Should the Canadian Government Use Monetary and Fiscal Policy to Stabilize the Economy - Term Paper Example

The low inflation is desirable for it removes uncertainty in the economy and in the decision making. Low inflation rate is achieved through changes in prime interest rate by central bank of Canada time to time. Bank of Canada has set inflation target of 2 percent to be achieved in 18-24 months period. The current inflation rate is hovering around 3.4 percent. Monetary policy helps achieve this through different measures. By hiking the interest rate, the Bank of Canada would try to bring the inflation rate on its target of around 2 percent.

The difficulty arises towards adjusting the size and timings of interest rate and that is where the question of using appropriate monetary policy comes into play. There are always some volatile components in the consumer price index that creates destabilizing effect time to time. For example, in the recent period the biggest volatile component has been crude oil, gasoline or diesel that keeps on fluctuating wildly throughout the year. In fact, that threatens to make the consumer index away from the target.

The prices of these commodities cannot be administered by the government in the free market economy. That is where the monetary policy intervention by adjusting the interest rate comes into picture to increase or decrease the consumption to keep the inflation on target. The general price level of all services and goods in the given economy has influence on the money demand and interest rates. Higher price level increases money demand and higher money demand causes higher interest rate. Higher interest rate decreases the demand of quantity of goods and services.

Inflation rate relative to the target is the indicator to judge where the demand is in relation to the supply. What Monetary Policy Cannot Influence in Long Run? The monetary policy can influence the other market variables such as investment, real output or unemployment only for short periods of time. It cannot exert influence on these parameters on sustained basis for a long period of time as it can do on the rate of inflation. As argued by Friedman (1968), this happens because any changes in real wages or unemployment are eventually offset by adjustments of market forces in response to demand-supply dynamics of the market.

Automatic Fiscal Stabilizers The automatic stabilizers are equally important. In Canada, employment insurance payouts and various kinds of tax revenues fall in this category. These fiscal stabilizers such as personal income tax deducted by the employer work immediately without any time lag to bring the desired effect but insurance payouts work with some time lag. They are quite effective and helpful in dampening outputs but only partly. Against this, the monetary policy is useful to create a complete offset any change in output but that cannot be achieved immediately; it takes about 12-18 months for an effect to take place.

Monetary policy and fiscal policy do not work in isolation. For example, when the government changes fiscal policy, they need to also think that how changes in fiscal policy will bring change in inflation rates. Similarly, the Bank of Canada while changing interest rates also needs to consider the changes in fiscal policy to judge the inflation and demand parameters. Conclusion Thus, the appropriate mix of the monetary and fiscal policies with clear objectives can bring about the desired economic stabilization