CHAPTER 19

DEFICITS, DEBT, AND FISCAL POLICY

Chapter Outline

Revenue, Expenditures and Deficits

Revenues and Expenditures for All Levels of Government
Federal Government Revenues and Expenditures
Measuring the Federal Deficit
The Burden of the Debt
Debt, Growth and Instability
Deficits and the Inflation Tax
The Governments Budget Constraint
The Bank of Canadas Dilemma
The Canadian Evidence
The Inflation Tax
Inflation Tax Revenue
Intergenerational Accounting
The Size of Government Debate
The Barro-Ricardo Problem
The Canada Pension Plan
CPP/QPP as Intergenerational Transfer
Social Security and Economic Efficiency
Working With Data

Changes from the Previous Edition

Chapter 19 has undergone some major changes. Chapter 19 has now been changed into a chapter
on government finance and fiscal policy. The material on the great depression has been removed form the
main body, and some of this material, along with material on the birth of Keynesian economics in new
Box 19-1. Section 19-1 now contains an overview of revenues and expenditures for all levels of
government, and also for he federal government. Section 19-2 is about measuring the deficit and the
debt, and Section 19-3 contains some of the old material on the inflation tax. Section 19-4 now contains
material on generational accounting, including the Barro-Ricardo material from Chapter 15 of the
previous edition and the material on social security.

Learning Objectives

Students should be familiar with Canadian budgetary trends for all levels of government and they
should understand the relationship between private domestic saving, investment, the budget deficit,
and the external balance.
Students should be familiar with the major components of federal revenues and outlays and should be
able to distinguish between mandatory and discretionary budget changes.
Students should be familiar with the concepts of seigniorage and inflation tax.

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 Students should be able to discuss the consequences of irresponsible fiscal policy on the Bank of
Canada's conduct of monetary policy.
Students should be familiar with the potential for instability arising from a debt-financed permanent
deficit and should know the importance of the debt-income ratio.
Students should be able to explain the real burden of the debt.
Students should understand how the Canada Pension Plan is financed and how the system affects
national saving.
Students should be familiar with current reform proposals for the Social Security system.

Accomplishing the Objectives

In spite of the amount of converge in the press, the actual fiscal position of must governments is
not well known. Students will be interested to go through the material in Section 19-1, to get an idea of
broad trends in financing over the years. During the 1970s and 1980s, Canada experienced large budget
deficits, which were not brought under control until the late 1990s.
Any government that is unwilling to show fiscal restraint will ultimately be faced with excessive
money growth and an increase in the inflation rate. Continued large government budget deficits create a
policy dilemma for a central bank, which must decide whether to monetize the debt. If the central bank
decides not to finance the debt, the increased borrowing needs of the government will drive interest rates
up, leading to the crowding out of private spending. The central bank may then be blamed for slowing
down economic growth. But if the central bank is worried about high interest rates and monetizes the debt
in order to keep interest rates low, inflation will increase and the central bank will be blamed for the
higher inflation rate.
The financing of government spending through the creation of high-powered money is an
alternative to explicit taxation. The ability of the government to raise additional tax revenue through the
creation of money (and therefore inflation) is called seigniorage. Inflation acts just like a tax since the
government is able to spend more by printing money, while people are forced to spend less since part of
their income is used to increase their nominal money holdings. This inflation tax revenue is defined as:

inflation tax revenue = (inflation rate)*(the real money base).

However, there is a limit to how much revenue the government can raise through an inflation tax.
As inflation increases, people reduce their currency holdings and banks reduce their excess reserves, since
holding money becomes more costly. Eventually the real monetary base falls so much that the
government's inflation tax revenue decreases.
While higher deficits can cause higher inflation if they are financed through money creation, it is
also true that higher inflation will contribute to deficits, since inflation reduces the real value of tax
payments. In addition, high nominal interest rates (caused by high inflation) raise the nominal interest
payments the government must make on the national debt. The inflation-adjusted deficit corrects for that
and is defined in the following way:

inflation-adjusted deficit = total deficit - (inflation rate)*(national debt).

Large government budget deficits and rapid monetary expansion are an inevitable part of
hyperinflation. The high rate of monetary expansion originates in the government's desire to raise its
inflation tax revenue. However, the government can only be successful if it prints money faster than the
public anticipates. Eventually, the process will break down, as the real money base becomes smaller.

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 To highlight the role of the national debt in the budget, it is useful to distinguish between the
primary (non-interest) deficit and the interest payments on it. While the overall deficit has been fairly
high over the last two decades, the primary deficit has been much lower. Most of the federal budget
deficits since the mid 1980s actually did not occur because current government spending exceeded tax
revenues but because of high interest payments on the debt previously incurred. This is the legacy of past
deficits.
With the gross national debt now approximately $600 billion, it becomes important to consider its
real burden. If individuals who hold government bonds consider an increase in government debt as an
increase in their personal wealth, then they will consume more and a lower share of GDP will be invested.
This will lead to a lower rate of capital accumulation and slower future economic growth. Another
concern is that about 25% of the debt is now held by foreigners. Since future tax payments to carry this
part of the debt will fall on Canadian residents but the recipients of these payments will be foreigners,
there will be a reduction in Canadian net wealth. The deficits of the 1980s will certainly increase the
burden on future generations since they have been accompanied by a falling savings rate, a decline in
investment and very large Canadian trade deficits. A growing external debt burden provides a powerful
argument for deficit reduction.
High deficits cannot be sustained indefinitely, but as long as national income is growing faster
than the national debt (implying a declining debt-income ratio), the potential for instability is very low.
But if the debt-income ratio increases, an unsustainable dynamic will lead to instability. Ultimately the
national debt will become so large that one of three things has to happen:

Taxes have to be raised to create additional revenue with which to service the debt.
Government spending has to be cut to lower debt growth below the growth in income.
A high rate of inflation has to be created to reduce the government debt in real terms.

There is some sentiment that the government may have grown too big and that taxes are too high.
On the other hand, many people argue for renewed government contributions in areas of health care and
education. The question of how much government intervention is desirable is not easily answered and will
definitely create a lively classroom discussion.
The current debate on the Canada Pension Plan and the increasing concern in many countries
about the financial difficulties that public pension systems will face in the near future warrants a closer
look at the social security system. The key to understanding the system is to understand that it is financed
largely on a pay-as-you-go basis. This means that the social security contributions of current workers are
not saved by the government but immediately paid out to finance the retirement benefits of the current
retirees. This transfer of resources from the young to the old can be accomplished if:

A growing population increases the working-age to retirement-age population ratio, which

makes financing public pension systems easier. (But if population growth slows, then
contributions have to be increased or benefits have to be cut.)
High income growth allows retirement benefits to be higher than past contributions, since the
source of the benefits is the higher income of the younger generations. (But if economic growth
slows down, the system will face financing difficulties.)
The political situation is favorable. Older people vote more than younger people (since some of
the young are not even of voting age), so the elderly can enforce this intergenerational transfer
through the political system. (But the young, who expect to receive far lower benefits relative to
their contribution than their parents did, may decide to no longer support the system through their
taxes.)

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 While the Canada Pension Plan system is often seen as a forced savings system, which makes
sure that everyone undertakes at least some savings for retirement, there is concern that the system
reduces private saving and may as a result reduce national saving. If this were the case, the decline in
saving would reduce the rate of capital accumulation and therefore future living standards.

Suggestions and Pitfalls

One of the most interesting questions that arises from the material on federal debt and deficits, is
how did the federal government eliminate its fiscal deficit? One of the suggested methods is covered in
Box 29-2. The question of downloading responsibilities without the ability to pay is a very lively
debate today. This is one of the (many) reasons why the provinces are currently demanding more money
for health care.
The dilemma that irresponsible fiscal policy can create for the Bank of Canada is also worthy of
discussion. If the government runs continued high budget deficits, the Bank has to decide whether it
should monetize the increased debt. If the debt is not monetized, interest rates will increase, leading to the
crowding out of private spending. Ultimately the Bank may be blamed for the lack of economic growth.
But if the Bank decides to finance the debt to keep interest rates low, the inflation rate will increase and it
may again be blamed.
Financing an increase in government spending through the creation of high-powered money is an
alternative to explicit taxation. The notion of inflation as a tax may initially seem strange to students, but
the section on hyperinflation should have given them a better understanding of this concept. Figure 19-3
shows that there is a limit to how much additional tax revenue the government can gain through inflation.
The inflation tax revenue is defined as the inflation rate times the real money base. During hyperinflation
the real money base will fall as it becomes too costly for people to hold currency or for banks to hold
excess reserves. The discussion of this chapter should make it clear that large budget deficits and rapid
growth are always present in times of hyperinflation.
The debate over the increasing national debt in Canada in the 1980s and most of the 1990s has
improved the publics awareness of the problems involved with deficit financing. The material presented
in this chapter should be of great interest to students and will easily capture their attention. However,
federal budget deficits have declined substantially in the 1990s and, after 1998, the Canadian government
actually ran budget surpluses. An important question is does it make sense to reduce the debt to zero?
What would be the implications of this for the Bank of Canadas open market operations? These are
interesting questions to ponder but they are theoretical in nature. Long-term economic forecasts are not
necessarily reliable and politicians with extra funds at their disposal are too eager to either cut taxes or
find ways to increase spending The current debate surrounding the budgetary process centers around the
best use of surplus funds.
Most students are probably not aware that the primary deficit (defined as total deficit minus
interest payments on the national debt) actually was a surplus for many years in the 1980s and 1990s. In
other words, tax revenues exceeded government spending were it not for the interest payments on the
national debt. These high interest payments are the legacy of the high deficits in the 1980s.
A simple numerical example can highlight the importance of these interest payments. If the
national debt is roughly $5 trillion (or $5,000 billion) and the government has to pay an average of 5% in
interest on the debt, then interest payments on the debt are $250 billion. A reduction in interest rates by
the Bank of Canada to 4% or 3%, will bring about a reduction in these annual interest payments to $200
billion or $150 billion, respectively. We can see that the Bank of Canadas policy to keep interest rates
fairly low throughout much the 1990s greatly helped in the effort to eliminate budget deficits. A sharp
increase in interest rates can quickly change predictions of continued large budget surpluses.
There is great confusion about whether a large national debt may impose a burden on the
economy. Instructors should stress the following points:

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 Increased borrowing by the government raises interest rates, potentially crowding out private
investment and net exports. The rate of capital accumulation declines and domestic jobs and part
of the manufacturing base are lost. This leads to lower future economic growth and a decrease in
the standard of living for future generations.
Foreigners hold part of the debt. This is a net debt to Canadian residents, since taxes will have to
be increased if these foreigners demand back their principal plus interest. This creates a burden on
future taxpayers. On the other hand, only a redistribution of income away from taxpayers and
towards government bond holders will result when the part that is owed to Canadian citizens is
repaid via taxation.
The Bank of Canada may be forced to finance the debt by increasing money supply. This will
create inflationary pressure. In the worst case scenario, the budget can get totally out of balance,
causing hyperinflation.
If taxes have to be raised to pay back part of the debt, disincentives to work, save, and invest may
be created, reducing the level of output.

To show the effects that large budget deficits can have on the economy, instructors may want to
recall an equation derived in Chapter 2, that is,

S - I = - (TA - G - TR) - (- NX) ==> S - I = BD - TD.

This equation states that the difference between private saving (S) and investment (I) is equal to
the difference between the budget deficit (BD) and the trade deficit (TD). Increases in the budget deficit
that cannot be financed by increases in private domestic saving will negatively affect the level of
investment and/or net exports and therefore negatively affect future living standards.
At this point, instructors may also want to briefly review the three ways in which budget deficits
can be financed: debt financing, money financing, and the sale of assets by the government (such as
public land or public sector enterprises). A government engages in debt financing if it finances a deficit by
selling government securities to the public. It engages in money financing if it borrows funds from the
central bank. Since the increase in the government's demand for credit may exert upward pressure on
short-term interest rates, the Bank of Canada may decide to conduct open market purchases to avoid
increases in interest rates. If the Bank buys government securities from the public, high-powered money
is increased and the Bank, in effect, finances part of the deficit (the Bank monetizes the debt). Thus, in
Canada, the Bank of Canada (and not the government) decides how much of the deficit is money
financed. Unless the Bank follows a policy of targeting interest rates, there is no direct link between
Department of Finance borrowing and an increase in high-powered money. It should also be mentioned
that money financing is inflationary.
It should also be clear that budget deficits are not necessarily bad and are often needed to
stimulate the economy out of a recession. Similarly, deficit reduction often can cause the economy to
slow down as aggregate spending is reduced. So why did the economy grow so rapidly in the 1990s, a
time when budget deficits were reduced sharply? One explanation is that decreased public spending frees
up funds, leading to increased private spending via lower interest rates.
Instructors should also point out that it is not the size of the deficit or national debt that matters,
but their proportion to GDP. The importance of the debt-income ratio (the national debt divided by GDP)
should be stressed. If national income grows faster than the national debt, the debt-income ratio will
decline and budget deficits may not be much of a problem. But if the debt-income ratio rises, the debt
problem will eventually become an inflation problem unless some fiscal policy action is taken. The debt-
income ratio has increased steadily from 1981 to 1996, before it began declining, and was roughly 64% in

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2000. As the economy is growing strongly and further budget surpluses are predicted, there should be a
downward trend in the debt-income ratio for some time to come.
One entitlement program that deserves particular attention is the Canada Pension Plan. Many
students, when asked, will admit that they do not expect to rely on the Canada public pension system for
their own retirement. They believe that the system will either be abolished or changed significantly by the
time they reach retirement age. In either case, they believe that they will not be able to afford an adequate
living standard after retirement unless they use funds from their private savings.
While it is impossible to correctly predict the future, current demographic trends seem to point
toward a financial crisis in the Canada Pension Plan unless the system is overhauled. The latest projection
is that the system will be bankrupt before the year 2030. In the current reform debate, provisions have
been suggested to address not only the insolvency problem but also the inefficiency aspects of the system.
There is empirical evidence that the system, because of its pay-as-you-go financing, has significantly
reduced national saving and the rate of capital accumulation. Some instructors may want to explain this
savings replacement effect in more detail, but it is more important to remember that several other effects,
including the goal feasibility effect, the induced retirement effect, and the bequest effect mitigate the
negative impact on saving.
Students are probably less interested in discussing these theoretical aspects and would rather
concentrate on the current debate on reform. The need to maintain Social Security as it exists can be
defended with the argument that the government should provide some sort of safety net for the elderly.
Some people may not have the foresight to save enough for retirement or may not be able to do so
because of financial constraints during their working years. They also may misjudge their life expectancy.
Therefore there always will be some elderly in need of government support. The Social Security system,
in a way, forces people to save for retirement. However, many people believe that Social Security should
be reformed and the following changes to the system have been suggested:

Increase the retirement age and abolish the earnings test.

Impose eligibility requirements that take into account earnings from assets.
Increase incentives for private saving to supplement retirement saving.
Build up the Social Security trust fund by increasing payroll taxes without an equivalent increase in
benefits.
Privatize the Social Security system (either totally or partially) and allow funds to be invested in the
stock market.

The rationale for privatizing Social Security is that the stock market has outperformed the bond
market over long time periods. This proposition, however, has great risks, since the stock market can
undergo large market swings. A large and long downturn could severely endanger the financial future of
retirees. Privatizing Social Security is a proposal that is often favored by free market economists.
However, it concerns others who do not believe that people are able or willing to save enough on their
own to guarantee that they can finance an adequate consumption stream over their retirement years. All
these issues will definitely pique students interest and will allow for very lively classroom discussions.

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 Solutions to the Problems in the Textbook

Discussion Questions:

1.a. Interest payments on the national debt can be divided into real payments and payments due to
inflation. In other words, we have to distinguish between real and nominal interest rates. During
periods of inflation most interest payments are offset by the decrease in the real value of the debt.
What we should be concerned about, however, is the interest payments in real terms.

1.b. The national debt is a burden on society primarily because of the negative effect it has on the rate of
capital accumulation. The increased borrowing needs of the government drive up real interest rates,
which then crowds out private spending, especially investment. As a result, future economic growth
may be impaired. High interest rates may also crowd out net exports, which may lead to a loss of
competitiveness and a decline in the manufacturing sector. This will also have a negative effect on
future living standards. In addition, the part of the debt that is held by foreigners will have to be
repaid (with interest), creating a tax burden on future generations. The part of the debt that is financed
domestically does not create the same burden, since future tax increases will be used to pay U.S.
citizens. It will, however, have redistributive effects, away from (mostly lower- and middle-income)
taxpayers to (mostly high-income) bondholders.

2. If an amendment to require an annually balanced budget were implemented, the government would no
longer be able to use discretionary fiscal policy as a stabilization tool. In addition, if the amendment
called for annually balancing the actual budget, it could do more harm than good.
Assume that the economy is at full employment and the budget is balanced. If the economy enters
a recession, the cyclical component of the budget surplus will become negative and an actual budget
deficit will develop. To balance the budget, the government can either increase taxes or decrease
spending to create a surplus in the structural component. This fiscal restriction will cause a deeper
recession, increasing the cyclical deficit even more. It is doubtful that the government would actually
succeed in balancing the budget. For this reason most economists do not favor a balanced budget
amendment.

3. It is more important to look at the debt-income ratio than at the absolute value of the national debt,
since the debt-income ratio tells us how much of our current income we would have to give up to pay
back the debt. Obviously a $5.6 trillion national debt is much harder to deal with in an economy with
a GDP of $5 trillion than in an economy with a GDP of $10 trillion. Similarly, if the economy grows
at a higher rate than the debt, we have less reason to worry about whether it is possible to service the
debt. However, if the national debt grows faster than GDP over a long time period, we may have to
worry about our ability to service the debt.

4.a. The pay-as-you-go financing of the Social Security system results in a transfer of income from the
young to the old. This is possible for three reasons. A growing population will make financing public
pension systems easier. A high growth in income due to higher productivity will allow retirement
benefits to be higher than past contributions. Finally, since older people are more likely to vote than
younger people they can enforce this intergenerational transfer through the political system.

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4.b. The pay-as-you-go financing of Social Security causes a savings replacement effect, that is, the
government does not save Social Security contributions but uses them immediately to pay for the
benefits of those currently retired. This decrease in national saving reduces the rate of capital
accumulation and negatively affects future living standards.

4.c. Current proposals for Social Security reform include the following suggestions: first, allow people to
invest at least part of their funds in private retirement accounts to ensure that they are productively
invested; second, increase payroll taxes, tax retirement benefits, and increase the retirement age to
make financing the system easier.

5. The further the economy is from the full-employment level of output, the more the Bank of Canada
should be willing to monetize the deficit. For one, at a time when unemployment is high, inflationary
pressure is probably low, so increasing money supply will not cause rapid price increases. Secondly, a
small increase in inflation may be tolerable since a high level of unemployment is costly in terms of
lost output. Therefore it might be desirable to return to full employment fast by increasing money
supply. However, when the economy is close to full employment, bottlenecks develop more easily. In
this situation, monetizing the deficit will ultimately fail to keep interest rates down or stimulating the
economy further. Instead a higher rate of monetary growth will cause inflation to increase sharply.

6. The ability of the government to raise additional tax revenue through the creation of money (and
therefore inflation) is called seigniorage. Inflation tax revenue is defined as the product of the
inflation rate times the real money base. Inflation acts just like a tax since the government is able to
spend more by printing money while people are forced to spend less since part of their income is used
to increase their nominal money holdings.

12. The answer to this question is student specific. There was no easy way to finance the massive increase
in government expenditures that was required to build up the infrastructure in the new Eastern states
and to ensure transfer payments to the large numbers of unemployed and retired people. The German
government struggled with this question and the transition period has not been easy.
The huge amount of funds required to finance these expenditures should not be raised solely by
increasing taxes. Tax increases are not only highly unpopular but may also provide disincentives to
work, save and invest and may thus have a significant negative impact on the performance of the
economy. Chancellor Kohl initially promised that Germanys re-unification would not be financed
through a tax increase, but when the costs of the re-unification became more apparent, he had to break
that promise.
An increase in expenditures that is debt financed leads to higher interest rates, crowding out some
private spending (investment and net export). In addition, it leads to a capital inflow that strengthens
the value of the domestic currency. In Germany, this process created a problem since exchange rates
among countries of the EC were fixed within a relatively small range. The European currency crisis
of 1992 was caused by the increase in the German budget deficit that was largely debt financed. The
subsequent inflow of funds from other EC-countries required massive government intervention to
keep exchange rates within their assigned range and caused problems for other European countries.
Eventually these countries had to devalue their currencies. In addition, Germany experienced a
current account deficit because of the high value of the D-Mark relative to the currencies of non-EC
countries. Thus, the situation in Germany in the early 1990s strongly resembled the situation in the
U.S. in the early 1980s, with its high interest rates due to large government borrowing (and fairly
tight monetary policy) and subsequent trade imbalance.
Financing large increases in government expenditures through money creation would serve to
keep interest rates low, which would not only reduce interest payments on the national debt but also

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 help to keep the value of the D-Mark from rising. However, money creation would also lead to
increased inflation. The Bundesbank, known for its independence and its aversion to inflation, chose
to let money supply grow only to a small degree. As a result, German interest rates rose substantially,
leading to an inflow of funds and a weaker performance of the economy.

Application Questions

3. The debt-income ratio is defined as (national debt)/GDP. Therefore if the national debt grows by 5% a
year, but GDP grows by only 4%, the debt-income ratio will increase.

4. With real output remaining constant, the additional tax revenue gained from inflation is:

inflation tax revenue = (inflation rate)*(real money base).

If the real money base is 10% of GDP and the inflation rate increases from 0% to 10%, we should
expect an increase in government tax revenues of 1%, as long as the real money base remains
constant. However, as inflation increases, people reduce their money holdings and banks reduce their
excess reserves since it becomes more costly to hold money. In countries that have sophisticated
banking systems, money holdings (and therefore the inflation tax revenue) fall to a much larger extent
than in countries where there are fewer alternatives to cash holdings.

Additional Problems:

1. In the early 1930s, interest rates were extremely low and the supply of money fell sharply. Does
this mean that the Federal Reserve used expansionary or restrictive monetary policy? Explain
your answer.

The low interest rates in the 1930s resulted from a sharp decline in the demand for credit due to the sharp
decline in aggregate demand, rather than from expansionary monetary policy. The decrease in money
supply was the result of a sharp decline in the size of the money multiplier (as a result of the many bank
failures) and not the result of restrictive policy by the Fed. The money multiplier fell sharply, since
consumers lost confidence in the banking system and started to hold much more currency, sharply
increasing the currency-deposit ratio. Surviving banks became much more careful and increased their
excess reserve holdings, decreasing the money multiplier even more.

2. "The Great Depression was a direct result of the U.S. Federal Reserves inept monetary policy."
Comment on this statement and indicate whether you think that the Fed has learned from past
mistakes.

The Keynesian explanation of what caused the Great Depression concentrates on the collapse of
investment, the reduction in consumption, and the decrease in aggregate demand that was further
exacerbated by poor fiscal policy. Monetarists concentrate on the behaviour of money, asserting that the
Fed failed to prevent the collapse of the banking system, which led to a sharp decline in the money
multiplier. They see the resulting decline in money supply as the primary cause of the Great Depression.
Both explanations seem to fit the facts and there is no inherent conflict between them. While the Great

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Depression was not caused by government actions, its severity could have been greatly reduced if active
expansionary policies had been employed by the government much sooner.
It can be assumed that the Fed has learned from its mistake. For example, after the stock market crash
of October, 1987 (when stock values dropped by more than 24%) the Fed, conscious of what had
happened in 1929, immediately assured financial markets that it would provide the liquidity needed to
prevent a financial collapse. The Fed also undertook open market purchases in an effort to drive interest
rates down.
The recession in 1981/82 serves as another good example. Although the downturn seems to have been
caused by the Fed's overly restrictive monetary policy, the Fed reversed its course and implemented
expansionary policies as soon as the size of the downturn became clear.

3. Do you think that a downturn in the economy as large as the one we experienced during the
Great Depression could happen again?

The answer to this question is student specific, even though most economists would agree that it could
not. The introduction of deposit insurance and other regulatory agencies, and programs such as the Social
Security system and employment insurance have brought institutional changes that have increased
automatic stability and limited the impact of even large disturbances. It also can be assumed that policy
makers have learned from past mistakes. In other words, recent history has shown that the government
does not sit still if the economy experiences a large disturbance. The recession of 1981/82 serves a good
example. With an unemployment rate over 11%, it was the most severe recession since the Great
Depression. It lasted a relatively short time, however, since expansionary policies were implemented
almost immediately after the magnitude of the downturn became clear.

4. What are the factors that would make an anti-inflation policy less costly in terms of increased
unemployment and subsequent loss of output?

A more gradual approach to reducing inflation is generally less costly than other options because it causes
less unemployment. Such an approach can only be successful, however, if it has a high degree of
credibility. It must be announced in advance by policy makers whose past records indicate that they are
willing to adhere to an announced policy. The greater the relative importance of the expected future rate
of inflation in determining the current rate of inflation is, and the more wage and price flexibility there is,
the more successful the anti-inflation policy would be.

5. Higher monetary growth will be followed by higher wage demands. Comment.

The equation %P = %M - %Y + %V implies that in the long run the rate of inflation (%P) is
determined by the growth rate of money supply (%M) adjusted for the growth rate of income (%Y)
and changes in velocity (%V). In addition, from the equation w = W/P, that is, real wages equal nominal
wages divided by the price level, we can calculate that (%w) = (%W) - (%P). This can be
reformulated into the equation (%P) = (%W) - (%MPN), assuming that w = MPN in a competitive
labour market. Thus we can see that inflation increases if nominal wages increase more than labour
productivity. But workers base their wage demands on their inflationary expectations and these are largely
based on the growth rate of money supply. Therefore an increase in money supply tends to be followed by
higher nominal wages.

6. "An increase in the growth rate of money supply by 2% will lead to an increase in interest rates
of 2%." Comment on this statement.

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From the equation MV = PY, it follows that %P = %M - %Y + %V, or = m - y + v. Thus we can
conclude that, in the long run, the rate of inflation (%P = ) will go up by 2% if the rate of money
growth (%M = m) is increased by 2%. This assumes that economic growth (%Y = y) and the growth of
velocity (%V = v) do not change. According to the Fisher equation, i n = r + , the nominal interest rate
(in) is equal to the real interest rate (r) plus the rate of inflation ( ). If the rate of inflation goes up by 2%
nominal interest rates will do so as well, in the long run. However, in the short run, the increase in
inflation and interest rates will be less than 2%, since the short-run AS-curve is upward sloping and
remains fixed.

7. "Hyperinflation requires a cold-turkey approach." Comment on this statement.

An economy experiencing hyperinflation needs to implement drastic measures to reduce inflationary

expectations enough to stabilize at a lower rate of inflation. In the 1980s the governments of Israel and
Bolivia used the cold-turkey approach and succeeded in ending periods of hyperinflation. Israel used
wage and price controls to avoid a large increase in the unemployment rate, but supplemented them with
sharp budget cuts and credit rationing. Bolivia sharply reduced its budget deficit, curtailed monetary
growth, stabilized exchange rates, and stopped external debt service. As a result, the rate of inflation in
these countries declined rapidly and sharply.

8. "A cold-turkey approach is a better policy for fighting inflation than a gradualist approach,
since it requires a shorter time to establish a long-run equilibrium at a desired lower inflation
rate." Comment on this statement.

The gradualist approach lowers money growth over a long period of time to minimize the severity of the
resulting recession. The cold-turkey approach achieves the reduction in inflation at the cost of a
significant increase in short-run unemployment. Normative considerations determine the relative merits
of the two approaches. The cold-turkey approach may benefit from a credibility bonus, since workers and
firms do not have to guess whether the government is really committed to lowering the rate of inflation.
The public may therefore reduce their inflationary expectations faster and the economy may adjust back
to full-employment much faster. However, if long-term contracts exist, wages and prices cannot adjust
quickly and a rapid return to a low-inflation equilibrium at full-employment is fairly unlikely.

9. "The most important factor in the Bank of Canada's fight against inflation is credibility."
Comment on this statement and explain the concept of time inconsistency.

If a policy measure designed to reduce inflation has credibility, then labour unions are more likely to
adjust their inflationary expectations and their wage demands downwards in contract negotiations. The
likely outcome will be low inflation and low unemployment. Restrictive monetary policy will shift the
AD-curve to the left, lowering inflation but increasing unemployment. If inflationary expectations, wages,
and prices adjust quickly, then the short-run AS-curve will shift quickly to the right, and the economy will
return rapidly to the full-employment level of output at a lower inflation rate. The Bank of Canada's
credibility is an important factor in this process, but so are long-term contracts. If long-term wage
contracts exist, then wages cannot adjust quickly to their market-clearing level, and it will take a longer
time to return to the full-employment level of output.
While the credibility of policy makers is very important in the fight against inflation, it is not easily
earned. If the government has not consistently adhered to its announced policies in the past, it will

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encounter the problem of time inconsistency. For example, if labour unions settle for lower wage
increases, the Bank of Canada may be tempted to create additional jobs by increasing monetary growth,
knowing that wages are locked in for the time being. The outcome is lower unemployment but a higher
than expected rate of inflation, and workers' real wages will be lower than expected. If policy makers
have shown a tendency to abandon their announced anti-inflation policy after wages have been settled,
any future policy announcement will suffer from time inconsistency. In that case, labour unions will
always expect faster monetary growth and demand higher wages in upcoming wage negotiations
regardless of what the Bank of Canada announces. As a result, inflation will not be reduced.

10. "There is a limit to how much additional tax revenue the government can create through
inflation." Comment on this statement.

The financing of government spending through the creation of high-powered money is an alternative to
explicit taxation. The inflation tax revenue is defined as follows:

inflation tax revenue = (inflation rate)*(real money base).

To maintain the purchasing power of their real balances when prices are rising, people must hold
increasing amounts of nominal money balances. Inflation acts just like a tax since the government is able
to spend more by printing money while people are forced to spend less and pay more to the government
in exchange for extra money. But with increased inflation, holding money becomes more costly, and there
is a limit to how much revenue the government can raise through this inflation tax. People reduce their
real currency holdings and banks hold as little in excess reserves as possible. Eventually the real money
base falls so much that the government's inflation tax revenue begins to decrease again.

11. The rational expectations approach and the monetarist approach both assert that
expansionary monetary policy simply increases inflation without any significant effect on
output or the unemployment rate. Comment on this statement.

The rational expectations approach asserts that all individuals and firms have access to all the necessary
information and consistently make optimal decisions based on rationally formed expectations. Wages and
prices are assumed to be flexible, so markets always clear rapidly. When a policy change is anticipated,
people will always try to adjust to the long-run outcome of that policy. This implies that any announced
expansionary monetary policy will immediately be reflected in a higher inflation rate without any
significant change in the rate of unemployment. Only unanticipated monetary policy changes will affect
output and unemployment in the short run.
Monetarists believe that monetary policy will have a short-run effect on output and the rate of
unemployment, even if it is anticipated. Monetary restriction will shift the AD-curve to the left and it will
take some unemployment to create downwards pressure on wages before the economy can adjust back to
the full-employment level of output (by shifting the short-run AS-curve to the right).

12. Monetarists and the rational expectations school share the belief that government intervention
usually makes things worse and that the Bank of Canada should adopt a monetary growth rule.
But they disagree on how the economy reacts to monetary policy changes. In what way?

Both monetarists and the rational expectations school believe that credibility is very important in the fight
against inflation and that credibility can best be established through policy rules. Thus they prefer a
monetary growth rule to discretionary policies. However, they disagree on how the economy adjusts to a
change in money supply growth. Monetarists believe that the economy reacts slowly to any policy

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change, with long and variable lags. Since markets do not clear rapidly, an increase in unemployment will
follow a significant reduction in money supply growth. The rational expectations school, however,
believes that markets do clear rapidly, and that inflation can therefore be reduced fairly rapidly and
without great costs in terms of higher unemployment.

13. "Inflation taxes money holders." Comment on this statement.

The financing of government spending through the creation of money (called seigniorage) is an
alternative to taxation. The government can obtain additional resources by printing more money. This,
however, will cause inflation to rise. To maintain the purchasing power of their real balances when prices
are rising, people must hold increasing amounts of nominal money balances. The public is forced to spend
less of its income and pay the difference to the government in exchange for extra money. In this situation
the government is said to be financing itself through the inflation tax, that is, it can spend more while the
public spends less, just as if the government had raised taxes.

14. Higher budget deficits cause more money growth and therefore an increase in the inflation
rate. Comment on this statement. In your answer briefly discuss the dilemma that the Bank of
Canada faces when the government runs continuous large budget deficits.

First we have to ask whether the increase in the budget deficit is cyclical or structural. An increase in the
cyclical deficit occurs if the economy goes into a recession. In this case we should not expect any increase
in inflation. An increase in the structural deficit occurs due to expansionary fiscal policy. In this case,
there may be some temporary inflationary pressure. However, fiscal policy is not inflationary in the long
run, since there is no change in money supply. Since interest rates increase, private spending (investment
and/or net exports) is crowded out. The Bank of Canada may decide to intervene and money finance the
deficit, that is, decrease interest rates through open market purchases. In this case, we have an increase in
money supply and inflation. Some people claim that debt financing may actually be more inflationary
than money financing in the long run, since higher interest rates lead to higher interest payments on the
national debt. This adds to the budget deficit, and eventually a higher national debt needs to be money
financed and then we can expect more inflation.
When the government consistently runs large budget deficits, the Bank of Canada faces a problem. It
can opt to accommodate the expansionary fiscal policy by lowering interest rates by monetizing the debt,
and as a result be blamed for the resulting inflation. It can also opt not to accommodate the expansionary
fiscal policy, but then be blamed for the resulting high interest rates, which are likely to crowd out
investment and net exports.

15. An increase in government spending financed by borrowing from the public will increase the
supply of money. Comment on this statement.

When the government borrows from the public, the public gives the government money in exchange for
bonds. If the government spends this money right away on programs, money supply is not affected at all.
This is simply a fiscal policy measure and does not involve the Bank of Canada. However, if the Bank of
Canada follows a policy of pegging nominal interest rates to a certain fixed rate, then open market
purchases will be undertaken any time the government increases its borrowing from the public. The
government's increased borrowing needs will put upward pressure on interest rates, but the Bank of
Canada's open market purchases will increase bank reserves and keep interest rates from rising. In
Canada, the Department of Finance does not directly borrow from the Bank of Canada and thus fiscal and
monetary policy are largely independent. But there are some countries where the government borrows

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heavily directly from the central bank through the printing of new money. Under these circumstances,
monetary and fiscal policy are much more closely linked.

16. Discuss the relative merits of tax financing versus debt financing of government programs as far
as efficiency and equity is concerned.

If government spending is financed by a tax increase, the increased income tax rate may provide a
disincentive to work. If any other form of taxation is used, some other misallocation of resources will occur.
If spending increases are financed through borrowing, the increased demand for funds will lead to upward
pressure on interest rates, which will affect interest sensitive sectors in the economy. Expansionary fiscal
policy will lead to the crowding out of some private spending. The most interest sensitive sectors in the
economy, such as agriculture, the construction industry, or banking are affected to a larger degree than the
less interest sensitive sectors. Thus deficit financing also leads to a misallocation of resources. Since
investment is negatively affected by the increase in the cost of capital, the rate of capital accumulation will
decrease and future economic growth will be slower.
There is also the question of equity, since tax financing affects current taxpayers, whereas debt
financing affects future taxpayers. In addition, it is important to consider who will benefit from the programs
that are financed.

17. Assume the government increases spending financed by issuing bonds. Does this create a
burden on future generations? Why or why not? Would it make a difference whether the
spending increase was used to finance the building of a new highway or to send troops abroad
to prevent social unrest in another country?

If an increase in government spending is financed through the sale of government bonds, the national debt
increases. The increased borrowing needs of the government may drive interest rates up and this may
crowd out private spending (investment and/or net exports). If the rate of capital accumulation is
negatively affected, it will lower future living standards and create a burden on future generations. If the
funds are used to send troops abroad, future generations would most likely suffer more than if the same
funds are used to build a highway. Building a highway creates a long-lasting government asset for future
generations. This can be considered government investment. However, if the funds are used to send
troops abroad, then no real capital will be created and this can be considered government consumption.

18 The debt-income ratio has been steadily declining since World War II, when it was at an all-
time high of over 100%. Comment on this statement.

The debt-income ratio is the size of the national debt divided by the size of nominal GDP. It is true that
the debt-income ratio was at an all-time high of over 100% at the end of World War II and significantly
decreased afterwards, since the economy was growing faster than the debt. However, as Figure 19-5
shows, the debt-income ratio increased again in the 1980s as the size of the national debt increased at a
faster pace than GDP. In the 1990s this trend reversed as the economy grew stronger and budget surpluses
developed. The (gross) debt-income ratio was about 64% in 2000.

19. "The federal budget needs to be balanced every year so the national debt does not grow any
larger." Comment on this statement.

Balancing the federal budget annually does not make much sense, since the government would have to
give up its ability to use fiscal stabilization policy effectively. If the economy were to go into a recession,
a budget deficit would develop. To balance the budget, a cut in government spending or a tax increase

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would have to be implemented. But such measures would lead to a deepening of the recession, making
balancing the budget even more difficult.

20. "Budget deficits cause money growth and thus inflation." Comment on this statement.

There is no automatic link between budget deficits and the monetary base, since the Bank of Canada
determines independently how much high-powered money to create. In other words, the Bank of Canada
is not required to accommodate expansionary fiscal policy. However, if the Bank of Canada is committed
to maintaining constant nominal interest rates on government bonds, an increase in the deficit will result
in open market purchases and an increase in the monetary base. If the Bank of Canada instead emphasizes
monetary growth targets, there is no automatic link between increases in the deficit and increases in the
monetary base. However, should high deficits persist, the debt burden and interest payments may become
unsustainable and the government may no longer be able to finance the debt by borrowing from the
public. In such a case, the Bank of Canada is forced to create money, which will increase the inflation
rate.

21. "The Bank of Canada can lower the federal budget deficit through open market purchases."
Comment on this statement. In your answer discuss whether money or debt financing is more
inflationary.

Open market purchases increase bank reserves and therefore money supply. This lowers interest rates,
leading to a higher level of investment and income. Since income tax revenues increase in a boom, the
budget deficit will decrease. Since interest rates are lower, the interest payments on the national debt are
lower. But if the debt is money financed, inflation will increase due to higher money growth and this may
lead the economy into a wage-price spiral. If the deficit is debt financed, money growth and inflation will
not change. But some people argue that increased interest rates increase the interest payments on the
national debt, which increase annual deficits. Eventually, the national debt has to be money financed
anyway, but since the debt will now be much larger, debt financing may actually be more inflationary
than money financing in the long run.

22. What are the implications for national saving, interest rates, and future living standards of
moving from federal budget deficits to budget surpluses?

Moving from a federal budget deficit to a budget surplus means an increase in national saving. This will
lead to lower interest rates, which will stimulate investment. A higher level of investment will lead to more
future economic growth and a higher future living standard. Lower interest rates will also cause an outflow
of some funds and this will decrease the value of the dollar, making Canadian goods more competitive
abroad. The budget surpluses can be used to pay off some of the national debt, leading to lower interest
payments. Highly interest sensitive sectors will be affected more by the decrease in interest rates than other
sectors. The assumption made here is that budget surpluses will not decrease the current level of economic
activity. If restrictive fiscal policy caused the budget surpluses and the fiscal restriction had a negative effect
on the economy, then saving and investment would decrease and future living standards might not increase.

23. Briefly state the advantages and disadvantages of the Social Security system as it is currently
structured. Would you revise the system if you could? If so, how?

The answer to this question is student specific. The advantages of the system include that it provides a
guaranteed retirement income for everyone and helps reduce poverty among the elderly. However, there is

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evidence that the system has reduced national saving and therefore the rate of capital accumulation, since
it is financed on a pay-as-you-go basis. The system also may induce people to retire earlier than they
would otherwise. Since there is an increasing segment of elderly in the population the tax burden on the
young to finance retirement benefits for the old is increasing. Suggestions for revisions might include:
Increasing the retirement age, taxing Social Security benefits above a certain income level, providing
more incentives for private retirement saving, allowing part of the Social Security trust fund to be
invested in corporate bonds and stocks, and allowing people to take care of their own private retirement
savings accounts.

24. Social Security benefits for the elderly should not be based on past earnings. Instead
everyone who retires should get the same benefits. Comment on this statement.

The system described above would be considered unfair by those who feel that people should get from the
system what they paid in. For many the rate of return on the taxes paid would change drastically, and this
could change their savings behaviour. However, since the system would be better understood by people,
financial planning for retirement would become easier. In addition, the system would change from a
social insurance program to an income redistribution program.

25. Do you believe that the Social Security system lowers the Canadian savings rate? Why or why
not? In your answer, give your opinion whether the government should change the Social Security
system. How would you address some of the concerns you may have about the system?

Social Security is financed on a pay-as-you-go basis, that is, payroll tax revenues collected from current
workers are immediately used to pay for benefits for retirees. This means that private saving isnt replaced
by government saving. This savings replacement effect reduces national saving. However, the system may
induce people to retire earlier, and the life-cycle hypothesis suggests that people will save more during
fewer working years to provide adequate funds for a longer retirement period (the induced retirement
effect). The recognition effect argues that the pure existence of the system makes people realize that they
need funds for retirement. The goal feasibility effect states that people realize that they can achieve a certain
goal (funds for retirement or bequest) more easily if they supplement their Social Security benefits with
additional savings. The desire to bequest funds to children and the uncertainties about the future of the
system may induce people to save more (the bequest effect). Thus the system may actually encourage
saving. Some economists argue that the system simply replaced the private inter-generational income
transfers that took place previously, so there should not be any overall effect on savings at all. The issue has
to be settled by empirical studies. Most studies show a negative the effect of Social Security on national
saving, yet no conclusive result about the magnitude of the effect has been established.
The need to maintain Social Security as it exists can be defended with the argument that the government
should provide a safety net for the elderly. Some people may not have the foresight to save enough for
retirement or they may not be able to do so because of financial constraints during their working years. They
also may misjudge their life expectancy. Therefore there always will be some elderly in need of government
support. The Social Security system forces people to save for retirement.
Many people believe that Social Security causes a reduced rate of capital accumulation, since the
system is financed on a pay-as-you-go basis. Thus the following changes to the system are often suggested:

Increase the retirement age and abolish the earnings test.

Impose eligibility requirements that take into account earnings from assets.
Increase incentives for private savings to supplement retirement savings.

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 Build up the Social Security Trust Fund by increasing payroll taxes without an equivalent increase
in benefits.
Privatize the Social Security system (either totally or partially) and allow funds to be invested in the
stock market.

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