Economic Policy CSC Volume 1 Chapter 5 PDF

Economic Policy 5 CHAPTER OVERVIEW In this chapter, you will learn about economic policy, both fiscal and monetary, and the impact of government policy decisions on the investment landscape. In this conte...

Economic Policy 5 CHAPTER OVERVIEW In this chapter, you will learn about economic policy, both fiscal and monetary, and the impact of government policy decisions on the investment landscape. In this context, you will learn about the roles and functions of the Bank of Canada and the challenges that governments face in setting their economic policies. LEARNING OBJECTIVES CONTENT AREAS 1 | Describe the components of fiscal policy and Fiscal Policy their impact on economic performance. 2 | Explain the roles and functions of the Bank The Bank of Canada of Canada. 3 | Analyze how the Bank of Canada implements Monetary Policy and conducts monetary policy. 4 | Summarize the challenges governments face The Challenges of Government Policy when implementing fiscal and monetary policy. © CANADIAN SECURITIES INSTITUTE 5 2 CANADIAN SECURITIES COURSE      VOLUME 1 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. balanced budget Lynx Bank Rate monetary policy basis points national debt budget deficit overnight rate budget surplus overnight repo drawdown overnight reverse repo fiscal agent Payments Canada fiscal policy redeposit © CANADIAN SECURITIES INSTITUTE  CHAPTER 5      ECONOMIC POLICY 5 3 INTRODUCTION Once a year, typically in February, the federal minister of finance announces the government’s budgetary requirements. The statement serves as the government’s annual fiscal policy score card of spending and taxation measures. Not far from Parliament Hill, the Bank of Canada uses monetary policy to maintain balance in the economy. The government also exerts influence over interest rates and the exchange rate toward that goal. The government operates largely independently from the Bank of Canada. However, they both share the goal of creating conditions for long-term, sustained economic growth. This chapter explores fiscal and monetary policy, particularly from the standpoint of making investment decisions. For example, if the economy is moving through expansion into the peak phase of the business cycle, what monetary policy initiative is the Bank of Canada likely to consider? If the economy has been stalled in recession and unemployment continues to rise, what fiscal policy initiative is the federal government likely to consider? Given your understanding of their likely course of action in each situation, what investments or strategies would you pursue? Economic policy and the policy decisions made by the federal government and the Bank of Canada are key factors in making investment decisions. Therefore, it is important that you understand the difference between fiscal and monetary policy, and that you can explain how policy actions affect the financial markets. Your knowledge in this area will help you make investment decisions based on current economic conditions, and on the likely impact that fiscal and monetary policy decisions may have on those investments. FISCAL POLICY 1 | Describe the components of fiscal policy and their impact on economic performance. Fiscal policy informs government decisions around the use of its spending and taxation powers. A government’s fiscal policy influences economic activity, employment levels, and sustained long-term growth. Most fiscal policy is a balancing act between taxes and spending. There are differing views about the effectiveness of fiscal policy. Both federal and provincial governments implement certain elements of fiscal policy. The federal government is responsible for services including national defence, employment insurance, pension income for seniors and the disabled, veterans’ affairs, foreign affairs, and indigenous and northern affairs. Provincial governments are responsible for other services including health care, education, securities regulation, and various social services. However, both the federal and provincial governments share some level of responsibility for those areas. A large segment of federal spending consists of transfer payments to the provincial governments to help pay for such shared responsibilities. THE FEDERAL BUDGET The government’s revenue comes primarily from different forms of taxation. The government’s budget balance is equal to that revenue less total spending. The federal budget contains projected spending, revenue, surplus or deficit, and debt for the coming fiscal year, which runs from April 1 to March 31, plus at least one subsequent year. The government’s proposed annual budget has one of the following three possible positions: Proposed Annual Budget Budget Position Revenue > Spending = Budget surplus Revenue < Spending = Budget deficit Revenue = Spending = Balanced budget © CANADIAN SECURITIES INSTITUTE 5 4 CANADIAN SECURITIES COURSE      VOLUME 1 The national debt consists of accumulated past deficits minus accumulated past surpluses in the federal budget. When the government runs a deficit, it must borrow from the capital markets to finance the national debt. The amount of the surplus or deficit each year, along with the current national debt, are the most important numbers in the budget. These amounts indicate the extent to which the government will be borrowing in the coming year and the impact it will have on the capital markets. Governments finance deficits by issuing debt instruments such as bonds and Treasury bills in the capital markets. Some of the national debt may also mature in that year and must therefore be refinanced. Government borrowings comprise these two amounts: refinanced debt and new debt. Capital markets have a finite amount of capital. Therefore, when a government borrows significantly from the capital markets, less capital remains for businesses to borrow. This effect, referred to as crowding out, can have a negative impact on the economy. The supply of capital may not be sufficient to meet the needs of the business community, and like any other market, when supply is less than demand, prices go up. In other words, interest rates rise, and it costs more to borrow money. HOW FISCAL POLICY AFFECTS THE ECONOMY As we discussed in the previous chapter, gross domestic product (GDP) largely comprises three major components: government spending, consumer spending, and business spending and investment. Fiscal policy generally targets all three components. The government’s key fiscal policy tools are spending and taxation. When the government announces a new budget, analysts scrutinize it closely. The budget tells us what the government plans to do with respect to spending and taxation. It also provides information about how our tax dollars are going to be used. The budget also reveals what the government thinks is going to happen in the economy within the next couple of years, which is an important indicator. FOR INFORMATION ONLY Key Economic Theories There exists a variety of theories to explain how the economy works and to guide economic policy. Two of the more popular theories are Keynesian economics and the monetarist theory. Keynesian economics advocates direct government intervention as a means of achieving economic growth and stability. You can see Keynesian economics in action in the government’s use of fiscal policy to stabilize the economy. When spending is insufficient and a recession looms, the government pursues a policy of increased spending and lower taxes. During an economic boom, or when higher spending threatens to create inflation, government policy changes in favour of lower spending and higher taxes. For example, during a recession, the Keynesian approach is to raise consumer income by increasing government spending or lowering taxes. With more money available, consumers increase their spending on goods and services. To meet higher consumer demand for their products, businesses expand production and hire more workers. The lower unemployment rate leads to a further increase in consumer income and spending until policymakers sense that spending is rising too quickly. At that point, economic policy shifts. The government then opts for reducing spending and raising taxes. Monetarist theorists argue that governments should not use fiscal policy to influence the economy. They claim that changes to the money supply cause fluctuations in the economy. Therefore, the money supply and interest rates should be used to control economic instability and inflation. As the name suggests, monetary policy is the key economic tool that monetarist theorists propose should be used. Monetarists believe that the central bank should expand the money supply at a rate equal to the economy’s long-run growth rate, such as 2% to 3% per year, for example. According to this view, the main policy goal is to control inflation, which creates a foundation for the economy to grow at its optimal rate. We look at monetary policy in the next section. © CANADIAN SECURITIES INSTITUTE  CHAPTER 5      ECONOMIC POLICY 5 5 SPENDING Just as companies spend money to run their business, the federal government spends money to run the country. The government pays for utilities, communications, salaries, and supplies, much like companies do. The government must also pay for programs it sponsors and investment in infrastructure projects. Governments at all levels can increase spending to stimulate the economy, or they can reduce spending when inflation is a concern. When the government provides funding for new infrastructure, the government spending component of the GDP obviously increases, but that is not all. To build a new highway, for example, workers must be hired and materials must be bought. The newly employed workers have more money to spend, which may increase the consumer spending component of GDP. As consumers spend more, business revenues also increase. Some companies may expand their operations to meet increased demand for their products. Therefore, the business spending component of the GDP may also increase. In this way, government spending on infrastructure can have a stimulative effect on the whole economy. TAXATION Several types of taxes provide the revenue for government spending. Some taxes are imposed on businesses; others are imposed on consumers. If the government wants to stimulate the economy, it can lower personal taxes, in which case consumers have more money to spend. It can also lower business taxes, in which case businesses have more money to spend and invest. And when businesses expand operations and hire more workers, this can lead to a drop in the unemployment rate. As with spending, the government may increase taxation to lower inflation, making it more difficult for consumers and businesses to spend. FOR INFORMATION ONLY Persistent deficits emerged in Canada during the 1980s, after which the annual deficit grew considerably and a vicious cycle emerged. Higher deficits led to increased borrowing, which led to a larger national debt and larger interest payments to service the debt. These larger interest payments further led to increasingly large deficits and debts. In fact, it was not until 1997 that the federal government managed to run a surplus. The federal debt in Canada, as a percentage of GDP, has fallen significantly over the past 20 years. The debt-to- GDP ratio is regarded as a sound measure of a country’s overall debt burden. The measure is relevant because the debt is measured against the government’s, and taxpayers’, ability to finance it. Figure 5.1 shows the annual federal government debt as a percentage of GDP for Canada from 1975 to the end of the 2022–23 fiscal year. As a share of GDP, federal debt sits at 42.2%, down from its peak of 68.4% in 1995–96. Note that the recent jump in debt as a percentage of GDP resulted from additional government spending because of the coronavirus pandemic. © CANADIAN SECURITIES INSTITUTE 5 6 CANADIAN SECURITIES COURSE      VOLUME 1 Figure 5.1 | Annual Federal Government Debt as a Percentage of Gross Domestic Product 80 70 60 Debt-to-GDP (%) 50 40 30 20 10 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 Year Source: Annual Financial Report of the Government of Canada, Fiscal Year 2023–3. FISCAL POLICY Can you define the fiscal policymaking process and identify the decision makers? Can you explain the impact of fiscal policy on the economy? Complete the online learning activity to assess your knowledge. THE BANK OF CANADA 2 | Explain the roles and functions of the Bank of Canada. The Bank of Canada (the Bank) is the nation’s central bank. It was founded in 1934 and began operations in 1935 as a privately-owned corporation. By 1938, ownership passed to the Government of Canada. The Governor and Deputy Governor are appointed for a term of seven years by the Board of Directors. The Board may also appoint one or more additional Deputy Governors. The Governor acts as both the Chief Executive Officer of the Bank and the chair of the Bank’s Board of Directors. The Board of Directors is composed of the Governor, Senior Deputy Governor, 12 independent directors, and the Deputy Minister of Finance. Though directors may provide insight into prevailing economic conditions, they neither formulate nor implement monetary policy. Responsibility for the affairs of the Bank of Canada rests with a Governing Council composed of the Governor, the Senior Deputy Governor, and any additional Deputy Governors appointed by the Board. ROLE AND FUNCTIONS OF THE BANK OF CANADA The main role of the Bank is to promote the economic and financial welfare of Canada. To do so, the Bank acts to stabilize the Canadian economy by using monetary policy. © CANADIAN SECURITIES INSTITUTE  CHAPTER 5      ECONOMIC POLICY 5 7 The Bank administers monetary policy independently, without day-to-day intervention by the government. However, policy itself is the ultimate responsibility of the elected government. The Bank has four main areas of responsibility: 1. Monetary policy Monetary policy is designed to preserve the value of the Canadian dollar by keeping inflation low, stable, and predictable. The Bank makes use of inflation control targets to influence interest rates and a flexible exchange rate when conducting monetary policy. 2. The Canadian financial system The Bank works with a variety of agencies and market participants in Canada and abroad to promote and maintain the efficient operation of the financial system. The Bank does this by overseeing the main clearing and settlement systems, working with domestic and international regulatory bodies, providing liquidity to the financial markets, and giving advice to the federal government. In its role as the nation’s central bank, the Bank is technically the ultimate source of liquidity in the financial system and is referred to as the lender of last resort. 3. Physical currency The Bank is responsible for designing, printing, and distributing Canadian bank notes. 4. Funds management The Bank is the fiscal agent for the Government of Canada. A fiscal agent is an institution appointed to advise in, and conduct, various financial matters of another. In the capacity of fiscal agent, the Bank has the following responsibilities: It manages the government’s accounts through which virtually almost all money collected and spent by the government flows. It manages the government’s foreign currency reserves, such as U.S. dollars, euros, gold, and silver. It manages the government’s federal debt, which consists mostly of Treasury bills and marketable bonds. The Bank keeps track of this debt by ensuring that interest payments are made, tracking who owns the debt, and ensuring that the debt is paid back or refinanced in a timely manner. It provides advice to the federal government regarding what debt can be issued, at what interest rate, and for what term, based on its assessment of the capital markets. The goal is to ensure stability of the capital markets. MONETARY POLICY 3 | Analyze how the Bank of Canada implements and conducts monetary policy. According to the Bank, the goal of monetary policy is to preserve the value of money in the economy by keeping inflation low, stable, and predictable. This goal helps to promote sustained economic growth and job creation. Since 1991, the Bank has acted to keep inflation between 1% and 3% by using inflation-control targets. DID YOU KNOW? Economic growth in the economy is important, but if that growth takes place too fast, the economy may experience inflation. Low or no growth can lead to unemployment, a stagnant economy, and a drop in the country’s standard of living. © CANADIAN SECURITIES INSTITUTE 5 8 CANADIAN SECURITIES COURSE      VOLUME 1 CANADA’S MONETARY POLICY FRAMEWORK The Bank’s key monetary policy tools for implementing monetary policy occur through the following means: Interest rate policy Open market operations The methods to apply these tools are explained in detail below. TARGET OVERNIGHT RATE Setting an official interest rate is the most noticeable and most important monetary policy tool the Bank uses. The Bank conducts monetary policy primarily through changes to what it calls the target for the overnight rate. By changing its target, the Bank can signal a policy shift toward an easing or tightening of monetary conditions to meet its inflation-control targets. The overnight rate is the interest rate set in the overnight market, a marketplace wherein major Canadian financial institutions lend each other money in the form of one-day loans (called overnight loans). Changes in the target for the overnight rate influence other short-term interest rates, for such things as consumer loans or mortgages. The overnight rate operates within an operating band that is 50 basis points wide. A basis point equals 1/100th of a percentage point. Each day, the Bank targets the mid-point of the operating band as its key monetary policy objective. For example, if the operating band is 1.5% to 2.0%, then the target for the overnight rate is 1.75%. DID YOU KNOW? One basis point is equal to 1/100th of a percentage point. Therefore, 50 basis points are equal to half of a percentage point, or 0.5%, and 100 basis points are 1%. DID YOU KNOW? The Bank Rate is the rate of interest that the Bank charges on one-day loans to the chartered banks and other major financial institutions that are members of Payments Canada. The Bank Rate is the upper limit of the operating band. The Bank Rate and the operating band are adjusted simultaneously whenever the Bank changes the target for the overnight rate of interest. Figure 5.2 shows the Bank’s operating band under specific conditions. Figure 5.2 | The Bank of Canada’s Operating Band Bank Rate 2.0% 50 basis points 1.75% target range 1.5% Bank Rate less 50 basis points © CANADIAN SECURITIES INSTITUTE  CHAPTER 5      ECONOMIC POLICY 5 9 The Bank announces whether or not it will change the target rate on eight pre-set fixed dates during the year. Changes to the rate send a strong message about the Bank’s outlook to the financial community, whose members then adjust their interest rates accordingly. EXAMPLE If the Bank lowers the target rate from 1.0% to 0.75%, its goal is to ease monetary conditions, making it cheaper for consumers and businesses to borrow money, and thus encouraging them to borrow money and increase spending in the economy. If the Bank raises the target rate, its goal is to tighten monetary conditions, making it more expensive to borrow money, and thus encouraging consumers and businesses to save more and spend less. OPEN MARKET OPERATIONS The two main open market operations the Bank uses to conduct monetary policy are overnight repos and overnight reverse repos. Instead of letting the rates vary from day to day depending on conditions in the market, the Bank initiates these transactions as often as needed, to keep the overnight market trading within the operating band. OVERNIGHT REPOS Overnight repos are used by the Bank when it wants to push interest rates down. If the overnight rate is trading above the target rate, the Bank may believe that the higher rates will dampen economic activity. To combat this risk, the Bank intervenes with an overnight repo, offering to lend money at a lower rate. An overnight repo generally works as follows: 1. The Bank offers to lend on an overnight basis, that is, with an agreement that the loan be paid back one business day later. 2. The Bank essentially purchases Treasury bills from another financial institution on an overnight basis. 3. To complete the lending, the financial institution sells Treasury bills to the Bank on an overnight basis. 4. The Bank’s purchase of the Treasury bills gives the financial institution more money to lend out. This activity increases the money available in the financial system, causing the overnight rate to fall. 5. The next day, the transaction is reversed and the financial institution pays back the loan to the Bank. EXAMPLE The upper limit of the operating band is 2.0%, whereas overnight money is trending up and trading at 2.10%. The Bank enters into an overnight repo and offers to lend at 2.0%, the top of the operating band. This offer encourages financial institutions to borrow from the Bank at the lower rate, rather than from other institutions at the higher market rate of 2.10%. As a result, overnight rates remain within the operating band. OVERNIGHT REVERSE REPO Overnight reverse repos are used to increase the interest rate. If overnight money is trading below the target, the Bank may believe that inflationary pressures in the economy will rise because it becomes too inexpensive to borrow money. To combat this pressure, the Bank intervenes and offers to borrow at a higher rate. For example, if the lower limit of the operating band is 1.5%, while overnight money is trading at 1.25%, financial institutions would much prefer the Bank’s rate. An overnight reverse repo generally works as follows: 1. The Bank offers to borrow money by selling Treasury bills on an overnight basis. 2. The Bank essentially sells Treasury bills to other financial institutions. 3. To complete the deal, the financial institution buys Treasury bills from the Bank. © CANADIAN SECURITIES INSTITUTE 5 10 CANADIAN SECURITIES COURSE      VOLUME 1 4. The transaction reduces the money available in the financial system because the financial institution must pay for the loan by drawing funds from its account. This action causes the overnight rate to rise. The next day, the transaction is reversed. DID YOU KNOW? Each day, billions of dollars flow through Canada’s financial system to settle transactions between the major financial institutions. These transactions include cheques, wire transfers, direct deposits, pre- authorized debits, and bill payments. Lynx is Canada’s high-value payment system that replaced the Large Value Transfer System in 2021. Lynx is an electronic wire system that facilitates the transfer of payments in Canadian dollars between financial institutions across Canada. This system allows participating financial institutions to conduct large transactions with each other through an electronic wire system. Lynx also provides an important setting for conducting monetary policy. Throughout the day, financial institutions send payments back and forth to each other as part of their normal operations. At the end of each day, all of the transactions that occurred during the day are added up. At this point, some financial institutions must borrow funds, whereas others have funds left over. For example, suppose that chartered bank ABC had $50 million in payments to other financial institutions and $40 million in receipts during the day. At the end of the day, it finds itself in a deficit position of $10 million for that day. Because participants in the Lynx high-value payment system are required to clear their balances with each other every day, chartered bank ABC will need to borrow $10 million in funds to cover that position. The bank will then need to borrow the funds from another participant at the current overnight rate. Overall, Lynx helps to ensure that trading in the overnight market stays within the Bank’s 50-basis-point operating target. Participants know that the Bank will always lend money at the upper limit of the band and borrow money at the lower limit. Therefore, it does not make sense for financial institutions in the system to borrow or lend outside of the target band. DRAWDOWNS AND REDEPOSITS Another strategy the Bank can use is to move money into or out of their chartered bank accounts. The federal government maintains accounts with the Bank and the chartered banks. Given its status as lender of last resort, the Bank can transfer funds from the government’s account at the Bank to its account at the chartered banks. Conversely, the Bank can transfer funds from the government’s account at the chartered banks to its account at the Bank. The Bank can use both strategies to influence short-term interest rates, either with a drawdown or a redeposit: A drawdown is the transfer of deposits to the Bank from the chartered banks, which effectively drains the supply of available cash balances from the banking system. Financial institutions consequently have less money available to lend to consumers and businesses, which causes interest rates to increase. Consumers and businesses are less willing to borrow at these higher rates. A redeposit is a transfer of funds from the Bank to the chartered banks. This increase in deposits and reserves increases the money available in the financial system, which in turn decreases interest rates. Consumers and businesses are then more willing to borrow, and banks have more money to lend. © CANADIAN SECURITIES INSTITUTE  CHAPTER 5      ECONOMIC POLICY 5 11 MONETARY POLICY Can you explain how and why the Bank of Canada sets monetary policy? Complete the online learning activity to assess your knowledge. THE CHALLENGES OF GOVERNMENT POLICY 4 | Summarize the challenges governments face when implementing fiscal and monetary policy. Fiscal and monetary policies may seem relatively straightforward. However, governments attempting to implement these policies can face the following challenges: Timing lags In economics, there are delays between recognizing an economic problem, deciding what policy action to take to solve the problem, implementing the policy, and ultimately seeing the benefit of the policy in action. These timing lags make monetary policy decisions more difficult and policy actions less effective. For example, according to the Bank, such actions can take more than 18 months for the full effect on inflation to work its way through the economy. Fiscal policy actions face similar delays, depending on parliament’s legislative cycle and the government’s budget position. For example, the impact of lower consumer and corporate taxes is felt much more quickly than the impact of major infrastructure spending. A project to spend billions on a major new transit project could take many years to plan and implement. Political Politicians typically work toward re-election, which creates what is known as a political considerations business cycle. While campaigning, they may advocate lowering taxes or spending on programs and infrastructure in their own riding. However, once they are elected, the national economic reality may call for lower spending. Future expectations Expectations can cause a policy initiative to fail. For example, the government may announce that it will cut personal tax rates to stimulate the economy. However, if the consensus is that the government is doing so only because it is near the end of its mandate, or if the tax cut is widely expected to be soon reversed, consumers may see it as a short-term action. Therefore, consumers may choose to save the tax cut instead of increasing spending, and the policy initiative fails. Coordination of Canada is a large country, with diverse populations and needs. For policy initiatives to federal, provincial, and work, they must be implemented nationally. However, not all of Canada may need the municipal policies same intervention. For example, British Columbia may be experiencing increased inflation while Nova Scotia suffers from a recession. If the government chooses to lower interest rates to stimulate the economy in Nova Scotia, the problem of inflation in British Columbia could worsen. High federal debt Several years of deficits can reduce the government’s flexibility with respect to spending. The higher the government debt, the higher the interest payments that must be made. A government’s plan to lower spending to fight inflation may fail if the interest payments are very high. © CANADIAN SECURITIES INSTITUTE 5 12 CANADIAN SECURITIES COURSE      VOLUME 1 Impact of international The economic performance of our major trading partners can have a significant impact economies on our economy. For example, Canada exports billions of dollars worth of goods to the United States. If the U.S. economy begins to suffer from a recession, exports to that country will decrease, causing a drop in Canada’s GDP, and perhaps even triggering a recession in Canada. Conversely, Canada also imports billions of dollars worth of goods from the United States. If the U.S. economy is suffering from inflation, the goods we import from them will increase in price, and perhaps even cause inflation in Canada. Table 5.1 summarizes the different methods used to apply fiscal and monetary policies. Table 5.1 | Fiscal and Monetary Economic Policy Economic Issue Fiscal Policy Monetary Policy Unemployment and recession Increase government spending Decrease interest rates Increase consumer spending and Decrease taxes investment with expansionary policies. High inflation Decrease government spending Increase interest rates Reduce consumer spending and Increase taxes investment with contractionary policies. Table 5.2 compares the advantages and disadvantages of fiscal and monetary policy. Table 5.2 | Advantages and Disadvantages of Monetary and Fiscal Policy Monetary Policy Fiscal Policy Advantages Advantages The effect on the economy may be more Government spending can be targeted to specific immediate. regions. The initiative (e.g., lower or higher interest rates) Tax cuts and increased benefits are popular. can be reversed once the objective is achieved. Consumers can more easily understand and It is independent of political considerations. experience the impact. Disadvantages Disadvantages It can be difficult to target a specific region. Tax increases and government spending cuts are unpopular. Lowering interest rates may not have any impact if the consumer doesn’t feel confident enough to There are challenges in stopping a project once it has spend. been implemented, even if the initiative is no longer necessary. If interest rates are already very low, lowering them even more may have no impact. Higher government spending can raise debt levels and lead to a greater proportion of revenue going toward interest payments. © CANADIAN SECURITIES INSTITUTE  CHAPTER 5      ECONOMIC POLICY 5 13 CASE SCENARIO Can you answer Saira’s questions about the Bank of Canada? Complete the online learning activity to assess your knowledge. CASE SCENARIO Bonnie has some concerns about her portfolio. As her financial advisor, can you help answer his questions? Complete the online learning activity to assess your knowledge. KEY TERMS & DEFINITIONS Can you read some definitions and identify the key terms from this chapter that match? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE 5 14 CANADIAN SECURITIES COURSE      VOLUME 1 SUMMARY In this chapter, we discussed the following key aspects of economic policy: Fiscal policy is the use of government spending and taxation to pursue full employment and sustained long- term growth. Governments pursue fiscal policy by spending more and taxing less when the economy is weak, and by spending less and taxing more when the economy is strong. In Canada, the federal budget is the key mechanism through which the government conducts fiscal policy. The Bank’s role is to monitor, regulate, and control short-term interest rates and the external value of the Canadian dollar. The major functions of the Bank include issuing and removing bank notes, acting as fiscal agent and financial advisor for the federal government, and implementing monetary policy. The goal of monetary policy is to improve the performance of the economy by regulating credit. The Bank achieves this goal through its influence over short-term interest rates and with the use of the following tools: The target for the overnight rate of interest Overnight repos and overnight reverse repos Drawdowns and redeposits The federal government faces the following issues and challenges regarding its policy decisions: An interventionist policy may be ineffective if the economy is too slow to react. Some participants oppose intervention in the belief that the economy will make its way quickly to a natural equilibrium. The national debt takes up a huge part of the resources available for government expenditure. Fiscal and monetary policies are often unsynchronized, which increases their cost to taxpayers. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 5 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 5 FAQs. © CANADIAN SECURITIES INSTITUTE