The Economy and Economic Policy

The economy is a collection of millions of individual consumers and firms interacting on a daily basis to determine which goods and services will be produced, which firms will supply various products, which consumers will take them home at the end of the day, and what prices will be paid for the many different products. Even in predominantly market economies, such as Canada and the United States, governments at all levels play an important role—they raise revenue by taxing many economic activities, and they spend these resources by providing such services as defence, health care, education, and public housing. Even when governments are not directly taxing or spending, their presence is often felt through the regulations they impose in such areas as product safety, foreign ownership, licences for television stations, quotas for milk production, and minimum wages, to name just a few.

Macroeconomics often glosses over much of the detail in markets for specific goods and services, focusing instead on the behaviour of economic aggregates such as total output, inflation, unemployment, and economic growth. Macroeconomic policy is divided into two broad types: fiscal policy and monetary policy. Fiscal policy is the set of decisions a government makes with respect to taxation, spending, and borrowing. Governments at all levels (federal, provincial, and municipal) have a fiscal policy, since they all have the ability to raise revenues through some form of taxation and to spend these resources on goods and services. There are numerous dimensions to any government's fiscal policy, especially at the federal level, because revenue can be raised through many different taxes, and spending can occur on countless products in different regions and aimed at different beneficiaries.

1.1 What is monetary policy?

Monetary policy is the set of decisions a government makes, usually through its central bank, about the amount of money in circulation in the economy. In Canada, monetary policy is conducted by adjusting very short-term interest rates to achieve a rate of monetary expansion consistent with maintaining a low and relatively stable rate of inflation.

Monetary policy in Canada has three main characteristics:

  1. Monetary policy is conducted by the Bank of Canada, a government-owned Crown corporation that operates with considerable independence from the federal government but is nonetheless ultimately accountable to Parliament. 1
  2. Because financial capital can move easily within Canada, interest rates on similar assets are the same across all Canadian regions. As a result, there is only one monetary policy for all of Canada. The Bank of Canada is the sole issuer of legal tender (bank notes) in Canada.
  3. Although several economic variables influence monetary policy decisions (many of which will be discussed later), the Bank of Canada has only one policy instrument.

The third point states that monetary policy can do only one thing (compared with fiscal policy, which can do many). This point is worth emphasizing, especially when thinking about what monetary policy is not. The Bank of Canada has no ability to set spending or taxation priorities for any level of government in Canada. Nor does it have the ability to directly regulate labour markets or product markets, although it does play a limited role in the regulation and oversight of parts of the financial system. As important and powerful as monetary policy is, it is much more limited than fiscal policy in terms of available policy instruments.

What is the Bank of Canada's policy instrument, and how is it related to the amount of money in the economy? The Bank's policy instrument is the target it sets for the overnight interest rate. 2 In Canada, commercial banks lend funds to each other for very short periods at the overnight interest rate, a market-determined rate that fluctuates daily. By announcing a specific interest rate (25 basis points above the target overnight rate) at which it is prepared to lend unlimited amounts to commercial banks and a second specific interest rate (25 basis points below the target overnight rate) at which it is prepared to borrow unlimited amounts from commercial banks, the Bank of Canada can keep the overnight interest rate within an announced operating band. Furthermore, by changing its target for the overnight interest rate, the Bank of Canada can alter the actual overnight rate at which commercial banks transact.

As we will see later in the paper, such changes in the overnight interest rate lie at the heart of how monetary policy affects the economy. For now, however, the purpose is simply to illustrate how the Bank's decision to set the target for the overnight interest rate influences the amount of money in the economy. By changing the target for the overnight rate, the Bank influences the entire spectrum of market interest rates, from the yield on 30-day treasury bills to that on 30-year government bonds, and from the rate on 3-month guaranteed investment certificates (GICs) to that on 10-year home mortgages. When the Bank lowers the target for the overnight rate, these interest rates fall, firms and households increase their demand for credit, and commercial banks increase their quantity of credit supplied. (Conversely, when the Bank raises the target, interest rates rise, firms and households reduce their demand for credit, and commercial banks decrease their quantity of credit supplied.)

With an increase in the amount of credit in the economy, there is an increase in the volume of transactions for goods and services, and thus an increase in the overall demand for money with which to make these transactions. Individual firms and households can satisfy their demand for money by making withdrawals from their accounts at commercial banks, often in the form of bank notes. But what do commercial banks do when they begin to run short of bank notes? They can buy them from the Bank of Canada by selling other assets—in particular, government securities. Thus, when the Bank of Canada increases the volume of bank notes in the economy, in response to the greater demand from commercial banks, it does so by purchasing government securities. Such a balance-sheet transaction for the Bank involves an increase in assets (government securities) and an increase in liabilities (newly issued bank notes). 3

Thus, we can see the connection between the Bank of Canada's target for the overnight interest rate, the Bank's balance sheet, and the amount of money circulating in the economy. Changes in the target overnight interest rate lead to changes in other market interest rates and, hence, to changes in the demand for credit, the demand for money, and the demand for bank notes. The Bank accommodates these changes in the demand for bank notes by conducting the required balance-sheet transactions. To some observers it may appear that the Bank can influence both interest rates and the amount of money independently. But this independence is illusory: the Bank's policy decision to change the target overnight interest rate has a direct effect on the eventual change in the amount of money circulating in the economy. There is only one instrument for monetary policy.

This concludes a very broad outline of monetary policy. More detail will be provided later. We now go on to examine why most central banks have adopted the control of inflation as their overall policy objective, rather than the control of variables such as aggregate output, employment, or the unemployment rate.

1.2 Why focus on inflation?

The ultimate objective of the Bank of Canada is to make the best possible contribution to a well-functioning Canadian economy and to the overall well-being of Canadians. Based on a large body of theoretical reasoning and empirical evidence, the policies of the Bank of Canada and most other central banks are grounded in two essential propositions:

  • High inflation is damaging to the economy and costly for firms and individuals.
  • Central banks are unable to directly influence variables other than inflation for any sustained period of time.

The costs associated with high inflation will be discussed in detail in the next section. Stated briefly, high inflation generates uncertainty in the economy, and this uncertainty interferes with the smooth functioning of a market economy, which relies on fluctuations in market prices to reflect changes in the scarcity of various products. The costs associated with this uncertainty explain why central banks attempt to maintain low and relatively stable rates of inflation.

But low inflation is only one of a large number of potentially desirable goals for economic policy. Central banks might also desire to keep the unemployment rate low or the rate of growth of aggregate output relatively high. After all, low unemployment and high rates of growth would mean higher real incomes and higher average living standards. This brings us to the second proposition above—the limitations on what can be achieved by monetary policy.

Arguments put forward most eloquently by Milton Friedman (1968) explain how monetary policy can influence many macroeconomic variables over short periods of time—including real output, unemployment, and investment—but can have a sustained influence only on the rate of inflation. In the late 1960s, these arguments were controversial and not fully accepted by the economics profession, but over the next decade they became widely accepted as more theoretical reasoning and empirical evidence emerged in their support. Central to the argument is the recognition that the changes in real wages and real interest rates that are initially generated by a monetary policy action are eventually offset by market adjustments in wages and interest rates in response to excess demands or supplies. Thus, a monetary policy action that in the short run can lead to a change in output and employment, in the long run, ends up changing only the rate of inflation. Almost 40 years later, Friedman's basic arguments regarding the limitations of monetary policy are so well entrenched in the profession's view that they appear in textbooks as core material.

Over the same few decades that Friedman's ideas were becoming widely accepted, there was another growing recognition, based on the experiences of many countries over many years, that significant differences in inflation rates had more to do with differences in monetary policy than with any other single macroeconomic variable or policy. This is not to say that no other factors have an effect on a country's rate of inflation; only that the single largest explanation for different inflation rates across countries is the difference in monetary policies. This close empirical relationship between inflation and money is shown in Chart 1, which plots the average annual rate of inflation against the average annual growth rate of the money supply for a broad cross-section of 38 countries from 1962 to 2003. 4 The annual averages are computed over many years to emphasize the long-run trends in the data and thereby avoid the empirical irregularities associated with short-run economic fluctuations. Obvious in Chart 1 is a clear positive correlation between inflation and money growth—in other words, countries whose money supplies grow quickly also tend to have high rates of inflation. 5 Canada appears in the lower bunching of data points, with average annual inflation of 4.6 per cent and average annual money growth of 8.5 per cent.

To summarize, central banks choose to focus on maintaining low and relatively stable inflation for two reasons. First, low inflation is beneficial for the operation of the economy. Second, both theory and evidence suggest that monetary policy cannot have a systematic and sustained effect on macroeconomic variables other than the inflation rate. Given this limited scope for monetary policy, it would make little sense for monetary policy to adopt other long-run targets, such as the unemployment rate or the growth rate of real output. It is natural for central banks to adopt a long-run target for the one thing that they can reasonably expect to influence over the long run—the rate of inflation. 6

That is why the Bank of Canada takes the view that its best contribution to the health of the Canadian economy is to maintain low and relatively stable inflation. To formalize this objective, the Bank, in 1991, together with the Government of Canada, adopted a system of inflation targeting that aims to keep the annual rate of inflation close to 2 per cent and within a range of 1 to 3 per cent. In such an environment of low and stable inflation, Canadian firms and households can then make spending, saving, and investment decisions that lead to steadily rising average living standards.

Given the strength of the theoretical and empirical evidence regarding the long-run effects of monetary policy, some observers may wonder why central banks failed to focus so intently on inflation much earlier—back in the 1980s or even the 1970s. Quite simply, what is now much clearer to many central banks and economists was anything but obvious at that time. Economists have learned much from the world developments and policy mistakes of the past few decades. More lessons will be learned in the future, and perhaps some events will transpire that will lead central banks to adopt different policy regimes. But, until then, our best reasoning and evidence continues to suggest that monetary policy aimed at maintaining low and stable inflation makes a great deal of sense.

We next discuss two central questions regarding the success of Canada's monetary policy. The first is how Canada's inflation performance has changed over the years, and why this matters. The second is the extent to which the growth of aggregate output in Canada is more stable in recent years, and why this greater stability is important for the well-being of Canadians. We then examine some details about how monetary policy actually works and what central banks require in order to conduct policy effectively.

  1. 1. If the Minister of Finance disagrees with the Bank's policies, he or she has the right to issue a public directive to the Governor. Such a directive has never been issued.[]
  2. 2. The Bank of Canada announces a target for the overnight interest rate on eight pre-determined fixed announcement dates (FADs) during the year.[]
  3. 3. As of December 2004, the Bank of Canada's assets (and liabilities) were $46.7 billion. The Bank's assets are almost exclusively held in the form of Government of Canada securities of various maturities. The Bank's liabilities are held predominantly in the form of the bank notes that it issues and that are circulating throughout the Canadian economy.[]
  4. 4. The data are from the International Monetary Fund's International Financial Statistics, and include both developed and developing countries. We exclude Argentina and Peru from the sample because their inflation and money growth rates over the sample period are so high (each at roughly 250-300 per cent) that to include them on the same diagram hides most of the interesting variations among the other countries.[]
  5. 5. Chart 1 shows a positive correlation between money growth and inflation, but it does not establish causality from money growth to inflation. However, considerable evidence exists for such causality: see, for example, Lucas (1980) for evidence and McCallum (2004) for a recent review and other references.[]
  6. 6. That monetary policy cannot have a sustained influence on variables other than the rate of inflation in no way suggests that it cannot have some influence in terms of stabilizing the level of aggregate economic activity—that is, reducing short-run fluctuations in aggregate output. In Section 4, we examine in detail the process whereby monetary policy does influence real macroeconomic variables over short periods of time.[]