In Chapter 9, we saw how the federal government’s Department of Finance uses fiscal policy to influence the level of aggregate demand in the economy. Since the monetary policy of the Bank of Canada discussed in this chapter also influences aggregate demand, we should review briefly how monetary and fiscal policies can interact so as to affect the performance of the economy.
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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