According to Keynesian methodology, there are two powerful tools the government and The Bank of Canada can employ to direct the economy in a positive direction: fiscal and monetary policy. Both policies, when used correctly, can be employed to stimulate the economy during times of recession or slow down the economy during times of inflation. The effectiveness of government intervention in the economy in the long and short run through fiscal and monetary policy has been the subject of controversy among many economists.
Fiscal policy is concerned with adjusting government spending levels and tax rates in order to influence the Canadian economy in such a way that it stimulates or slows down economic growth. Monetary policy is governed by the Central Bank of Canada, where the main focus is managing the money supply and interest rates. The following report concludes by proposing a government policy that should be used by Canada in the coming year.
Employing a fiscal policy by adjusting government spending and decreasing or increasing the tax rate, the government has the power to influence a nation’s productivity level. During times of recession, the government can cut tax rates in order to encourage spending amongst businesses and households. With an increase in an individual’s disposable income, they now have the option to either save their money or spend it. Spending money increases demand for goods and services, thus increasing a businesses production level.
With an increase in productivity, a firm needs to hire more employees, thus decreasing the unemployment level in the economy. If an individual decides to save their money, this will increase the supply of loanable funds, causing an increase in investment. The drawback is that a reduction in taxes will reduce the government’s revenue. If the government does not have enough revenue to support their spending initiatives, they will have to borrow from the Bank of Canada, thus reducing the supply of loanable funds available.
This will create a crowding out effect, as government borrowing increases the interest rates, and discourages businesses and households from borrowing money for investment. If the government wants to slow down an economy’s growth, it can raise taxes. Raising taxes provides the government with more revenue, but individuals will have less disposable income to spend on goods and services. Due to the lack of demand for goods, firms will need to cut costs by laying-off employees.
These employees will now have less money to put into savings, causing the supply of loanable funds to fall and there to be a decrease in investment. Fiscal policy has greater long-term effects, which is more beneficial for the growth of the Canadian economy. According to the majority ruling Federal Liberal party, one of their election platform fiscal plans is to increase the marginal tax rate on Canada’s top one percent so that taxes can be cut for the middle class (The Liberal Fiscal Plan and Costing, 2015). There are both pros and cons to this approach.
The pros are that with reduced taxes, the middle class sector will have more disposable income. However, the middle class individuals have a tendency to either save money or increase their debt load. With an increase in debt load, an individual is spending more money than they have. The banks are then loaning more money, increasing their chances of default. Canada’s top one percent typically do not have debt load, they have investments and savings, and all of their disposable income is injected back into the economy through the purchase of goods and services.
An increase in spending increases the production of goods, and decreases unemployment, as more people have to be employed to meet the increase in demand. The drawback of taxing Canada’s one percent is that these individuals will be less inclined to inject money back into the economy, as the government is taxing more of their income. Increasing taxes on Canada’s one percent will be beneficial to the economy. The government will still receive revenue, which they can then spend on education, research and development, infrastructure, health care, and military initiatives.
Upper class spending habits does not foresee to have a drastic change, as these individuals have income that is large enough for them not to change spending habits, while at the same time they are able to afford an increase in taxes. Middle class individuals will have more disposable income as a result of the lower taxes; however, in order for these individuals not to increase their debt load, the Central Bank should increase interest rates to encourage saving. More savings will increase the money supply, thus encouraging firms and households to invest.
Statistics Canada reported Gross Domestic Product (GDP) fell in the second quarter, indicating the Canadian economy was in a recession, which is two consecutive terms of negative GDP growth, in the first half of 2015 (Flavelle, 2015). Although the budget is currently in a slight surplus, the government should increase spending, in conjunction with the increase in taxes on Canada’s one percent. Attempting to balance the federal budget after getting out of a time of crisis will potentially push the economy back into a recessive state.
With an increase in interest rates in an attempt to encourage savings from the middle class sector, there will be an increase in supply of loanable funds and a decrease in demand of loanable funds as not as many people will be able to afford the higher interest rates. This discourages firms and households from investing in infrastructure or capital equipment. However, with an increase in supply of loanable funds, the government can borrow the surplus of loanable funds in order to decrease their debt, without crowding out individuals who are interested in investing.
Without investment, it is very difficult for the economy to experience growth, as they will be less productive without technological and machinery advancements. Therefore, to encourage investment, the government can offer investment tax incentives to firms and households who are looking to invest in infrastructure and/or capital equipment in order to increase efficiency, and thus productivity. With an increase in productivity as a result of the tax investment incentive, there will be an increase in demand for workers, which will lower the demand-deficient unemployment.
The government can also help to reduce structural unemployment within the economy by using the government revenue from taxes to employ a number of policies. The government can provide education and training to teach new skills to long-term unemployed workers in order to enable them to find employment in developing industries. An increasingly skilled labour force will be able to increase production output, and with an increase in productivity, the government can focus their efforts on exporting more goods to foreign countries.
An increase in exports will cause net exports to rise, thus increasing the countries GDP, which leads to long-term economic growth. In conclusion, in order for our Canadian economy to prosper in the coming years, which is long-term forecasting and the focus of every leader in power, the government should follow a fiscal policy. In theory, by adjusting government spending levels, tax rates, and interest rates, the government can influence the Canadian economy in a positive light and work towards achieving a balanced budget.
