Chapter 5
What is the main difference between the Rational Expectations,Keynesian,Monetarist,Supply-Side Economics Theory s?
These theories differ primarily regarding the ideal level of government involvement. Under rational expectations theory, governments should have little involvement in the economy and simply set basic rules. Under Keynesian theory, governments should have direct involvement in the economy and should set spending and tax policies. Under monetarist theory, governments should have little influence on the economy and should simply control inflation (and the money supply). Under supply-side economics theory, governments should have little direct influence in the economy and should only affect changes through tax rates.
What is the Rational Expectations Theory?
What is the theory? The theory suggests that firms and workers are rational thinkers and can evaluate all the consequences of a government policy decision, thereby neutralizing the intended impact of the policy. What is the theoretical level of government involvement? Governments should be less active or less interventionist. The economy is better served if the government simply adopts sets of rules to govern its activities. For example, a rule could stipulate that the money supply would only increase by a certain amount each year. How does this theory work in action? The Bank of Canada decides to let inflation accelerate in hopes of achieving a higher level of demand and lower unemployment. Firms and workers realize inflation is rising, immediately adjust their prices and wage demands upward, and no increase in real demand occurs.
When does the Bank of Canada use Sale and Repurchase Agreements (SRAs)? a. When there is undesired downward pressure on overnight rates. b. When there is undesired upward pressure on overnight rates. c. When the exchange rate becomes volatile and moves outside of a desired trading range. d. When the output gap moves from positive to negative.
a)Sale and repurchase agreements are used to alleviate undesired downwanrd pressure on overnight lending rates. Through SRAs, the Bank of Canada sells securities to the chartered banks and agrees to repurchase them the next day. This reduces the liquidity in the system and helps maintain the level of overnight rates.
What current monetary policy target does the Bank of Canada use to promote sustained economic growth with price stability? a. Maintain inflation within a 1% to 3% operating band. b. Maintain growth in the money supply at a 5% annual rate. c. Keep inflation within a 1% range of our major trading partners. d. Ensure that the value of the Canadian dollar stays within a narrow trading range of the U.S. dollar.
a)Since 1991, the Bank has committed to specific inflation-control targets that establish a target range within which it aims to contain annual inflation as measured by the year-over-year rate of increase in the CPI. Currently, the target range extends from 1% to 3%.
What is the Keynesian Theory?
What is the theory? Keynesian economics advocates the use of direct government intervention as a means of achieving economic growth and stability. What is the theoretical level of government involvement? Governments should play an active role in stabilizing the business cycle. Governments should lower taxes and increase spending during recessions and reduce spending and raise taxes as the economy expands. How does this theory work in action? Consider the case where the Canadian economy has been mired in recession for two full years and unemployment has increased to 13.2%. a. To combat this, the federal government announces the immediate elimination of the GST and an increase in employment insurance benefits. b. Buoyed by this new-found wealth, Canadian consumers increase their discretionary spending on big-ticket items, such as furniture, washing machines and cars. c. To meet higher consumer demand for their products, businesses hire more workers to expand production, and unemployment falls.d. Lower unemployment leads to a further increase in consumer income and spending.e. The increase in income and spending may continue for some time.
What is the Monetarist Theory?
What is the theory? Monetarists advocate that the economy is inherently stable and, left to its own self-adjusting mechanism, will automatically move to a stable path of growth. In contrast to the Keynesian view, monetarists believe that instability in the money supply is the major cause of fluctuations in real GDP and that rapid money supply growth is the major cause of inflation. What is the theoretical level of government involvement? Government involvement should be kept at a minimum and the central bank should expand the money supply at a rate equal to the economy's long-run growth rate. How does this theory work in action? The Bank of Canada decides that its current inflation control targets are no longer working as intended. Instead it decides to implement a policy whereby the monetary aggregate M1 is allowed to expand at a rate of 2.75% per annum, which is in line with Canada's long-term real growth rate.
What is the Supply-Side Economics?
What is the theory? Supply-side economics advocates that changes in tax rates exert important effects on supply and spending decisions in the economy. The theory maintains that reducing both government spending and taxes provides the stimulus for economic expansion. What is the theoretical level of government involvement? Government intervention should be kept at a minimum and only occur through changes in tax rates. How does this theory work in action? In the early 1980s, the United States pursued a policy of lower marginal tax rates for higher wage earners in the belief that this would move the economy to a higher level of output and growth. The government believed that lower tax rates for wealthier individuals would help to stimulate investment in the economy and would ultimately lead to a trickle-down effect to all wage earners.
Last year, the government ran a budget surplus. What impact is this likely to have on the national debt? a. The national debt will decrease if the government chooses to use the surplus to pay it down. b. The national debt will increase by the amount of the surplus. c. It will have no impact on the national debt as the government budget and the national debt are unrelated. d. It will have no impact on the national debt as all surpluses must be spent in the year they are incurred as the government must always run a balanced budget.
a) If the revenue collected during the year exceeds spending for the year, the government has a budget surplus. If total spending for the year is higher than the revenue collected, the government has a budget deficit for the year. The amount of the surplus or deficit is the most important number in the budget, because it tells markets the extent to which the government will be borrowing in the coming year and how it will compete with other borrowers for funds. The government can use the surplus to pay down the national debt.
What impact do automatic stabilizers, such as the tax system and employment insurance, have on the economy? a. They help to reduce the fluctuations in real GDP. b. They tend to worsen the fluctuations in real GDP. c. They work in opposite directions. d. They have a negative impact on monetary conditions.
a) Some parts of the government budget automatically move counter to the business cycle. For example, when the economy enters a recession unemployment rises and tax revenues tend to fall. Government payouts in the form of employment insurance increase and premiums from employers and employees decrease. Thus, government transfers to persons increase at a time when wage income decreases, softening the drop in disposable income and spending. Transfer payments and the tax system are considered automatic stabilizers as their actions taken together help to reduce the fluctuations in real GDP during both recession and expansion periods.
When growth is slowing, what can the government do to stimulate the economy? a)Run a deficit b)Run a surplus c)Increase taxation d)Pay down outstanding debt
a) The government could run a deficit to stimulate the economy. When the government runs a budget deficit, it is effectively spending more than it is taking in. Spending more can have a positive impact on the economy as it transfers money from the government to businesses and consumers.
Why would the federal government increase transfer payments to the provinces? a)To encourage consumer spending b)To reduce provincial debt levels c)To improve its popular support d)To transfer debt to the provinces
a)An increase in transfer payments is considered an expansionary fiscal policy. The expectation is that the provinces will use the increase to reduce taxes or to increase spending on provincial requirements. Ultimately, the expectation is that the transfer payments will make their way to the pockets of consumers.
Which of the following allows participating financial institutions to conduct transactions with each other through an electronic wire system? a)Large Value Transfer System b)Canadian Payments System c)Canada Investment and Savings System d)Sale and Repurchase Agreements
a)The Bank established the Large Value Transfer System (LVTS) to facilitate the transfer and settlement of large transactions between participating financial institutions. The system allows financial institutions to track their LVTS receipts and payments electronically throughout the day.
If the government used Keynesian economic policy, under what conditions would it lower income tax levels? a)In periods of strong economic growth b)In periods of recession c)When the deficit is high d)When there is a need for increased spending
b) When there is a need for increased spending
Which of the following involves transferring deposits to the Bank of Canada from the chartered banks? a. Redeposit. b. Drawdown. c. SPRA. d. Monetary suasion.
b)A drawdown refers to the transfer of deposits to the Bank from the chartered banks, effectively draining the supply of available cash balances from the banking system. This decreases deposits and reserves available to the banks to utilize in their business. Removing money from the system causes a contraction in the availability of loans to consumers and businesses, and this places upward pressure on interest rates.
How could an increase in unemployment be stabilized? a)Through a reduction in wages. With wage income going to a smaller pool of workers, the overall national wealth increases b)Through transfer payments going to jobless, in the form of employment insurance c)Through a slowing of inflation because of fewer in the workforce d)Through reduced consumer spending, so that economic growth slows to more sustainable levels
b)An increase in unemployment can be stabilized through transfer payments. Employment insurance (EI) is a type of automatic stabilizer. If an individual loses his job and qualifies for EI payments, this source of income helps to cushion the blow of losing employment income. The individual can begin a new job search and can use the EI payments on goods and services.
Which of the following fiscal policy measures could the federal government use to stimulate the economy? a. Spend less and tax more. b. Spend more and tax less. c. Spend less and tax less. d. Spend more and tax more.
b)Governments, through their power to tax, spend, and borrow, exercise enormous influence on the economy. Since the end of the Second World War, most Western governments have taken it for granted that one of their duties is to smooth out the business cycle, by spending more and taxing less when the economy is weak, and by spending less and taxing more when it is strong.
Over the past three months, Canada has reported inflation rates of 2.7%, 2.9%, and 3.3% (in months 1, 2 and 3 respectively). What policy action will the Bank of Canada likely take? a)Lower short-term interest rates b)Raise short-term interest rates c)Loosen monetary conditions d)Raise the exchange rate
b)In this scenario, with inflation rising above the range, the Bank will intervene by raising short-term interest rates. The Bank of Canada closely monitors the inflation rate to ensure that it does not rise above the current target range of 1% to 3%. The Bank will likely use a Sale and Repurchase Agreement (SRA) to reinforce the operating band, possibly by raising the lower limit to reinforce inflation targets. Raising the lower limit of the band also increases the top end, thus raising the Bank Rate.
What is a significant negative implication for a country with a large national debt? a. Interest rates must be maintained at low levels to reduce government interest expenses. b. The government must continue to run deficits to finance the debt. c. Fiscal policy options are restricted. d. Fiscal and monetary policy becomes ineffective.
c) A large national debt constrains the government's fiscal policy options. For example, in a recession, the government cannot increase the deficit to stimulate the economy as this would also increase the national debt level.
If the Bank of Canada is concerned that interest rates are too high, what policy action can they take? a. Implement a drawdown to increase the money supply in the economy. b. Implement a drawdown to decrease the money supply in the economy. c. Implement a redeposit to increase the money supply in the economy. d. Implement a redeposit to decrease money supply in the economy.
c) A redeposit is a transfer of funds from the Bank to the chartered banks. This increases deposits and reserves and the availability of funds in the banking system. Adding money to the system places downward pressure on interest and gives banks an incentive to increase loans to consumers and businesses.
If the government adhered to the supply-side theory of economics, what type of fiscal policy would it promote? a)A policy that is active rather than passive b)A policy that lets the money supply grow at a constant rate c)A policy that lowers personal tax rates d)A policy that encourages higher government spending
c)A fiscal policy employing lower personal tax rates would support the supply-side view. In a previous activity, we learned that supply-side theory advocated lower government spending and tax rates.
What key interest rate does the Bank of Canada use to conduct monetary policy? a)The Prime Rate b)The 90-day Treasury bill rate c)The Bank Rate d)The C$\US$ exchange rate
c)The Bank Rate represents the upper limit of the Bank's operating band. Changes in monetary policy are conducted at the upper limit, which has a direct impact on the Bank Rate.
What are the two most important ways in which the Bank of Canada influences interest rates? a. Cash management and moral suasion. b. Open market operations and setting reserve requirements. c. Cash management and open market operations. d. Moral suasion and open market operations.
c)The Bank of Canada conducts monetary policy through its influence over short-term interest rates. It does this primarily through cash management mechanisms and open market operations.
How is the Bank Rate set? a. 0.25% above the average treasury bill rate. b. The average of the bids received for government securities at auction. c. Upper limit of the Bank of Canada's "operating band". d. Lower limit of the Bank of Canada's "operating band".
c)The Bank of Canada sets the Bank Rate at the upper limit of the operating band for overnight financing. The Bank will announce, through a press release, changes to the band in response to changing monetary situations.
What action will the Bank of Canada take if an increase in demand for overnight money has lead to upward pressure on overnight financing rates? a)Use a SRA and borrow at the upper limit of the operating band b)Use a SRA and borrow at the lower limit of the operating band c)Use an SPRA and lend at the upper limit of the operating band d)Use an SPRA and lend at the lower limit of the operating band
c)The Bank uses Special Purchase and Resale Agreements (SPRAs) to relieve upward pressure on overnight financing rates. If overnight money is trading above the target of the operating band, the Bank may believe the higher rate will dampen economic activity. To combat this, the Bank intervenes and offers to lend at the upper limit of the operating band.
Recommend a fiscal policy the Government of Canada can pursue to stimulate the economy. a. Increase taxes and decrease spending. b. Decrease taxes and decrease spending. c. Increase taxes and increase spending. d. Decrease taxes and increase spending.
d) Fiscal policy affects the economy in several ways: • Spending: Governments can purchase goods or services themselves, such as a new highway, thereby boosting economic activity. • Taxes: Lowering tax rates increases the disposable income of consumers, thereby increasing their spending.
The Bank Rate is currently 4.5%. If the overnight market becomes volatile and the Bank of Canada needs to intervene, at what point will they begin to offer SRAs? a. When rates rise above 4.5%. b. When rates rise above 5.0%. c. When rates fall to 4.25%. d. When rates fall below 4.0%.
d) SRAs are conducted at the bottom end of the band. The band itself is 50 basis points wide. In this question, the top end of the band is 4.5% while the bottom or floor is 4.0%. This operation is used to reinforce lower the limit or floor of the operating band.
When the economy weakens, choose the outcome that occurs as a result of automatic stabilizers. a. Tax revenues increase and employment insurance payments rise. b. Tax revenues increase and employment insurance payments fall. c. Tax revenues decrease and employment insurance payments fall. d. Tax revenues decrease and employment insurance payments rise.
d) When the economy weakens and unemployment is rising, government payouts for employment insurance increase and premiums from employers and employees decrease. Thus, government transfers to persons increase at a time when wage income decreases and this helps to soften the drop in disposable income and spending. Tax revenues decrease as profits and employment decline, which tends to increase the size of the budget deficit.
If overnight money is trading at 3.5% and the Bank of Canada wants to lower the rate, it may offer to lend overnight money to money market dealers at 3.25%. The dealers give the Bank treasury bills as collateral for the loan, getting them back the next day when the loan is repaid. What type of activity is this is known as? a. Reverse special agreement. b. Sale and repurchase agreement. c. Drawdown agreement. d. Special purchase and resale agreement.
d)The Bank of Canada has a separate set of open market operations to influence the overnight rate. If overnight money is trading at 3.5% and the Bank of Canada wants to lower the rate, it may offer to lend overnight money to money market dealers at 3.25%. The dealers give the Bank treasury bills as collateral for the loan, getting them back the next day when the loan is repaid. Because the Bank is essentially buying the T-bill with an agreement to sell it back the next day, this operation is called a special purchase and resale agreement, or special for short.
Which of the following is not a function of the Bank of Canada? a. To issue the nation's bank notes. b. To act as banker to the federal government. c. To manage the nation s money supply. d. To prepare the federal budget each year.
d)The Bank of Canada has several key functions to fulfill. However, preparing the federal budget falls within the domain of fiscal policy and is the responsibility of the Department of Finance.
If the Bank of Canada would like to reduce the supply of cash balances in the banking system, what policy action can it take? a)SPRA b)SPRA c)Redeposit d)Drawdown
d)The Bank of Canada would institute a drawdown. A drawdown refers to the transfer of deposits to the Bank from the chartered banks, effectively draining the supply of available cash balances from the banking system. This decreases deposits and reserves available to the banks in their business. Removing money from the system causes a contraction in the availability of loans to consumers and businesses, which places upward pressure on interest rates.
Considering the four economic theories that you have reviewed, which theory do you think Canada's current fiscal and monetary policy is most aligned with?
here is no correct answer to this question. At any one time, government fiscal and monetary policy could reflect a number of these theories. For example, a lowering of corporate or personal income taxes could be considered a Keynesian approach to the economy, but it could also be interpreted as the supply-side approach of reducing tax rates to spur economic growth. Current monetary policy follows an inflation control rule and so has some basis in the rational expectations and monetarist approaches. However, some might argue that the Bank of Canada takes an active role in controlling inflation and so therefore is more Keynesian. What is important about these theories is that they help us to better recognize the policy actions of the government and the impact that changes in policies can have on the economy.