Canada is one of the richest nations of the world, with nearly three fourths of the population engaged in the service industry and contributing to more than two thirds of the Gross Domestic Product (GDP). After growing 0.1% in January, 2007 the Canadian economy increased 0.4% in February as energy production returned to a more normal level. Excluding oil and gas extraction and utilities, economic activity grew 0.2%. Both goods and services production rose. Wholesale trade, manufacturing and financial services posted gains. However, these gains were partly offset by declines in construction, retail trade, rail transportation and the accommodation and food services sector (http://www.statcan.ca/start.html). The Canadian economy has been doing well, despite the slowdowns seen in the rest of the developed world. With low interest rates, high employment levels and a strong construction sector, the economy has seen balanced economic growth with a robust export performance.
Source: The Economist
There are regional variations that one finds in Canada in terms of economic growth. The highest GDP per capita in 2002 was $40,156 capita in Alberta and the lowest of $23,929 in Prince Edward Island. Ontario and Quebec were at $37,049 and $30,483 respectively. After joining NAFTA, in its 1994 version and now with the revised agreement, the Canadian economy is now increasingly integrated with the US economy. However the slowdown in the US economy has not resulted in any large fallout in Canada because of the strong fundamentals the economy is based on.
Employment jumped by an estimated 55,000 in March, 2007 continuing the upward trend that began in September 2006. Despite this growth in employment, the unemployment rate remained unchanged at 6.1%, as more people entered the labour market (http://www.statcan.ca/start.html ).
The Canadian Economy
The Canadian economy is a trillion dollar economy and the GDP is now close to 1.3 trillion US dollars. Canadian economic policy in recent times is characterized by a prime interest rate kept at the 6% mark, the exchange rate at a stable 1.13 to a US dollar and a foreign exchange reserve of nearly 33 billion dollars. With exports at more than 400 billion dollars and imports at more than 350 billion dollars, Canada’s external trade is critical to the economy and that is the most important reason for Canada’s monetary policy aimed at keeping the Canadian dollar a floating currency (IMF, 2006).
A free float enables a currency to absorb shock. And countries that are so clearly exposed to external shocks need to be able to cushion external changes. Historically, Canada’s monetary policy as regards the currency rate was one where the state intervened in currency transactions and the central bank closely monitored the exchange rate. However this changed after September 1998, when the Canadian exchange rate regime because a true floating mechanism that would change with the market situation as regards imports and exports. With a value that is slightly less than the US dollar and with most of Canada’s trade heading to or coming from the US, the trade balance (exports minus imports) has been positive. A cheaper local currency encourages exports and discourages imports keeping the trade balance positive.
Monetary policy is often predicated upon the inflation rate. In democratic countries, price rise is often politically unacceptable especially with frequent elections. Hence the central bank and the treasury tend to keep a close watch on the inflation and on the customer price index. On this front, the Canadian economy has performed well with modest inflation helped by an interest rate that is stable. The low inflation rate might have an impact on domestic demand, as the aggregate supply curve would tend to flatten given stable prices. Also with a low unemployment rate and stable salary levels the demand curve too would be flat. Therefore growth would be restricted to growth in external trade helped by a favorable exchange rate that is what we are witnessing in Canada over the last five years or so.
The Business Cycle
As a result, the major factor that would impact the economy now is the business cycle. In economic theory, business cycles show growth in initial phases, then a stability followed by a decline. These are periodic swings that most economies pass through. During these cycles production and supplies go up due to price and demand increases and then as demand stabilizes, so do prices. Producer surplus comes down, and investment levels stabilize. Then when the curve starts sliding down, prices reduce, demand levels fall and till the supply reaches a new equilibrium the economy goes downhill resulting in unemployment and retarded growth. Each country goes through such alternating phases of growth and stagnation, though the length of the cycle is very often uncertain and unpredictable. Economic expansion is the phase where the real GDP rises steadily and recession is the stage where the real GDP falls. This is followed by a phase of economic recovery (Koustas, 2003).
Canadian business cycles have not been any different from the rest of the world. A globalised economy like Canada is prone to expansion and recession in the rest of the world. The first big recession was borrowed from the US in the 1930’s. However the economy stabilized soon after thanks to some tight monetary policies and a harsh fiscal policy, where the government taxed its citizens at high rates to keep the public sector functional and to provide social security to those hurt by slowdowns. Each slowdown affects jobs, growth and economic prosperity adversely. In the post war period, Canada has been relatively stable and has only passed through two serious recessions. The first was in 1982 and in the second in the early 1990s. Since then, Canada has seen a period of healthy economic expansion and prosperity, despite a slowdown in services trade and the internet bust that pushed the US into a recession at the turn of the century (Den Haan, 2000).
Fiscal policy is the economic term that defines the set of principles and decisions of a government in setting the level of public expenditure and how that expenditure is funded. Fiscal policy and monetary policy are the macroeconomic tools that governments have at their disposal to manage the economy. These are the two most important components of a government’s overall economic policy, and governments use them in an attempt to maintain economic growth, high employment, and low inflation. Fiscal Policy is the means by which a government adjusts its levels of spending in order to monitor and influence a nation’s economy. It is the deliberate and thought out change in government spending, government borrowing or taxes to stimulate or slow down the economy, also known as the contractionary policy. It contrasts with monetary policy, which describes the policies about the supply of money to the economy.
Canada’s tax structure has been criticized for a while for charging high taxes on business. However, over the years tax rates have been cut and now the federal corporate income tax rate is down to 21%. There is a surcharge that is levied on top of this 21% tax figure. This federal surcharge for all businesses of 4% is set to go in 2008. On top of this federal tax, provincial governments charge a corporate tax at differing rates between 10% and 16%. There are other provincial taxes that also levy sales taxes on capital goods and some provinces also levy a tax on capital. In sum, the effective tax rate in Canada is the highest tax on capital in the developed world.
Canada’s fiscal policy reflects the concerns of the political leadership in seeking to increase government revenue and expenditure. The health system is huge and needs constant doses of capital to sustain itself. In addition to the health sector, the social security system and the education system too is largely subsidized and calls for higher tax rates. Increasing tax rates tend to dampen demand and slow down the growth rate as higher taxes lead to a slowdown in supply, which also gets affected by higher unemployment. However government revenue goes up and government expenditure can increase as a result of higher tax collections. The business cycle then goes into a recessionary phase. But with increased government expenditure, public utilities get benefited. Therefore fiscal policies need to be well balanced and not cause an irreversible slowdown of the economy leading to spiraling inflation rates (Department of Finance, Canada., 2006)
Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known as Keynesian economics, this theory states that governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending. This influence, in turn, curbs inflation (generally considered to be healthy when at a level between 2-3%), increases employment and maintains a healthy value of money. In globalizing economies, the threat of borrowing slowdowns is as serious a concern as the opportunities that come through foreign expansionary phases in global business cycles. Fiscal measures tend to shore up the domestic economy in the face of external pressures. Canada’s fiscal policy in that sense has prudently tried to balance growth with inflation, and increase government expenditure whenever unemployment threatens to increase. Also, tax revenue has enabled the setting up of a health and education system that supplies most of the skilled labour force that works in Canada’s large service sector.
When inflation is too strong, the economy may need a slow down. In such a situation, a government can use fiscal policy to increase taxes in order to extract money out of the economy. Fiscal policy could also dictate a decrease in government spending and thereby decrease the money in circulation. The fall in money supply causes a decline in demand and hence a fall in prices. However, the possible negative effects of such a tax policy in the long run could be a sluggish economy and high unemployment levels. It is important that this process continues under close watch as the government uses its fiscal policy to fine tune spending and taxation levels, with the goal of evening out the business cycles. However, with inflation in check, Canada’s fiscal policy too has not been as drastic as it could have possible been.
Canada requires s stable financial system that is able to meet the expectations of depositors, investors and the government. Canada’s democratic system and economic structure, which is heavily dependent on the US economy and the success of NAFTA, presents many challenges to the formulation of its monetary and fiscal policy. It is important that the fiscal policy takes into consideration the key issues of public and government expenditures. The monetary policy should be formulated accordingly so as to bring down the threat of fiscal deficits. Taking the need for institutional changes into consideration, there should be potential improvements in the economy in order to provide the right directions to the policymakers. It is felt that the quality of expenditures at federal and provincial levels has been deteriorating over the period of time; therefore it is very important for the government to have a rational approach towards these expenditures. Expenditure restructuring must accompany expenditure control. Privatization combined with increased competition, plays a major role in reducing the fiscal deficits.
Tax rates have to be brought down as the economy looks for increased investment. It is not feasible to have high tax rates in a world competing for global investments. Interest rates cannot be kept high for a long time and must compete with the interest rate mechanism in the US. Aggregate supply and aggregate demand in Canada is intrinsically tied up with supply and demand in the US, and apart form the construction sector, all other sectors of the economy now closely follow the business cycle that is seen in the US. Infact the integration of the world economy, impacts North America considerably, especially by way of rising oil prices, which have a way of impacting almost all sectors of the economy. A monetary policy that ensures a stable exchange rate, low levels of inflation and higher levels of employment along with a fiscal policy that tends not to dampen GDP growth, is what the future would require.
Den Haan, W. J. (2000), The comovement between output and prices, Journal of Monetary Economics 46, pp. 3-30.
Department of Finance, Canada. (2006). “The Economic and Fiscal Update: Canada’s New Government.
International Monetary Fund, Canada, (2006). “Staff Report for the 2006 Article IV Consultation”.
Koustas, Z. (2003) “Stylized Facts of the Canadian Business Cycle”. At http://spartan.ac.brocku.ca/~zkoustas/Cycle.pdf. Last Accessed May 1, 2007.
Statistics, Canada. (2007) At http://www.statcan.ca/start.html. Last Accessed May 1, 2007
Townsend, J. (2006) Aggregate Demand and Aggregate Supply. At http://io.uwinnipeg.ca/~jtownsen/1103/Chapter_15.pdf. Last Accessed May 1, 2007.