Can Fiscal Policy Save the Economy?

What is fiscal policy

It’s been a bad news month for oil prices, dipping as low as $27 per barrel last week. This, along with a sputtering economy, has some economists questioning whether the Bank of Canada will respond with another interest rate cut next month. But can the central bank really counter the economic downturn alone?

Expectation is growing for the Liberal government to step in with a plan to increase spending to further aid economic growth. A budget heavy on spending and stimulus was a key element of the newly-elected Grit’s campaign; now rumoured to be revealed around March 21, many wonder just how effective the new budget may be. In fact, representatives from the Bank of Canada have gone on record to say monetary policy can only go so far and that the government needs to step up fiscal policy in the form of more government spending.

So how can the government and the Bank of Canada work together to improve economic conditions? Here’s a breakdown.

Fiscal vs. Monetary Policy

Beyond market conditions, nations can influence their economies with two primary government tools: fiscal policy and monetary policy.

  • Fiscal policy is handled by the federal government and refers to the total government spending and taxation.
  • Monetary policy is managed by a country’s central bank and refers to interest rates and the supply of currency circulation.

So far, Canada’s federal government has relied heavily on monetary policy to stimulate the struggling economy. The Bank of Canada cut interest rates twice last year in an effort to jump start it – once in January and again in July, eventualy bringing the overnight lending rate down to 0.5 per cent. There was speculation that a further rate cut would take place last month, that never materialized. Instead the Bank of Canada decided to take a wait-and-see approach.

Time to Spend?

However, relying solely on interest rates can lead to all sorts of unintended consequences, mainly rising household debt, which is encouraged by low interest rates. The average Canadian owes $1.64 of debt for everyone dollar of disposal income. Low interest rates means many Canadians aren’t in any hurry to repay their consumer debt. While that’s all fine and dandy if interest rates remain low, many Canadians are going to be in for a rude awakening if and when interest rates rise.

Deputy bank governor Timothy Lane believes there are situations where fiscal policy is the more prudent way to boost the economy.

“It is possible that in a situation of sustained weak aggregate demand, relying primarily on monetary policy to provide stimulus may lead to financial vulnerabilities …,” said Lane. “In such circumstances, fiscal policy may be called upon to provide stimulus, particularly since it is likely to be more effective at low interest rates.”

The federal Liberals are hoping to counterbalance low oil prices by pushing the government into further debt with fiscal stimulus. On top of previously announced tax cuts, the Grits are planning billions of dollars in new infrastructure spending over the coming years.

With seven more interest rate announcements left in 2016, the Bank of Canada has plenty of time to step in if fiscal policy isn’t enough to send the Canadian economy in the right direction.

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