Fiscal policy, deficits, debt and what sets interest rates
◈ 6 cardsParliament’s two tools against the Bank’s one, a deficit as a flow and the debt as a stock, crowding out, and the loanable-funds list of what sets the level of rates.
Two policies, two actors
Monetary policy is the Bank of Canada moving one rate to steer inflation (Lessons 8.3–8.5). Fiscal policy is the Government of Canada, through Parliament, changing taxation and spending to steer demand. A tax cut is fiscal; a rate cut is monetary. The exam's trap is the actor: "the Bank of Canada cut taxes" is wrong twice over — the Bank has no tax power, and the Government has no rate lever.
Fiscal policy is expansionary when spending rises or taxes fall (more demand, a larger deficit) and contractionary when the reverse. It is slower to enact — budgets pass through Parliament — but acts directly on demand once it does; monetary policy can be changed on eight dates a year but takes 18–24 months to bite.
Worked example — a $40 billion deficit
In one fiscal year the Government spends $40 billion more than it collects: a deficit of $40 B. It borrows the difference by issuing Government of Canada bonds and bills (Lesson 9.2), so the outstanding debt rises from $1,200 B to $1{,}200 + 40 = \mathbf{1{,}240}$ B — =B2+B3. Against GDP of $3,100 B the debt-to-GDP ratio is — =B4/B5. A $15 B surplus instead would retire debt: 1,185 B, 38.2 % of GDP.
The deficit is a flow — one year's shortfall. The debt is a stock — the accumulation of every past deficit not yet repaid. A deficit adds to the debt; a surplus subtracts from it; a balanced budget leaves it unchanged. Debt-to-GDP, not the dollar figure, is what rating agencies and bond buyers watch, because GDP is the tax base that services it.
Crowding out
When the Government borrows heavily it competes with firms for the same pool of savings. Bond supply rises, bond prices fall, yields rise — and some private investment that would have been financed at the lower rate is not. That displacement is crowding out: fiscal expansion that raises rates and squeezes the private borrowing it was meant to stimulate.
What sets the level of interest rates
Crowding out is one instance of the general picture, the loanable-funds market: the interest rate is the price that clears the supply of savings against the demand for borrowing. The determinants the paper expects:
- Supply of savings — household and foreign saving; more supply, lower rates.
- Demand for investment — firms' and governments' borrowing; more demand, higher rates.
- Expected inflation — lenders demand the Fisher premium (Lesson 8.2); rates rise with expected inflation.
- Risk premiums — default, liquidity and term risk add to the base rate (Lesson 9.6).
- Central-bank policy — the Bank sets the overnight rate directly and shifts expectations of the rest.
The first four move the market's rate; the fifth is the one the Bank controls. Lesson 8.7 turns this into a curve across maturities.