Monetary Policy

All economies display fluctuations in the growth rate of aggregate outputThe sum of the value of all goods and services produced in the economy during a particular period of time, usually a year. The most common measure of aggregate output is gross domestic product (GDP).. These fluctuations are often referred to as business cycles, even though they rarely exhibit the smoothness and regularity suggested by the term.

We have discussed why the Bank of Canada focuses on maintaining low and stable inflation. What we have not said is that this policy objective embodies within it a second and related objective of providing some stability to the growth rate of output.¹¹ What explains this connection?

The details of how monetary policy works are discussed in the next section, but we can sketch a broad outline at this point. In order to do so, we first need to define the concept of potential outputThe economy's level of production capacity. This is the level of aggregate output the economy can produce on a sustained basis, without causing inflation to either rise or fall.—the economy's production capacity. This is the level of output that the economy can produce in a sustained manner, without causing inflation to either rise or fall. The gap between actual output and potential output—the output gapThe difference between the actual level of aggregate output (GDP) and the economy's level of potential output. A positive output gap means that actual output exceeds potential output; this is a situation of excess demand. A negative output gap means that actual output is below potential output; this is a situation of excess supply.—is an indication of the amount of excess demand or excess supply in the economy and plays a central role in explaining changes in inflation.

Suppose the Bank of Canada's best available information is that, in the near future, actual output is likely to rise above potential output and that such excess demand will lead to an increase in inflation. In that case, the Bank's objective is to reduce these emerging inflationary pressures by trying to keep output from exceeding potential. By raising its target for the overnight rate, the Bank can dampen the demand for credit in the Canadian economy sufficiently to reduce aggregate spending. This reduction in spending will, in turn, lead firms to reduce their output (or to reduce the growth rate of output). The Bank's actions in raising the target will therefore be working to pull actual output back towards potential output, thus helping to contain the inflationary pressures.

Conversely, suppose the Bank of Canada expects actual output in the near future to move below potential output, thus leading to a situation of excess supply in which inflation starts to fall. If the Bank wants to keep inflation relatively stable, its policy will be designed to increase output back towards potential, and it will do this by reducing its target for the overnight interest rate. The resulting easing in credit conditions will eventually increase aggregate spending and lead firms to increase their output. As the actual level of output moves back towards potential output, the downward pressure on inflation diminishes.

The previous description suggests that, by attempting to keep inflation close to its target, the Bank of Canada responds to significant changes in the economic environment in such a way that the growth rate of aggregate output is made more stable. When shocks are expected to cause actual output to rise above or to fall below the level of potential output, the central bank acts to offset these shocks. This is why many economists view an inflation-targeting policy as an output-stabilizing policy.

3.1 Has Canadian output growth become more stable?

Chart 4 shows the path of real output (gross domestic product, GDP) growth in Canada from 1981 to 2004. The Bank's policy of inflation targeting began in 1991, and if this policy has indeed been a stabilizing one, real GDP growth should have been more stable in the 1990s than it was in the 1980s. This pattern is confirmed in the chart.

During the 1980s, the annual rate of output growth fluctuated between -3 per cent and +6 per cent, but on a few occasions was outside this range. Since 1992, however, output growth has always been in the narrower range of +1 per cent to +6 per cent. Thus, the stability of output growth has clearly increased following the adoption of inflation targeting.¹² We address below the important question of whether this reduced volatility was a consequence of better monetary policy or whether other factors might explain it.

A different way to see the increased stability of output is to examine the path of the output gap. In Chart 5, we show the output gap as a fraction of potential output. For example, in late 1982, when the Canadian economy was in the depths of a significant recession, actual output was almost 6 per cent below potential output. In contrast, when the Canadian economy was booming in 2000, actual output was almost 2 per cent above potential. It is clear in Chart 5 that the output gap has been less volatile in the past 10 years than it was in the first 10 years of the sample. In the first decade, the output gap ranged from -6 per cent in 1982 to +2 per cent in 1989; in the second decade, the output gap ranged from -3.5 per cent in 1992 to +2 per cent in 2000. The standard deviation of the output gap from 1982 to 1991 was 2.1; this measure of the output gap's volatility falls to 1.5 for the 1992-2004 period.

Two questions related to the stability of Canada's output growth remain. First, why is greater stability of output growth desirable? Second, is the greater stability that Canada experienced after 1991 a result of the Bank of Canada's monetary policy, or has Canada just been lucky to experience an uneventful decade during which the central bank was not faced with many significant challenges? We address these two questions in turn.

3.2 Why stable output growth is desirable

To understand why it is desirable to have relatively stable output growth (or to keep actual output relatively close to the smoothly growing level of potential output), it is necessary to understand what is going on in the economy over the course of a typical business cycle. We consider two different situations: when actual output is above potential output, and when actual output is below potential output.

Consider first the situation in which actual output is above potential output. In this case, the Canadian economy is producing more goods and services than is sustainable, given firms' current stock of productive capital and workers' willingness to work. Actual output can exceed the economy's capacity only by operating plant and machinery more intensively than is sustainable and by working employees harder than is normal—typically through overtime hours, but often by increasing part-time employment. The problem with this state of excess demand is that firms are generally operating so intensively that they are unable to maintain their plant and machinery in the usual manner, and workers are frequently working so intensively that they are unable to take as much leisure as they would like. Firms' profits and workers' incomes may be high in this setting, and these are notable benefits, but the situation is not sustainable—eventually the excess demand will push up wages and the prices of other inputs to the point where widespread inflationary pressures start to build. Given the Bank's objective of maintaining low and stable inflation, having actual output in excess of potential output is a situation worth avoiding.

Now consider the opposite situation, in which actual output is less than potential output. In this case, the Canadian economy is producing fewer goods and services than is sustainable. Producing less output than is sustainable typically involves using fewer machines than are currently on hand, or using the existing machines less intensively. In such a situation of excess capacity, firms are typically not receiving the full rate of planned or expected returns on their investments, and their profits will typically be lower as a result. Similarly, producing less output than is typically possible involves employing fewer workers than normal, and this decision usually involves layoffs for some workers and reductions in hours for others. The excess supply generates pressures for wages and the prices of other inputs to fall (or for their rate of increase to decline), and this situation eventually causes inflation to fall. Given the Bank's objective of keeping inflation stable and within a target range, this situation should also be avoided.

Relative stability in output growth is therefore desirable for two reasons. First, by keeping actual output close to the steadily growing level of potential output, firms and workers avoid circumstances in which they are pushed to work beyond their limits, as well as those in which they are idle for considerable periods of time. Second, by avoiding such situations of excess demand or excess supply, the pressures for inflation to either rise or fall are kept to a minimum. Low and stable inflation is easier to maintain if output gaps are kept relatively small.

3.3 Good policy or just good luck?

Although it is clear from Chart 5 that output gaps have been less volatile in the years after 1991 than before, it is not clear that this reduced volatility is a consequence of the Bank of Canada's monetary policy. Perhaps Canadians have simply been lucky in the period following 1991, and the greater stability has had little or nothing to do with the Bank's policies.

It is often very difficult in macroeconomics, especially over relatively short periods of time, to determine cause and effect, for the simple reason that many variables are changing simultaneously. This paper will not attempt to offer a formal analysis of the effect of Canada's inflation-targeting regime on the stability of output growth. Instead, it simply reminds the reader that the past two decades have seen many shocks to the Canadian economy, and it is not obvious that the most recent decade has been less eventful than the one preceding it.¹³

The decade from 1980 to 1989 included the aftermath of the second oil shock emanating from the Organization of Petroleum Exporting Countries (OPEC), the decision to reduce inflation from very high levels, a 20 per cent depreciation of the Canadian dollar against the U.S. dollar, a strong economic recovery in the middle of the decade, the collapse of world oil prices in 1986, the implementation of the Canada-U.S. Free-Trade Agreement in 1989, the gradual entrenchment of fiscal deficits and the accumulation of government debt, and the beginning of the Bank of Canada's drive towards "price stability." Not a quiet 10 years.

But the next decade was no less eventful. The Goods and Services Tax (GST) was introduced, a prolonged recession occurred in the early years of the decade, and the Mexican peso crisis spilled over into Canada and highlighted the federal government's fiscal challenges. The federal government then instituted a series of budget measures to cut public spending, the Quebec referendum produced significant worries in financial markets, and the Asian crisis contributed to a significant depreciation of the Canadian dollar. A few years later, the terrorist attacks of 11 September 2001 shocked the North American economies, large increases in the world price of oil threatened to stall a global economic recovery, and a large appreciation of the Canadian dollar forced some painful adjustments within the Canadian economy.

It is difficult to look back on the past dozen years and conclude that Canada has simply been lucky in avoiding the large numbers of significant shocks of the previous decade. On the contrary, there were many shocks during that time, and the Canadian economy has been pushed in various directions. Given this recent history, it seems reasonable to conclude that at least some part of the greater stability in output growth has been owing to the Bank of Canada's conduct of monetary policy.

Some recent research reaches the same conclusion but with greater precision (Cecchetti, Flores-Lagunes, and Krause 2004). It empirically disentangles the combined effects—output stability and inflation stability—on macroeconomic performance that resulted from a change in the volatility of economic shocks and from a change in the success of monetary policy. The evidence suggests that the volatility of economic shocks hitting Canada after 1991 increased relative to the earlier period, but that the greater economic performance was the result of an even greater improvement in monetary policy. In other words, not only did the Bank's monetary policy improve following the adoption of inflation targeting in 1991, but it improved enough to more than offset an increase in the number of economic shocks, with the overall result being better macroeconomic performance.

Having discussed how Canadian economic performance has improved, and how these improvements may be related to the Bank's monetary policy, it is time to go into more detail about how monetary policy actually works. A little knowledge in this area is essential for gaining an appreciation of the difficulties involved in the successful conduct of monetary policy.