs, and indigenous and northern affairs.
 Provincial governments are responsible for other services including health care,
education, securities regulation, and various social services.

Looking at the role of government in the area of:

 Taxation
 Government spending
 Government borrowing

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Fiscal Policy (continued)
 Main tool of fiscal policy is the annual Federal Budget.
 The budget contains projections for the coming year in the areas of spending, revenue,
the deficit and debt.

Proposed Annual Budget Budget Position

Revenue > Spending = Budget surplus
Revenue < Spending = Budget deficit
Revenue = Spending = Balanced budget

 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.

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Fiscal Policy (continued)
Fiscal policy can impact the economy in many key ways:

Spending
‒Via government spending in the economy and through transfer payments to citizens.

Taxes
‒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.

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Economic Theories
 Rational expectation theory

 Keynesian theory
‒ Advocates direct government intervention as a means of achieving economic
growth and stability

 Monetarist theory
‒ 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.

 Supply-side economics

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The Bank of Canada
 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.
 To do so, the Bank regulates the money supply and acts to stabilize the Canadian
economy by using monetary policy.
The Bank has four main areas of responsibility:
‒ Monetary policy is designed to preserve the value of the Canadian dollar by keeping
inflation low, stable, and predictable.
‒ Promote and maintain the efficient operation of the financial system.
‒ The Bank is responsible for designing, printing, and distributing Canadian bank notes.
‒ Fiscal agent for the Government of Canada.

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Monetary Policy Framework
 The Bank’s key monetary policy tools are interest rates and the money supply

 Inflation
‒ Interest Rates
o The Bank raises interest rates
‒ Money Supply
o The Bank reduces the money supply - Interest rates rise in response

 Recession and unemployment

‒ Interest Rates
o The Bank lowers interest rates
‒ Money Supply
o The Bank increases the money supply - Interest rates go down in response

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Implementing Monetary Policy
 The Bank can influence interest rates and the money supply through the following
means:
‒ Target overnight rate
‒ Open market operations
‒ Drawdowns and redeposits

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Target Overnight Rate
 The BoC implements monetary policy by influencing “overnight money”:
‒ The overnight market is a marketplace where financial institutions lend each other
money on an overnight basis.
‒ When the BoC changes the target for the overnight rate, other short-term interest
rates also usually change.

 The BoC establishes a 50 basis point “operating band” for overnight financing.
‒ The Bank Rate is set at the upper limit of the operating band
‒ Changes in the operating band indicate an easing or tightening of monetary
conditions.

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Operating Band

SPRA: BoC lends overnight at the upper limit of the operating band

i s
th
BANK RATE

if x
Operating Band: 50 Basis Points or 0.5%
to
e d
(BANK RATE – 0.50%)
SRA: BoC sells securities at theelower limit of the operating band
N
The Bank announces whether or not it will change the target rate on eight pre-set
fixed dates during the year.

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Open Market Operations
 Policy aimed at having a direct impact on the demand for credit in the economy. Special Purchase and
Resale Agreements (SPRA), commonly called Specials, and Sale and Repurchase Agreements (SRA).

 Special Purchase and Resale Agreements (SPRAs)

When
‒ Overnight money is trading above the target rate
Objective
‒ Relieve upward pressure on overnight rates and reinforce the upper limit of the target
Why
‒ May dampen economic activity by leading to higher short-term rates across the entire spectrum of
market rates
How
‒ BoC buys short-term government securities from primary dealers.
‒ The securities are then sold back at a predetermined price the next business day
‒ The BoC lends to a FI overnight at the top end of the target.
o If a FI has a need to borrow overnight, the preference is to borrow at a lower rate than what is
prevailing in the market.
o The BoC becomes an alternative to borrowing from other lenders, this drives down short-term
interest rates back to the target.

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Open Market Operations (continued)
 Sale and Repurchase Agreements (SRAs)
When
‒ Overnight money is trading below the target rate
Objective
‒ Relieve downward pressure on overnight rates and reinforce the upper limit of the
target
Why
‒ May lead to lower interest rates throughout the economy and to increase in inflation
pressures in the economy.
How
‒ BoC offers to sell government securities to primary dealers
‒ The securities are bought back at a predetermined price the next day
‒ The BoC borrows from a FI overnight at the bottom of the target
o If a FI has a need to lend overnight, the preference is to lend money at a higher
rate than what is prevailing in the market.
o The BoC becomes an alternative by offering higher overnight lending rates, this
drives up short-term rates back to the target.

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The Large Value Transfer System
 To facilitate the transfer of payments, the Bank established the Large Value Transfer
System (LVTS) in 1991. This system allows participating financial institutions to
conduct large transactions with each other through an electronic wire system
 Throughout the day, financial institutions in the LVTS send payments back and forth to
each other as part of their normal operations.
 At the end of each day, all of the transactions that occurred during the day are added
up and some may have to borrow to meet their settlement obligations

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Drawdowns and Redeposits
 The federal government maintains accounts with the Bank and the chartered banks.
Given its status as lender of last resort, the Bank can transfer funds from the
government’s account at the Bank to its account at the chartered banks.
 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
 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

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The Challenges of Government Policy
 Timing lags
‒ 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
 Political considerations
‒ Politicians typically work towards re-election, which creates what is known as a
political business cycle
 Future expectations
‒ Expectations can cause a policy initiative to fail
 Coordination of federal, provincial, and municipal policies
‒ For policy initiatives to work, they must be implemented nationally. However, not all
of Canada may need the same intervention
 High federal debt
‒ Several years of deficits can reduce the government’s flexibility with respect to
spending
 Impact of international economies

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Advantages & Disadvantages of Monetary & Fiscal Policy
Monetary Policy

Advantages:
‒ 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

Disadvantages:
‒ 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

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Advantages & Disadvantages of Monetary & Fiscal Policy (continued)
Fiscal Policy

Advantages:
‒ Government spending can be targeted to specific regions.
‒ Tax cuts and increased benefits are popular.
‒ Consumers can more easily understand and experience the impact.

Disadvantages:
‒ 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.

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