1. a Balance of Payments deficit, when payments exceed receipts,
2. a Balance of Payments surplus, when receipts exceed payments, and
3. equilibrium in the Balance of Payments, with payments equal to receipts

Using Canada as an example, we will examine the results of each of these situations.

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Who should make such important decisions? Some people believe that the financial experts at the Bank of Canada, who possess specialized knowledge of monetary matters, should have the responsibility and the power to decide the nation’s monetary policy. Other people disagree. They argue that such important policy decisions should not be made by the appointed officials at the Bank of Canada, but rather by the government, which was elected by (and is ultimately responsible to) the people.

The question of who possessed the final responsibility and authority for monetary policy remained somewhat vague until 1960, when matters came to a head in the celebrated “Coyne affair.” James Coyne, governor of the Bank of Canada, was pursuing a tight-money policy at the same time as the federal government was trying to stimulate the economy with budget deficits. When Coyne refused to alter the Bank of Canada’s policies, the government in effect dismissed him by introducing legislation declaring his position vacant. By this act, the government established itself as the final authority in the area of monetary policy. This was given legislative authority in amendments to the Bank of Canada Act in 1967, which stated that in the event of disagreement between the government and the Bank of Canada, the government can direct the central bank in writing as to the monetary policy to be followed.

Supporters of the government’s authority over the Bank of Canada argue that, without this authority, the government cannot ensure that the Bank of Canada’s monetary policy is consistent with the federal government’s fiscal policies, and point to the Coyne affair as evidence on their behalf. Critics of the government’s authority over monetary policy have little faith in the economic judgement of politicians.

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During a recession, when aggregate demand is inadequate, a budget deficit (achieved through increased government spending and/or tax reductions) is usually combined with an easy-money policy consisting of lower interest rates and increased availability of loans. The objective of these policies is to increase the demand for goods and services by households and businesses. This increase in spending will be added to by the respending effect of the multiplier, and will be in large part financed by increases in the money supply resulting from increased bank lending. Also, it is possible that increased consumer spending may cause businesses to increase their investment spending (the accelerator effect), a process which would also be financed by the increased money supply through bank lending, encouraged by reductions in interest on loans. The overall result would be to stimulate output and employment in the economy.

During a period of inflation, aggregate demand for goods and services is so high that the supply of them cannot keep pace, with the result that prices rice with unusual rapidity. To combat inflation, a combination of a budget surplus (tax revenues in excess of government spending) and tight money, with loans relatively scarce and interest rates high, is appropriate. The objective of these policies is to depress the demand for goods and services, so as to relieve the pressure of excess demand on the supply and on the prices of goods and services. Government spending will be held down, while tax increases and high interest rates will restrain borrowing and spending by consumers and businesses. With total demand depressed in these ways, the rate of inflation will tend to decrease.

By combining the the fiscal policy of the Department of Finance and the monetary policy of the Bank of Canada in these ways, the effect can be considerably stronger than if either were used by itself.

In summary, then, tight-money policies are used to combat inflation by depressing the level of aggregate demand. While these policies will slow down inflation, they also tend to slow down the economy and increase unemployment, and they have particularly severe effects upon certain industries.

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Tight money also affects some industries more severely than others. Construction is probably the industry most severely affected by tight money, because high mortgage rates and scarce credit discourage the buying of new homes and commercial and industrial buildings. Because investment spending is depressed by high rates, tight money also tends to have bad effects on all the capital-goods industries, such as building materials and industrial equipment. In the consumer-goods sector, the effects of tight money fall the hardest on the “big-ticket” items such as cars and appliances, which involve considerable borrowing and/or tied to sales of new houses.

Governments seeking to combat inflation with tight money often encounter political problems due to the high mortgage interest rates associated with such a policy, which are especially burdensome to prospective home buyers. Rising mortgage interest rates have a dramatic effect upon the monthly payments faced by homeowners. While home buyers are hardest hit, all borrowers are adversely affected high interest rates. This problem is really a political one more than an economic one, but this political reality places a limit on the level of interest rates and, thus, on the effectiveness of tight money as an anti-inflation weapon.

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Following the late 1960′s, however, experience with government monetary and fiscal policy was much less satisfactory. Excessive stimulation in the late 1960′s led to rapid inflation; in response, strong anti-inflation policies were applied, causing unemployment to rise to high levels. Again in the 1970′s, excessive stimulation generated very severe inflation, followed by anti-inflation policies and a recession.

Clearly, something had gone wrong: the monetary and fiscal policies that were supposed to be used to reduce economic instability were being applied in a stop-go fashion that actually created instability, wrenching the economy from rapid inflation to recession and back again. The bad economic effects of these policy decisions have led some economists to argue that the government should not actively manage the level of demand in the economy with its monetary and fiscal policies. They believe that, due to political pressures and the problems of time lags, government attempts at “demand management” tend to become mismanagement, with negative effects on economic stability and prosperity.

To remedy this, these economists argue, governments should be required to followed fixed rules for monetary and fiscal policy rather than be allowed to adjust the federal budget and rate of growth of the money supply as they see fit. In particular, it is sometimes argued, the money supply as they see fit. In particular, it is sometimes argued, the money supply should be allowed to grow at only a certain rate and the federal budget should always be balanced. Such rules, these people say, would prevent governments from making major errors in economic policy, especially in the direction of overstimulation.

Other economists disagree with this view. They point out that our economic system has a history of instability, culminating in the Great Depression of the 1930′s. They argue that the government can and should actively intervene in the economy growth has been more rapid and recessions less frequent and less severe than before. They also argue that, if mistakes were made in the use of these policies, we should learn from those mistakes rather than abandon the policies altogether in the blind hope that it will all work out somehow.

Which view is correct? There seem to be elements of truth in both views. Management of demand by government can have either beneficial or negative effects on economic stability and prosperity, depending on whether the policies are used with the proper timing and strength. For such policies to benefit the economy, the government must base its decisions on the effectiveness of policies intended to stimulate the Canadian economy. Because so much (about 30 percent) of the respending effect of the multiplier is drained off by imports when Canadian authorities inject additional demand into the economy, the multiplier effect is quite small. As a result, policies intended to stimulate the Canadian economy have less impact on output and employment in Canada than Canadian authorities would like.

In summary, the heavy exposure of the Canadian economy to international economic forces creates special difficulties for Canadian economic policy-makers. In particular, the importance of exports and of foreign capital inflows places significant limitations on Canadian authorities in deciding monetary and fiscal policies, forcing them to consider not only domestic Canadian problems, but also international factors, when formulating policies.

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First, by steadily increasing the cost of the GNP, these cost-push pressures force the Bank of Canada to continue to increase the money supply at inflationary rates in order to avoid an economic downturn due to inadequate demand, thus maintaining inflation at high rates. Furthermore, “inflation psychology” is strong risks touching off an explosion of wage demands and price increases, while strong cost-push pressures on prices make inflation very resistant to policies that depress aggregate demand.

Thus, “inflation psychology” tends to significantly reduce the effectiveness of monetary and fiscal policies in dealing with both inflation and recession. It is ironic that this problem resulted from excessive use of these policies in the late 1960′s and early 1970′s, when excessive monetary and fiscal stimulation in many nations generated the strong “inflation psychology” that has undermined the effectiveness of monetary and fiscal policies themselves.

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In summary, the heavy exposure of the Canadian economic policy-makers. In particular, the importance of exports and of foreign capital inflows places significant limitations on Canadians authorities in deciding monetary and fiscal policies, forcing them to consider not only domestic Canadian problems, but also international factors, when formulating policies.

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This decrease in the price of the Canadian dollar will cause the automatic adjustment mechanism referred to earlier to operate in the opposite direction.

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This increase in the price of the Canadian dollar will set into motion and automatic adjustment mechanism, which will tend to eliminate the Balance of Payments surplus. Because the Canadian dollar is more costly to foreigner Canada’s receipts will fall: foreigners will buy fewer Canadian goods, travel less to Canada, and invest less in Canada. Also, because the international value of the Canadian dollar has risen, it will buy more foreign currency than before, making it less costly for Canadians to buy, travel and invest in other nations. As Canadians increase their purchases of imports and then traveling to and investing in other nations, Canada’s payments will rise. With receipts falling and payments rising, the Original Balance of Payments surplus will tend to disappear, with the international value of the Canadian dollar having moved to a new, higher equilibrium level which is more consistent with the high demand for Canadian exports.

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