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Lesson #13 : Monetary and Fiscal Policy

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The government uses monetary and fiscal policy to control the size of the money supply. In recessionary times, the government will take monetary and fiscal actions to increase the money supply while in inflationary times, the government will work through its monetary and fiscal policies to reduce the supply of money. Note that the money supply is made up of two components: the amount of money in circulation plus the money held in banks’ chequing accounts.

In theory, increasing the money supply will stimulate our national economy while reducing the money supply will restrain it.

Monetary policy is carried out by the Bank of Canada, the bankers’ bank. Fiscal policy is executed directly through government taxation and spending policies.

Let’s deal with fiscal policy first because it is short and sweet.
In recessionary times, the government will either increase spending or decrease taxes or do both, thereby increasing the money supply and stimulating the economy. When government acts in this manner, it is said to be working to expand its national economy.

Conversely, in times of inflation, the government will either decrease government spending or increase taxes or do both, thereby decreasing the money supply and restraining the economy.

The Bank of Canada has a number of possible actions it can take to either stimulate/expand a recessionary economy or to restrain an inflationary one.

In recessions the bank can use any or all of the following monetary policies to help pump money into a stagnant economy.

1.The central bank can lower the bank rate which is the rate of interest it charges the chartered banks to borrow money from it. With the chartered banks following suit, interest rates will be lowered thus allowing consumers to actually borrow money more cheaply.

2.The Bank can also increase its transfers of funds to the Canadian chartered banks which will then have more money to lend out.

3.The Bank can also buy back bonds it had previously sold to the chartered banks.By buying back some of these bonds, the chartered banks, having converted their bonds into cash, will have more money to lend to individuals and businesses.

4.The Bank also uses moral suasion to put pressure on the chartered banks to lower their respective interest rates and to take other actions serving to expand the money supply and thereby to stimulate an economy in recession.

During inflationary times, when rising (inflated) prices cause the quantity demanded for goods to decrease, the national bank has a number of potential actions at its disposal to help decrease the money supply and thereby restrain the economy.

1.It can raise the bank rate (the interest rate it charges the chartered banks to borrow its money). This should cause banks to raise their own rates of interest thus encouraging saving rather than spending, thus causing the economy to slow down.

2.The national bank can also decrease its transfers of money to the chartered banks thus cutting down the money available for loans.

3.The Bank can, in addition, sell bonds to the chartered banks. This will reduce the funds that the banks have available to lend, thereby serving to restrain an inflationary economy.

4.The Bank may also employ moral suasion to get banks to take action to decrease the supply of money, thus again restraining the economy as a whole.

Now use your understanding of monetary and fiscal policy to respond to the following questions. See tomorrow’s JuicyLesson for the correct answers. Note that for one or two of these questions, a general knowledge of economics is required.

ANSWERS AND EXPLANATIONS WILL BE FOUND IN TOMORROW’S JUICYLESSON (#14).

1. The Bank of Canada, as the bankers’ bank, heads up the Canadian banking
system. Which of these is the most important function of the Bank of Canada?

A) To lend money to the chartered banks
To pay government bills and collect government revenues
C) To manage and control the Canadian money supply
D) To transfer funds to the chartered banks

2. Which of the following transactions would result in the creation of money within Canadian banking system?

A) Kayla uses her credit card to purchase a computer.
B) Hugo borrows $150 from his brother.
C) Patrick deposits his pay cheque in his chequing account at the Royal Bank.
D) William pays his CEGEP tuition with a money order.

3. During recessionary periods in the Canadian economy, the government, in its role as “stabilizer”, can decide that its main objective is to keep unemployment from exceeding acceptable limits. It will therefore adjust its fiscal and monetary policies accordingly in order to stimulate the economy.

Select the two scenarios which would be adopted to stimulate a recessionary economy.

1. Increase government spending
Reduce income tax rates

2. Reduce government spending
Increase income tax rates

3. Buy savings bonds from consumers
Lower the Bank Rate
Transfer cash to the banks

4. Sell savings bonds to consumers
Increase the Bank Rate
Withdraw cash from the banks

A) 1 and 3
1 and 4
C) 2 and 3
D) 2 and 4

5. The Bank of Canada decides to sell savings bonds to consumers.

Select the correct statement related to this situation.

A) The national economy will expand.
Aggregate (total) demand in the Canadian national economy would increase.
C) The inflation rate would probably decrease.
D) Interest rates will naturally decrease according to the law of supply and demand.

6. When the government follows expansionary monetary and / or fiscal policies it is trying to deal with recessionary periods in the Canadian business cycle.

Which one of the following would decrease as a result of the implementation of expansionary monetary and/or fiscal policies by the Canadian government?

A) The unemployment rate
The money supply
C) Government spending
D) Housing prices

7. At times of high inflation, which one of the following would be an appropriate FISCAL (as opposed to monetary) policy for the government to adopt?

A) Buy back government bonds from the chartered banks
Raise the bank rate
C) Increase the GST (Goods and Services Tax) by one percent
D) Increase its spending

8. Which two of the following are consequences of increased interest rates?

1. An increase in consumption (consumer spending) as opposed to consumer savings
2. A decrease in the demand for commercial loans
3. A decrease in interest rates paid by banks on deposits
4. A decrease in the demand for consumer goods

A) 1 and 2 1 and 3 C) 2 and 4 D) 3 and 4

9. Which one of the following is a fiscal (as opposed to a monetary) policy?

A) Increase taxation
Transfer of funds from the Bank of Canada to the chartered banks
C) Buying government bonds
D) Selling government bonds

10. Which row in the chart contains, IN ORDER, a CAUSE of inflation, a CONSEQUENCE of inflation, and a MEANS OF CONTROLLING IT?

1. Most households have less purchasing power than they used to.

2. Consumers take advantage of low interest rates to spend money on such goods as new cars, furniture, and vacations.

3. Just this week, the Bank of Canada has increased interest rates.

Possible Answer Cause Consequence Means of controlling inflation
A. 1 2 3
B. 3 2 1
C. 2 3 1
D. 3 1 2

Reminder: Tomorrow’s JuicyLesson (#14) will provide answers and explanations for these ten questions.

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