David Dodge: The interaction between monetary and fiscal policies
The Donald Gow lecture by Mr David Dodge, Governor of the Bank of Canada, to the School of Policy
Studies, Queen's University, Kingston, Ontario, 26 April 2002. Footnotes and references have been
omitted; please see the Bank of Canada's website for these.
* * *
Thank you for the invitation to give the Gow Lecture for 2002. Donald Gow had a great interest in
public administration and in budgetary reform in the federal government. He was one in a long line of
Queen's professors who have focused on various budgetary matters at the federal level.
The late Doug Purvis was another. In 1998, when I was asked to give the Doug Purvis Memorial
Lecture, I chose to talk about my "Reflections on the Role of Fiscal Policy." In that lecture, I discussed
the past practice of fiscal policy in Canada and drew from that experience some lessons that might
guide its future practice. In that context, I touched briefly on the interaction between fiscal policy and
monetary policy.
Today, after some experience on the monetary side of the fence, I would like to reflect more fully on
this important interaction. In doing so, I will be restricting myself to the macroeconomic aspects of
fiscal policy. Thus, I will be dealing with deficits and debts-both in terms of fiscal planning and in
terms of the responses of fiscal policy to economic surprises. These are the key aspects of fiscal
policy in terms of its interaction with monetary policy.
To begin, I find it helpful to look back to May 1970 when Canada returned to a floating exchange rate.
At that time, there was no formal anchor for monetary policy and therefore no anchor for nominal
economic variables. Nor had much thought been given to a medium- to long-run goal for fiscal policy.
Both policies had a rather short-run focus, and economic fine-tuning was still in its heyday.
Unfortunately, the early 1970s soon brought a number of surprises that were damaging to an economy
with no policy anchors-world energy prices skyrocketed, the underlying trend rate of productivity
growth slowed, and revisions to the employment insurance system increased the longer-run
equilibrium unemployment rate in the economy. By 1975, inflation had climbed above 10 per cent, and
the general government budget had moved into a deficit of 3.5 per cent of GDP.
In response to this rise in inflation, two policies were put in place. The Bank of Canada adopted targets
for the growth of the narrow monetary aggregate M1, and the federal government established an
AntiInflation Program in the autumn of 1975, which was in force until 1978. Although the controls aspect of
this program was aimed at facilitating the transition to lower inflation, the fiscal and monetary policies
under the macroeconomic aspect of this program were insufficiently restrictive to achieve permanently
lower inflation.
Overall, through 1982, M1 monetary targeting was not as effective in bringing down inflation as had
been anticipated. The links between money growth and inflation over a policy-relevant horizon were
not as tight as had been expected. The high interest rate elasticity of money demand meant that
interest rates did not have to be raised by much to slow down money growth. And, at times, this
problem was compounded by unexpected downward shifts in the desire to hold M1 balances. Thus,
although the targets for the monetary aggregate were achieved, spending and inflation did not decline
as much as had been hoped.
In the 1970s, fiscal policy was concentrating on cushioning shocks in a discretionary manner and on
expanding the amount of public goods and services. There was little realization that it was going off
track when examined from a medium- to long-term perspective. This was partly because real interest
rates were very low (and, indeed, often negative) throughout the decade. This situation could not last
forever, and it did not. Once real interest rates returned to higher levels and the economy continued to
experience lower trend growth rates, the vicious circle of debt dynamics set in.
Overall, one can view the period since 1970 as one in which the authorities struggled to establish
appropriate medium-term anchors for both monetary and fiscal policies. During this time, they learned
about the appropriate interaction between those two policies in the context of economic stabilization
and growth under a flexible exchange rate regime.
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In the rest of this lecture, I will deal with four interrelated topics: the appropriate goals for fiscal and
monetary policy, building policy credibility, the appropriate stabilization role for the two policies, and
policy co-operation. I will conclude with some thoughts about the future.
The appropriate goals and focus for monetary and fiscal policies
I will start with the topic of the appropriate goals for monetary and fiscal policies.
In the 1970s, it was not only Canada, but most industrialized countries, that went off track in terms of
their economic performance and budgetary outcomes. The global economic surprises that occurred
during the course of the decade were partly to blame. But, more fundamentally, the problem was that
central banks and governments had not yet established an appropriate macroeconomic framework for
dealing with such surprises. This framework would have to operate in a world of floating exchange
rates with high capital mobility and a high degree of substitutability between assets denominated in
domestic currency and assets denominated in foreign currencies. Although Canada had been on a
flexible exchange rate regime for most of the 1950s and into the early 1960s, it had operated on a
fixed-rate regime from 1962 to 1970. Most other industrialized countries did not float their currencies
until 1973 or later. And, although Canadian capital markets had historically been closely linked with
those in the United States, the same could not be said for most other countries.
Much of the academic literature around 1970 was focused on short-run stabilization, short-run
changes in policy instruments, and static analysis. Not much attention was paid to changes in the
stocks of assets and liabilities, which influence economic behaviour in the medium to longer run. Even
though the large econometric models that were being constructed at that time did have dynamic
behaviour and some limited role for asset accumulation, they were not typically used to look at
alternative policy rules or regimes. Apart from the literature linked to the monetary aggregates, little
had been written that dealt with a coherent medium-term policy. And there was also little or no
concentration on the long-run effects of fiscal policy. Given all this, it was not surprising that we
struggled to come to grips with our problems here in Canada.
Short-run static analysis
There was still an active debate in the early 1970s as to whether there was a long-run trade-off
between inflation and unemployment. Those who believed that there was, were more willing to engage
in a high level of fine-tuning the real economy. Models were used to mimic fine-tuning exercises, with
interest rates or fiscal policy levers changed to get back quickly to desired output levels. Empirical
models of the Canadian economy under flexible exchange rates were hampered by the fact that the
experience was all from the 1950s-a time when the economic structure was much different from that
of the 1970s and the exchange rate did not fluctuate very much. Not surprisingly, it proved difficult to
develop an equation that explained exchange rate movements very well.
Fortunately, there were some extremely powerful theoretical models of the short-run effects of
monetary and fiscal policy, developed in the early 1960s by Robert Mundell and Marcus Fleming. The
sharpest prediction of the early models occurred under the assumption of perfect substitutability
between domestic and foreign assets and a fixed domestic price level. In a flexible exchange rate
regime, only monetary policy (and not fiscal policy) would affect the level of output ("internal balance").
Expansionary fiscal policy would, however, lead to a sizable deterioration of the current account of the
balance of payments. Conversely, in a fixed exchange rate regime, only fiscal policy (and not
monetary policy) would affect the level of output, while monetary policy would affect the balance of
payments through its implications for changes in official reserves.
Mundell had used quite restrictive assumptions regarding prices and expectations of exchange rate
changes and inflation in his simple models. It is important to note, however, that relaxing these
assumptions, while maintaining a hypothesis of perfect asset substitutability, still leads to the
conclusion that monetary policy has no effect on output under a credible fixed exchange rate regime
(because it must be used to defend the fixed rate and therefore is endogenously determined).
Moreover, with perfect asset substitutability, monetary policy has a more powerful effect on output-
and fiscal policy has a less powerful effect on output-under a flexible exchange rate regime than a
fixed exchange rate regime. This comes about because the domestic effects of monetary policy are
augmented by its impact on the exchange rate, whereas the domestic effects of fiscal policy are
reduced by exchange rate movements.
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Even though Mundell's models dated from the early 1960s, it is not clear that policy-makers had taken
their implications into account for the change in exchange rate regime when Canada floated in 1970.
Medium-run analysis
Central banks, including the Bank of Canada, had long favoured a goal of price stability. And the
Economic Council of Canada, founded in the mid-1960s, favoured "reasonable price stability" as one
of its preferred policy objectives (but it did believe in "inflation-unemployment trade-off zones"). But by
1970, the only anchors for obtaining price stability or good inflation performance that were given
prominence in the literature were monetary aggregates. The 1960s and 1970s saw a battle between
the "monetarists," who favoured low and stable growth of a monetary aggregate, and the
"Keynesians," who believed in fine-tuning and (in some cases) considered monetary policy to be
ineffective.
On the fiscal policy side, there was little analysis of medium- to long-run effects. In large part, this was
because the federal debt-to-GDP ratio had been on a long downward trend since the end of the
Second World War to 1974. It was only after this ratio had increased for a number of years that it
became obvious that there was a problem with sustainability.
As the Canadian economy moved into the 1980s, taking with it a legacy of problems from the 1970s,
attention turned more and more to the importance of policies that would be sustainable over the long
run, as well as to what policies should be expected to accomplish over the medium to long run under a
floating exchange rate regime.
Evolution of thought about monetary policy in the 1980s and early 1990s
In 1982, and just before the Bank dropped its M1 target, Governor Gerald Bouey gave the Per
Jacobsson Lecture. In that lecture, he discussed the "search for a better analytic framework within
which monetary policy choices are made." Importantly, he noted that the Bank had found itself "taking
a view of policy that is more forward-looking than one based solely on monetary targets on the
grounds that it is wise to respond immediately to any potentially inflationary shocks rather than to wait
until such shocks are reflected in higher inflation and higher money growth." In the 1982-86 period,
the Bank looked for a target-monetary aggregate or other measure-that would provide
a nominal anchor as a medium-term guide to policy (that is, a target that would prevent

cumulative policy error)
a place to stand that would be used to communicate policy to the public, and

an anchor that could potentially affect the formation of inflation expectations.

Research failed to turn up a monetary aggregate that could fulfill these conditions. But to aid
policy-making, Bank staff set out a desired path for inflation that would lead to price stability in the
context of internal economic projections.
In 1988, in his Hanson Lecture, Governor John Crow laid out the case for price stability as the best
way that monetary policy could contribute to raising living standards. He also made it clear that, in his
view, 4 per cent inflation was not price stability.
It is important to review the case for low and stable inflation that the Bank has been making since
1988. The first key element in this case is that there is no long-run trade-off between inflation and
output-a belief fully borne out by events. Moreover, low and stable inflation would be expected to
actually increase output or economic welfare by
 reducing uncertainty about the future (and thus aiding planning and investment)
 reducing the costs of having to cope with inflation
increasing equity and fairness

leading to a more stable economy

The government was also sensitive to the problems caused by volatile inflation and by inflation
expectations that were not solidly anchored. Thus, by late 1990, there was a growing shared desire to
have an explicit target that would provide a better anchor for inflation expectations.
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The fact that the credibility of monetary policy can potentially be frustrated by inappropriate fiscal
policy-a theme to which I will return later-is one of the reasons that it is essential for both the
government and the central bank to sign on to an agreement.
In fact, an agreement was reached on specific inflation-reduction targets and was announced in a joint
press release at the time of the February 1991 budget. You may recall that a series of targets was
announced in that agreement, aimed at bringing the 12-month CPI inflation rate down to 2 per cent
(plus or minus 1 per cent) by December 1995. The target has subsequently been extended three
times, retaining the 2 per cent target midpoint.
For ten years now, inflation has been low and stable, and households and businesses have
increasingly come to believe in its predictability. The increased transparency of the Bank's conduct of
policy and its enhanced communications strategy have played key roles in this success.
An understanding of the appropriate medium- to long-run goals for monetary policy, both conceptually
and quantitatively, was thus solidly in place in the early 1990s. Moreover, the quantitative targets were
achieved in short order. It took longer, however, for medium- to long-run goals to be established and
achieved on the fiscal side.
The evolution of thought about fiscal policy in the 1980s and early 1990s
While central bankers and monetary theorists had always kept at least one eye on price stability or low
inflation, the fiscal authorities in industrialized countries had typically not had to deal with rising
debtto-GDP ratios during peacetime. Therefore, it took a while before there was any recognition that there
was a longer-run problem on the fiscal side. The recognition lag was exacerbated by an unexpected
decline in the trend rate of productivity growth, now dated at around 1973, and a rise in the actual real
interest rate to some longer-run equilibrium that occurred sometime in the early 1980s.
In my Purvis Lecture, I noted that in the 1971-83 period, "Expansionary fiscal policy was used . . . as a
substitute for appropriate structural policies." This was particularly true with regard to the response to
the two oil-price shocks. Thus, the contribution that fiscal policy could make to savings and longer-run
growth was largely neglected in discussions during that period.
During the 1983-85 period, academic economists began to discuss the sustainability of public deficits
and the appropriate role for fiscal policy. (Queen's professors Neil Bruce and Doug Purvis were key
contributors to this discussion.)
The sustainability problem really comes down to two things. First, the stock of government debt cannot
grow faster than the economy indefinitely. Eventually, fiscal policy must be adjusted. Second, because
of this, when the rate of interest on government debt exceeds the growth of the economy, a rise in the
government deficit relative to the size of the economy today means that there must be a rise in tax
rates or a cut in the ratio of government program expenditures to GDP sometime in the future. That is,
there are important transfers among generations.
Economists were also becoming more convinced that deficits and debts have significant real effects
on the economy. These effects occur because, in practice, changes in private sector savings do not
fully offset changes in government saving. That is, reduced government saving leads to some decline
in overall national saving.
In a small open economy such as Canada's, when the international substitutability of assets is very
high, the most important effect of changes in government debt will be on foreign indebtedness. It
works this way. A decrease in the deficit lowers domestic expenditures relative to domestic production
and thus increases the current account balance. There is a corresponding decrease in net capital
inflows and thus in foreign indebtedness. The decline in foreign indebtedness will lower the interest
and dividend payments flowing abroad and thus raise domestic net income relative to gross domestic
product.
To the extent that domestic interest rates decline when the domestic government debt-to-GDP ratio
falls, a decrease in government debt will tend to increase business investment and the capital stock.
This is the second major effect of a decline in deficits and debts on the Canadian economy.
Combining these two major effects, one can say that the appropriate longer-term goal for fiscal policy
should be increased savings, investment, and output through an appropriately low debt-to-GDP ratio.
A decline in the debt-to-GDP ratio can have additional favourable effects. First, to the extent that a
lower debt-service burden leads to lower taxes, rather than higher expenditures, it leads to a reduction
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in the usual distortionary effects of taxes. Second, to the extent that it reduces the effect of a given
change in interest rates on the government's balance, it makes fiscal planning much easier. Third, in
situations of very high (and perhaps rising) debt-to-GDP ratios, markets may build a premium into
interest rates to cover the perceived probability that debt will be monetized. Lower debt ratios reverse
this effect. Finally, when the economy weakens, governments facing high debt ratios may feel that
they have to override the automatic stabilizers to avoid making a bad situation even worse-as often
had to be done in the 1990s. This effect will tend to disappear at lower debt ratios. I will come back to
the last two points later in this lecture.
In the mid-1980s, the Canadian federal government developed a plan to gradually deal with the rising
debt-to-GDP ratio. But little progress was made, and thus more significant measures had to be taken
in 1993 and 1994. It was not until the budget of February 1995, however, that the cumulative effects of
all the measures taken were perceived to have put fiscal policy back on a sustainable track.
Since that budget, the debt-to-GDP ratio at the federal level has fallen from 70 per cent to 50 per cent,
and the provinces have, by and large, also put their fiscal houses in order. Largely as a result of these
fiscal moves, the ratio of Canada's international indebtedness to GDP has been halved from 40 per
cent to around 20 per cent.
Differentials in nominal long-term bond rates between Canada and the United States have come down
from over 2 per cent in 1990 to between 1/4 and 1/2 per cent over the past year. Canadian long-term
interest rates in real terms have also declined. With lower government financing needs, Canadian
corporations could more easily issue debt in Canada. All these changes have favoured increased
business fixed investment in Canada, which rose from 10.3 per cent of GDP in 1992-95 to
12.4 per cent of GDP in 1996-2001.
As for future objectives, it is plain that the federal government and many provinces clearly intend to
pursue further significant declines in their debt-to-GDP ratios over the medium term. The federal
government, for example, has a framework of targets and contingency reserves in each annual budget
that reduces to low levels the probability of running a deficit. The usual nominal growth in the economy
will thus reduce the debt-to-GDP ratio. While the objective in the fiscal area may not be as specific as
in the monetary area, it is the most definitive and operational medium- to long-term objective that there
has been for Canadian fiscal policy in recent memory.
What medium- to long-term objectives accomplish
Whether one is thinking about monetary policy or fiscal policy, there are two important results when
medium- to long-term objectives are established and achieved. First, a sustainable situation is created
over time. Policy instruments are forced to adjust to surprises-particularly permanent surprises-
because there is a longer-run anchor. Second, in choosing long-term objectives, appropriate
consideration is given to the type of policy framework that will raise our living standards over the
longer run. The longer-run outcome should be more than the result of a series of ad hoc short-run
decisions aimed at economic fine-tuning.
As a by-product, the economy gets the appropriate "assignment" of policies: long-run "internal
balance"-that is, low and stable inflation-is assigned to monetary policy and long-run "external
balance"-wealth accumulation coming, at least partly, from an increase in net foreign assets-is
assigned to fiscal policy. This should be taken as only a rough parallel to Mundell's results for
shortrun policy under flexible exchange rates with perfect international asset substitutability. It misses the
richness of the dynamic process through which both the capital stock and the stock of net foreign
assets can be affected, as discussed earlier.
The credibility of monetary and fiscal policies
I would now like to turn to the credibility of monetary and fiscal policies.
After establishing appropriate medium- to long-term objectives for monetary and fiscal policies, it is
important to achieve them. This is not only because in a democratic system it is important to be
accountable, but also because there are gains to be reaped from having credible policies.
The short- to medium-run credibility of monetary policy was established quite quickly, as inflation fell to
2 per cent in early 1992, more than three years before the inflation-reduction target itself was slated to
be 2 per cent. By early 1993, the inflation expectations of private sector forecasters and businesses for
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short-run horizons had fallen in line with the midpoint of the target range. It took a while for these same
inflation expectations at a 6- to 10-year horizon to fall to 2 per cent. This occurred by about early 1996.
And at a 30-year horizon, as measured by the spread between the yields on conventional and Real
Return bonds, expectations remained above 3 per cent until late 1996, before falling quite sharply to
around 2 per cent by late 1997 and staying there.
The significant deviation of long-term expectations from the target was partly a result of concerns
about pressures that could arise because of a fiscal situation that was still not perceived to be fully in
control. That is, financial markets were concerned with "fiscal dominance" over monetary policy in that
period.
There are a couple of strands in the theoretical literature on the interaction between fiscal and
monetary policy, which essentially assert that fiscal policy will eventually dominate in determining
longrun monetary policy. Both these strands, however, require that the fiscal authorities will either
eventually require the monetary authorities to monetize the debt or convince the financial markets that,
ultimately, the fiscal authority will have the upper hand. These appear to be extreme assumptions
because they depend on the view that fiscal authorities are unconcerned with any inflationary
consequence of their actions and ignore the many legal and institutional separations that exist
between fiscal and monetary authorities. Nonetheless, market concerns about the potential for fiscal
dominance can potentially have significant effects in financial markets, particularly on longer-term
bond rates. These concerns were definitely at play in Canadian financial markets in the early and
mid1990s.
As I noted earlier, it was only in February 1995 that the Government of Canada was perceived to have
established an objective for fiscal policy that was specific enough to provide a basis for achieving a
reduction in deficits to zero and setting the economy on a path that would reduce the debt-to-GDP
ratio. This objective was regarded as a foundation on which to build credibility for fiscal policy.
As in the case of monetary policy, credibility did not come immediately. It had to be earned.
Considerable credibility was gained, however, over the 2- to 2 1/2-year period after the 1995 budget.
The deficit-reduction milestones were more than achieved and successive budgets reinforced the
intention to stay the course.
It is important to note the supporting role that the credibility of monetary policy played in this process.
In part, because the short- to medium-run credibility of monetary policy was high, short- to
mediumterm interest rates on government debt had fallen significantly. Even long-term rates were much lower
than in the early 1990s. These lower interest rates reduced the real cost of the existing government
debt as it was rolled over.
Thus, there was an interaction between the credibility of fiscal and monetary policies. The joint
credibility of the two policies led to lower rates on long-term bonds as risk premiums related to the
debt-to-GDP ratio and to inflation uncertainty fell. The spreads between Canadian and U.S. long-term
bond rates even became negative for most of the period from mid-1997 to late 2000.
Canada's experience in the 1990s thus strongly suggests that there are important spillovers in
credibility between fiscal and monetary policies. Moreover, it is easier for everyone-policy-makers
and the private sector alike-when the frameworks for both monetary and fiscal policy are clear and
understandable.
In discussing the establishment of credibility, I have so far put the emphasis on achieving the
established objectives. This is certainly the most important factor. But communication has also played
a key role-communication about the quantitative objectives and about the framework of the
mechanisms that enable us to attain those objectives. Communication has been equally important for
both monetary policy and fiscal policy.
Policy credibility has led to important gains for the Canadian economy.
The joint credibility of the two policies has lowered long-term interest rates in real terms, favouring
business investment and, therefore, economic growth.
The credibility of monetary policy has apparently led to a change in the nature of the inflation process
itself. In the short run, inflation does not seem to respond as strongly to measures of excess demand
and supply. As well, because inflation expectations have been well anchored near the 2 per cent
target midpoint, the labour market today operates much more efficiently than it did during the
high-inflation years. Union contracts have lengthened considerably and wages are rarely indexed to
the cost of living. Moreover, there are no immediate reactions of wages to big changes in oil prices.
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Thus, relative wages are better anchored and tend to better reflect demand and supply conditions in
particular markets. I regard all this as an extraordinarily important contribution, since I spent two years
with the Anti-Inflation Board struggling to settle down a labour market that had become terribly
distorted by high inflation in the early 1970s. Overall, credibility has stabilized the inflation process
and, therefore, inflation itself. Moreover, effective monetary policy seems to have reduced the
variability in the real economy as well.
The credibility of fiscal policy has enhanced investment planning by the business sector since it has
drastically reduced the risk of future increases in taxes stemming from a need to deal with fiscal
problems.
Thus, credibility has led to a more stable Canadian economy and one that is better positioned for
future economic growth.
Stabilization policy
There is a connection between credibility and my next topic-stabilization policy. The achievement of
policy credibility has meant that the automatic stabilizers in the economy-those features of macro
policy that tend to stabilize output-can be allowed to work fully.
When the monetary and fiscal authorities are attempting to establish credibility, there is a natural
inclination-and sometimes a necessity-to err on the side of overachieving the targets. This means
that explicit actions may have to be taken to prevent the automatic stabilizers from working, as was the
case with fiscal policy in the 1990s. Moreover, the lack of a credible fiscal policy was one of the factors
that seemed to hinder the Bank's ability to achieve the monetary conditions that it desired at certain
points in the early- to mid-1990s. Thus, the stabilizing properties of monetary policy were not able to
fully work at that time. Now that the credibility of both policies is very high, both the federal government
and the Bank can allow the automatic stabilizers to do their job.
Monetary policy and stabilization
In the case of monetary policy, interest rates actually have to be changed to get the stabilizing result.
Nonetheless, although judgments are made based on the special factors at play and the balance of
inflation risks going forward, the changes in rates can be considered as more or less automatic in
response to surprises in demand. Our 2 per cent inflation target limits our discretion. Changes in
interest rates independent of those in the United States are made possible by our flexible exchange
rate regime.
Let me explain how monetary policy focused on an inflation target plays a stabilizing role when there
are demand surprises. Suppose that the economy is operating at its production potential, and inflation
is at the 2 per cent target midpoint. A downward shift in demand-coming from, say, a tightening in
fiscal policy-would create excess supply in the economy, putting downward pressure on inflation. To
bring inflation back to 2 per cent over an 18- to 24-month horizon, the Bank of Canada would lower its
target for the overnight interest rate. This action, through its effect on market interest rates and the
exchange rate, would increase the level of output in the economy towards its production potential.
Inflation would therefore return to target shortly after the excess supply disappeared from the
economy. Because the inflation-targeting framework operates symmetrically, the same process would
occur in reverse in response to an upward shift in demand.
Supply shocks-which take the form of higher (or lower) inflation than expected for a given level of
demand-are always more difficult for policy-makers to deal with than demand surprises.
Nevertheless, the Bank's framework for inflation-targeting allows temporary supply shocks to be
largely ignored, so long as they do not feed into inflation expectations. The credibility that has been
established means that they no longer do so. Consider price surprises coming from the most volatile
components of the consumer price index-components such as fruit and vegetables or oil and gas. As
our operating guide, we use a measure of core inflation that excludes such components. This gives us,
and economic observers, some confidence that we are looking at the underlying trend of inflation.
Thus, our interest rate response to price shocks that are perceived to be temporary can be minimal.
As a result, there will be little effect on output. In other words, monetary policy does not turn temporary
supply shocks into something that is destabilizing for aggregate output.
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Fiscal policy and automatic stabilization
On the fiscal side, the automatic stabilizers are tax revenues and employment insurance payouts.
When the economy weakens, tax revenues tend to fall, and employment insurance payouts tend to
increase. This buffers the effec