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.
Easy-money policies are used to stimulate bank lending and spending by consumers and businesses at times when the economy is in a recession and unemployment is unusually high. If the easy-money policies cause aggregate demand to increase, real output will rise more rapidly and unemployment will decline.
These beneficial effects of easy money are, however, not automatic. If the economy is in quite severe recession and expectations regarding the future are gloomy, consumers and businesses may be reluctant to borrow and spend money. Also, the banks may choose to hold some excess reserves rather than make loans that might prove risky due to poor economic conditions. Thus, easy money merely increases the banks’ reserves and makes more loans possible; it does not automatically create money and boost aggregate demand. This problem has been likened to “pushing on a rope,” which suggests that easy money by itself may not always be sufficient to lift the economy out of a recession. For this reason, many people believe that easy money should be combined with federal budget deficit, which can provide a more direct boost to aggregate demand and can thereby start the economy on its way toward recovery.
When easy money does generate higher aggregate demand, the results are not totally beneficial: a side effect of the increased total spending may be more rapid inflation. While the reduced unemployment from the easy money policies may make some additional inflation acceptable, this side effect does place a limit on the use of easy money.
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During a period of “easy money,” when the banks have plentiful reserves and are ready to make numerous new loans, interest rates tend to fall, to encourage borrowers to borrow additional funds. Thus, “easy money” tends to involve two characteristics – increased availability of loans and lower interest rates – both of which tend to stimulate borrowing and spending by consumers and businesses.
During a period of “tight money,” the scarcity of loans causes interest rates to rise, so that the available loans tend to go better credit risks and the highest bidders among them. These two characteristics of “tight money” – reduced availability of loans and higher interest rates – both tend to depress borrowing and spending by consumers and businesses.
Thus, monetary policy can influence the money supply through either the supply of loans or the demand for them. By increasing or reducing the banks’ reserves, the Bank of Canada can influence the availability (or supply) of loans, and by altering interest rates, the Bank of Canada operates in both ways, influencing both the availability and the cost of credit.
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“Moral suasion” refers to attempts by the Bank of Canada to persuade the managements of the chartered banks to voluntarily cooperate with the central bank’s objectives regarding lending policies, interest rates or any other aspect of monetary policy. Due to the fact that there are so few banks in Canada,it is relatively simple for the Bank of Canada to discuss its objectives with the banks with a view to enlisting their support, which they are expected to provide.
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To dampen aggregate demand in the economy, the federal government can use a budget surplus, with government expenditures less than tax revenues.
The most likely approach to a budget surplus is for the government to curb the growth of (or even reduce) government expenditures. Such curbs on government spending will be especially helpful in slowing inflation if they reduce the need for the government to increase the money supply to finance its expenditures.
*Because interest payments are one of the cost of doing business, some people believe that the way to curb inflation is to reduce interest rates rather than to increase them through a tight-money policy. While lower interest rates would have a slight cost-reducing effect on business, the easy money associated with lower interest rates would more than offset this by increasing the money supply and aggravating the problem of excess demand. In short, reducing interest rates is exactly the reverse of what is needed to combat inflation.
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Excess demand is not merely the result of people wanting more: they must also have more money with which to buy, thus driving prices up. For society in general (consumers, businesses and governments) to be spending more money, there must be more money in circulation – the money supply must rise. Any period of rapid inflation is accompanied by rapid increases in the money supply. And, as we have seen, the growth of the money supply is controlled by the Bank of Canada, which is ultimately responsible to the federal government. Thus, the key factor underlying the rate of inflation – the money supply – is in the final analysis determined by the federal government. In determining its monetary policy, however, the Bank of Canada is not concerned solely with combating inflation. In particular, we have seen that increases in the money supply (easy money) can be used during recessions, to reduce unemployment. While easy money policies can help to lift the economy out of recession, there is a danger that the government will boost the money supply too quickly and/or for too long a time. Of course, this will result in a new surge of inflation, but only after a time lag.
Experts in the monetary aspects of economics say that if the money supply is increased excessively rapidly, inflation will probably begin to increase after about a year and will continue to work its way through the economy for another two years more. Thus, while rapid increases in the money supply may look like a good idea to a government faced with a recession and high unemployment, they are all too likely to cause a much worse inflation problem in the future. An excellent example of this was in Canada, where rapid increases in the money supply in 1972, 1973, and 1974 led to a very serious wave of inflation in 1973 and beyond. Following this experience, the Bank of Canada undertook to keep the rate of increase of the money supply within specified limits.
Generally then, the level of aggregate demand for goods and services is the key factor underlying the rate of inflation. Generally, inflation tends to be most severe during economic booms, when demand is high, and less severe during recessions, when demand is sluggish.
The growth rate of the money supply is, over time, the single most important determinant of the inflation rate.
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