LESSON 5: ADAS AND PUBLIC POLICY

INTRODUCTION
This lesson touches on economic fluctuations in the economy and what fiscal policies can
be implemented to minimize the size of such fluctuations.
Fiscal Policy
The governments has a number of levers at its disposal o affect the overall
economy if it needs to. Two key tools include government spending and altering
taxes. Governments collect taxes from both individuals and corporations alike
and spend revenues on goods and services demanded by economic agents in
the economy. Great care must be taken however to ensure that government
spending achieves the objective of smoothing growth rates in GDP around the
long term trend. Spending can be inflationary, and can impact both real GDP and
the price level. If used responsible, government spending can achieve the
governments goal of smoothing out growth in GDP and minimizing variation of
the actual economy from its potential level. As rule, governments should spend
(use expansionary fiscal policy) in times of recession and cut spending
(contractionary policy) when the economy does well.
Fiscal Policy is needed to assure that economic agents and society as a whole
receive the goods and services they need from the government. Spending pays
for many good and services and includes spending on social services such as
healthcare, to natural defense. Federal governments also provide provinces with
transfer payments and part of budgets go to service debts. Countries that have
large and growth debts restrict themselves when it comes to service the debt.
When debts are high, a larger proportion of government revenues go to service
such debt, taking resources away from other, more pressing areas such as
health care and education spending.
Revenues that governments receive are from many sources. A majority of
revenues are made up of personal and corporate income taxes. While Canada
has one of the lowest corporate tax rate regime in the world, it has high personal
tax rates. Other sources of revenues include CPP contributions and excise
taxes.
There has been a shift towards lower taxation. Individuals are taxed very
highly while corporations are tax at some of the lowest rates in the G7. Is
this a good public policy approach? Many argue that corporations have
the ability to move relatively quickly and that Canada needs to stay
competitives. Others argue low corporate tax rates reduce governemnts
budgets and spending needed for social programs.
Types of Tax: A closer look

Taxes can take on many forms and include progressive, regressive or excise
taxes. Progressive taxes are taxes that rise as a percentage of ones income
level. Canada has a progressive tax structure. Progressive tax structures serve
to reduce income inequality given those with modest income levels pay little in
the form of taxes.
This differs markedly from regressive taxes that fall as a proportion of income.
Those earning sizable incomes pay less as a percentage. Regressive taxation
serves to increase income inequality given those that can least afford to pay tax
pay a higher proportion.
Lastly, excise taxes those taxes levied against products such as alcohol. This
may lead to inefficiencies given they isolate only a few products.
Change in tax and fiscal policy can have a sizable impact on the economy.
When governments spend money, this often has a larger impact that initially
contemplated. When governments issue stimulus checks for instance, not only
does it create the initial bump that such spending has on the economy, but it
also has the intended consequence of getting other sectors of the economy
spending as well. Consumers who get such stimulus packages take the money
and either spend or save it. The portion of money spend by consumers from an
additional dollar of income is called the marginal propensity to consume (MPC).

One way to measure the total impact of the initial dollar spent by government is
by looking at the multiplier effect. The total impact of an initial change by using
the multiplier formula:
multiplier = 1/(1-MPC)
As can be imagined, money spent on imports, taxation and savings reduce the
effect of the multiplier.
As can be seen the larger is the marginal propensity to consume, the larger is the
multiplier effect. An increase in government spending will therefore increase the
aggregate demand curve by more than the initial government spending.
Dynamic considerations surrounding fiscal policy:
Economic policy must be considered carefully given the impact it has on the
economy may not be realized over many months. When governments decide to
spend or cut taxes, the full impact this may have on the economy may be up to
two years. In this time the economy may face additional shocks that the initial
policy action did not account for.
Governments spending and the crowding out effect
Governments that run large and persistent deficits hurt the economy in many
ways. Budget deficits adds to the level of debt a country has. For example. If a
country has 1 Billion dollars in debt and the budget deficit is 100 million in 2012,
than the countries debt level at the end of 2012 is 1.1 Billion. Much of this deficit
is funded by bond issuance. Spending a large percentage of governments
budgets on servicing debt rather than investing in education and health care
hurts productivity levels in the economy. Also government borrowing drives up
interest rate, reducing consumption by households and investment spending by
firms. Investment by the private sector is most efficient and as suggested in
earlier classes becomes important in driving economic growth. Not surprisingly
many argue that governments should target balance budgets such that this
crowding out affect does not occur.
Government purchases also have unintended consequences globally. Increased
government purchases tend to drive up interest rates which attracts capital from
abroad. When interest rates in Canada increase, the demand for Canadian
dollars also increases (given people want to invest in Canadian denominated
assets that earn higher interest rates), thus driving up the value of the Canadian
dollar. This serves to reduce exports given it now costs foreigners more to
purchase Canadian produced goods and services.

When countries have large debts and deficits a concerted effort is need to reign
in spending and eliminate such deficits. Any surpluses that are generated in the
future should be devoted to paying down the debt and investing in programs that
improve productivity and the capacity of the economy to expand economic
activity. Such activities include investing in education and health care.
Question: how does this change when we are in recession? Clearly in a
recession, the private demand to invest is much weaker. Lets discuss

SECTION SUMMARY
This section of the lesson touches on economic fluctuations in the economy and what
fiscal policies can be implemented to minimize the size of such fluctuations.

Special Topics: What is Transfer Pricing?

Definition
Transfer pricing investigates the price that one member of a multinational firm
charges another for goods, services and intangibles. Related party transactions
account for a significant part of global trade with approximately 80% of
international trade between related parties and the remaining 20% of
international trade between unrelated, multinational companies. 1
Transfer pricing encompasses the investigation of the price associated with many
company transactions. While the typical example in transfer pricing textbooks
involve the sale of a manufactured good to a related distributor, it also includes
the charge that one related party charges another for the provision of services, or
the use of intangible property. As the world economy becomes more globalized,
integrated related parties in more industrialized countries are performing more
valued added services and developing valuable intangible assets. Low cost
countries are performing more labour intensive manufacturing activities.
Valuations of intangible transfers therefore have become increasingly relevant,
especially in high tax jurisdictions.
Transfer pricing attempts to determine what the appropriate intercompany price
ought to be between related parties by asking the following question: The
inherent question transfer pricing attempts to answer is:
"If the related parties to any transaction were arms length, what
would they need to pay for the good service or intangible?
While the question that transfer pricing may attempt to answer seems simple the
implications of transfer pricing is quite significant. The price that multinational
firms charge a related party for goods, services and intangibles directly impacts
the profitability of each segment in different tax jurisdictions. For example, an
automobile multinational that controls manufacturing operations in Country A
must transfer (or sell) these cars to a related distribution entity operating in a
different tax jurisdiction located in Country B. Implicitly, multinational entities may
have an incentive to transfer goods, services and intangibles in such a way that
profits are maximized in the low tax jurisdiction. For example, if the corporate tax
profits in Country A are 25% while they are 50% in Country B, a multinational firm
may ensure that, after tax, having Country A sell the product at an excessively
high price maximizes profits. This would result in more profits being taxed at
25% as opposed to 50%.
International trade has increased in volume over the last 3 decades. The U.S.
Census Bureau, U.S. Department of Commerce, announced that in 2005 alone,
1 David Wakeford, Security Initiatives on International Trade

related party trade accounted for 41 percent ($1,059 billion) of total goods trade.
2

The ability of multinationals to manipulate transfer prices charged between

related parties for the transfer of goods, services or intangibles has induced most
countries, including Canada, and has forced world governments to enact laws
and regulations that limit how transfer prices can be set.
Most countries adhere to the arm's length principle (ALP) as defined in the
Organisation for Economic Co-operation and Development (OECD) Transfer
Pricing Guidelines for Multinational Enterprises and Tax Administrations. The
OECD guidelines are provided in the OECD Report, "Transfer Pricing and
Multinational Enterprises (1979). The Committee on Fiscal Affairs approved
them on June 27, 1995 and by the OECD Council for publication on July 13,
1995.
In Canada, the pricing of transactions between two related parties are governed
by Section 247 of the Canadian Income Tax Act taken together with CTHE CRA's
most definitive statement of administrative practice (Information Circular (IC) 872R) and audit experience often leaves taxpayers confused as to what to do about
setting, documenting and defending their transfer pricing policies.
In what follows, we provide a brief overview of the law and administrative practice
from a practical standpoint, point out a number of areas of uncertainty, and
review the current audit or enforcement environment in Canada. For Canada's
biggest trading partner, the United States, governs its intercompany price by
Section 482 of the Internal Revenue Code (IRC).
International Trade and its Effect on Transfer Pricing Regulations: Why
World Economies will need to Implement Transfer Pricing Legislation from
a Macro perspective
As the world economy becomes increasingly globalized, pressure is building on
nation states to conform to internationally changing norms. Of particular
prominence is the shift towards the development of large-spanning trading blocks
including the North American Free Trade Agreement (NAFTA), the European
Union (EU) and an emerging Asia Trading Bloc.
Increasing globalization is easing the flow of capital between countries. In recent
years, significant foreign direct investment has been seen in many countries
around the world, but most notably in developing countries, such as China. This
is largely attributable to rising economic returns on capital and labour due, in no
small part, to the low wage structures of developing nations. Europe is
witnessing a similar phenomenon whereby capital is seen flowing from the richer
European nations to the poorer ones, also taking advantage of the lower wages
2 (12 May 2006) http://www.census.gov/foreign-trade/www/

and higher returns to invested capital. Overall, this trend has allowed developing
nations to achieve solid growth over the past few years.
Indeed, international trade has been good for a country in the developing world,
such as China. According to the Economist Magazine, Gross Domestic Product
(GDP) growth in China in 2005 was estimated at 8.1%. Putting this in context,
GDP growth in Canada was estimated at 3.0% for the same period. In order for
this growth trend to continue, however, China will have to further reduce
uncertainty and provide foreign investors with additional confidence in its
regulatory and tax systems.
The trend toward increased globalization has, and will, continue to put pressure
on nation states to increase transparency and clarity regarding transfer pricing
legislation and issues. While developed nations such as the United States,
Canada and other G7 countries have relatively transparent and clear regulations
regarding transfer pricing matters, developing countries are beginning to catch
up. China and other developing countries have recently undertaken progressive
transformations of their transfer pricing regulations, due in part to their desire to
attract investments and to more fully integrate into the world economy. China, in
particular, is enjoying much success in attracting the investments of foreign
multinationals; and improving transparency is fundamental for maintaining this
momentum.
The development of new transfer pricing regulations serves amongst other things
to increase certainty and transparency (and therefore attractiveness) of investing
in a particular tax jurisdiction. This can be illustrated mathematically using the
following Net Present Value (NPV) equation:

where C0 is the upfront costs of investing, C t is the after tax cash flow, r is the
discount factor (or measure of risk) and T is the number of periods the
investment project is to last.
Increased uncertainty surrounding transfer pricing legislation will serve to
increase the discount factor, r, which will reduce the NPV of a project and
decrease the attractiveness of investing in a particular tax jurisdiction. Therefore,
it is in a developing countrys best interests to increase certainty regarding
transfer pricing legislation.

Arm's length Principle, the OECD and the Canada Revenue Agency
The ALP is the condition or the fact that the parties to a transaction are
independent and on an equal footing 3. The ALP is the root of setting all transfer
pricing between related parties. It is believed that the price determined by
unrelated parties is the benchmark for determining all intercompany prices.
Generally speaking, unrelated parties do what is in their best interest and thus
price transactions that maximize their individual welfare. Mathematically, firms
attempt to maximize profits subject to a set of identifiable constraints. This
involves the following firm utility maximization problem:
Max : PF(K,L) - Wl rK subject to all constraints
Where P is Price, F(K,L) is the production function which is a function (comprised
of Capital (K), and Labour (L)) for which the firm is attempting to maximize, W is
wages, L is labour, r is the rental cost of capital, and K is the Capital employed.
Generally, firms will choose the price of inputs such that doing so maximizes the
firms profit maximization problem given above. When firms act as independent
agents, they generally choose to maximize profits by purchasing or selling goods,
services or intangibles at the most preferable price.
Applying transfer pricing rules based on the arms length principle is not easy,
even with the assistance of the OECDs guidelines. It is not always possible
and certainly takes valuable time to find comparable market transactions to set
an acceptable transfer price. A computer chip subsidiary in a developing country
might be the only one of its kind locally. But replacement systems suggested so
far would be extremely complex to administer.
How THE CRA has reacted to Aggressive tax planning: An Overview
The Canada Revenue Agency (CRA) is establishing 11 Centres of Expertise to
strengthen and enhance its audit and collection programs to counter international
tax avoidance and evasion and aggressive international tax planning. These
centres will be located in regional Tax Services Offices across Canada and will
bring together international tax auditors and tax avoidance officers. They will
develop new ways to track and combat aggressive tax planning and the use of
international tax shelters.
Aggressive international tax practices are significant problems that the CRA is
addressing. Tax avoidance and tax evasion schemes that involve the abuse of
tax havens, for example, are a growing concern, not just for Canada but also for
all countries participating in the global economy.
3 Wikipedia.com

Generally, a tax haven can be seen as a jurisdiction with no taxes or a very low
rate of tax, a lack of transparency in the operation of its tax system, and a lack of
effective exchange of information with other countries. Tax havens usually also
have strict bank secrecy laws. There may be legitimate reasons why a tax haven
is used. However, tax havens provide opportunities for some taxpayers to avoid
or evade Canadian tax. Potential non-compliance by Canadians investing
offshore is an ongoing concern of the Canada Revenue Agency because it could
erode the tax base.
In the February 2005 Budget, Finance Minister Ralph Goodale announced that
the CRA is to receive $30 million annually to strengthen its capacity to
administer the tax system in areas where aggressive tax planning and
compliance risks have the potential to erode the tax base. The funds will be used
to:

hire additional resources in international audit and tax avoidance to deal

with international transactions;

train employees on the latest developments in abusive international tax

planning;

work with other countries to detect abusive international tax schemes; and

develop communication initiatives to inform taxpayers and tax planners

about international tax arrangements that may contravene Canadian tax
laws.

The CRA has already put the following measures into place to bolster its capacity
and ability to identify and combat abusive schemes that utilize offshore
jurisdictions:

an increased number of field auditors have been assigned to do both

regular international audit work and targeted projects involving offshore
jurisdictions;

new legislation has been introduced to help address potentially abusive

situations concerning non-resident trusts and foreign investment entities;

there has been an increase in staff training on detecting and identifying

abusive schemes.

The CRA also participates in a number of groups that work to combat offshore
abusive tax schemes, including the Organization for Economic Co-operation and
Development (OECD), the Pacific Association of Tax Administrators (PATA), the
Joint International Tax Shelter Information Centre (JITSIC), and the Seven
Country Tax Haven Working Group.

General Trends in International Tax Enforcement in Canada

The CRA is increasing its enforcement relating to its audit and inspection activity.
This trend is consistent with the CRAs objective of focusing more on international
transactions and, more specifically, aggressive taxpayers. Aggressive tax
planning, which includes international tax compliance, has been one of the CRAs
top four compliance priorities. The CRAs budget related to international taxation
has also increased. The 2005 federal budget allocated $30 million annually to
address aggressive international tax planning. As of March 2006, the CRA had
320 auditors and researchers and 210 non-resident auditors and program
officers. The time budgeted for an international audit of a large corporation has
also increased significantly.
The CRA has also increased its propensity to issue requirements during the early
stages of an audit.
In addition, contemporaneous documentation letters are being issued at the initial
contact stage for the audit. In prior years the contemporaneous documentation
requests were issued at the discretion of the auditor. However, the trend is now
for all CRA auditors to request the contemporaneous documentation at the
beginning of the audit.
Another important trend involves foreign documentation requests. The 2007
auditors report revealed that the CRA has increased the use of information
requests from foreign tax jurisdictions. The report concluded, however, that the
auditors were still not making sufficient use of these provisions where taxpayers
failed to provide the information voluntarily.
The CRA has recently announced the opening of 11 centers of expertise
designed to assist auditors when conducting transfer pricing audits. This has
resulted in an increased number of transfer pricing adjustments being made to
multinational corporations with operations in Canada.
The increase in audit activity has resulted in the CRAs need to increase audit
staff, as well as managers. As a consequence, transfer pricing adjustments are
taking more time to resolve given the influx of new staff. In addition, the
Canadian Competent Authority has hired 9 new analysts and 3 new managers to
assist in the APA program and to negotiate the transfer pricing audits with foreign
countries.
The CRA has also increased the use of its legislative powers by implementing
the use of 247(2)(b) of the Canada Income Tax Act. The concept of recharacterization in a Canadian transfer pricing context permits for the redefining
of transactions when it is felt that the transactions undertaken by related nonarms length parties are not consistent with similar transactions that would
normally be undertaken by arms length parties. This is a clear signal that the

CRA is taking a more aggressive stance in using its power to raise transfer
pricing adjustments. This has resulted in the increased number of cases being
referred to the Transfer Pricing Review Committee.
As of December 2007, a total of 25 cases had been referred to the Transfer
Pricing Review Committee (TPRC) for possible re-characterization. There has
also been an increase in the number of penalties being applied by the TPRC in
accordance with 247(3). As of December 2007, a total of 115 cases had been
referred to the TPRC with a total of 67 cases actually penalized. It seems that
this trend will continue to rise in the future and the need for up-to-date, viable
documentation of a contemporaneous nature will only increase.
Conclusions to Special Topics
Transfer pricing attempts to assign arms length pricing to the transfer of goods,
services and intangibles between related parties. According to some estimates,
approximately 80% of trade across international borders are accounted for by
related parties. Firms naturally have the incentive to price goods such that
profits are maximized in low tax jurisdictions. To address this fact, nation states
have developed transfer pricing rules and regulations that attempt to provide a
framework for determining the intercompany pricing of goods services and
intangibles between related parties.
With the world economy becoming more globalized and investors attempting to
maximize after tax profits, developing countries such as Brazil, Russia, India and
China will need to increase certainty around transfer pricing legislation. For
individual economies competing for a fixed supply of capital, developing
economies will need to institute every evolving transfer pricing legislation that is
fair and transparent.
As countries such as China strive to improve its global competitiveness, it must
continually increase the certainty and transparency of its transfer pricing policies.
This is necessary not only to attract further MNC investment but also to protect
against an exodus of existing foreign investment. MNCs seek certainty and
confidence in their investment decisions. Countries that address and ultimately
increase the transparency of their transfer pricing policies are strongly positioning
themselves to reap large dividends.

THE BANK OF CANADA

INTRODUCTION
Money is something we use on a day to day basis without thinking much about
what it is. It is neither static nor easy to define. It has taken many forms and
continues to evolve today. The introduction of the internet, email transfers and
use of credit cards have changed how we look at money. This lesson highlights
the role of the central bank and the tools it has at its disposal to impact the
economy. We will also discuss some of the difficulties the Bank of Canada has
when conducting policy.
BACKGROUND
The Bank of Canada is Canadas central bank. Its key policy objective to
maintain price stability and its objectives are outlined in the Bank of Canada Act.
Its stated objective is to keep inflation between 1 and 3%. This stated policy
objective occurred in 1991. Before this time, inflation in Canada was much
higher and more unstable. In addition to its key objective of achieving price
stability, it is also responsible for regulating credit and the money market. It
needs to work to protect the value of the Canadian dollar. It also serves to
moderate fluctuations in output and employment if this does not come at the
expense of price stability. Put simple, the Bank of Canada is mandated to
promote the economic and financial welfare of Canada.
Its most important role is to control the money supply. The Bank of Canada is not
a chartered bank and is owned by the federal government. The governor of the
Bank of Canada is appointed for a seven year term and the current governor is
Mark Carney. While the government has final responsibility, the Bank of Canada
acts independently and conducts policy to meet its stated objectives. Given its
goal is mainly to achieve price stability, its objective can sometimes differ
markedly form that of the ministry of finance that is more concerned with output
stability.
Five Main Functions of the Bank of Canada include:
1)Issues currency.
2)
Acts as banker to federal government.
3)
Acts as banker to chartered banks.
4)
Lender of last resort to promote stability.
5)
Controls the money supply.
The Equation of Exchange and Dynamics of the Money supply and the
Dynamics:

Money plays a critical role in determining equilibrium GDP and the level of
prices. The relationship can be presented as:
MXV = PXQ
where:
M
is the money supply
V
is the income velocity of money
P
is the average prices of final goods and services
Q
is the physical quantity of final goods and services produced in a year
The money supply has a direct impact on interest rates and aggregate demand.
When the Bank of Canada alters money supply through open market operations
or changes in the bank rate, it changes the money market equilibrium. The
money market is where money demand and money supply determine the
equilibrium nominal interest rate
The equation of exchange can be used to assess impact of a change in money
supply. For example, if M increases, one of the following must happen namely,:
V must decline by the same magnitude so M V and P Q are unchanged
Or P and Q must rise either individually or together. If money supply increases
and the velocity of money does not change, there will be either higher prices in
the economy (i.e. inflation), greater output of goods or services or a combination
of both.
If money supply increases and the velocity of money does not change, there will
be either inflation, grater output of goods and services or a combination of both.
Controlling the Money Supply
In order to achieve their stated policy objective of keeping inflation in a low and
stable bound between 1 an 3 percent, the Bank uses two key policy tools to
accomplish this. They include open market operations and alteration of the bank
rate.
1. Open market operations
2. The bank rate

Open Market Operations

Open market operations involve the purchase or sale of government securities
by the Bank of Canada in order to affect the money supply. In doing this, the
Bank of Canada can alter the price level via the money supply. This than impacts
the interest rates present in the economy and thus overall demand.
Supposes the central bank wants to increases the supply of money in the open
market. It can buy government bonds, which results in those holding bonds
receiving currency from the Bank of Canada. In return the central bank takes the
bonds and places them in the vaults of the bank. The Bank of Canada has done
this many times in Canadian history especially during the years weak economic
times when growth in output is lagging and little if any pressures exist on prices.
When the economy is in an recessionary phase of the business cycle and facing
an recessionary gap situation, we will often see a an increase in the money
supply in order to stimulate output given little pressure on prices and inflation
exists.
If it was decided that the central bank wanted to decrease the money supply in
order to reduce aggregate demand, it would sell government bonds, thus taken
money off the market. This type of policy is often carried out when the economy
is in an expansionary phase of the business cycle.
The Bank Rate
The main reason banks can operate with a low reserve ratio is that they can
borrow from The Bank of Canada. The bank rate is the interest rate charged to
chartered banks. The higher the rate, the lower is the profit on new loans. In
such a world, fewer loans are made and less money is created. If the Bank of
Canada wanted to reduce the money supply, it would simple raise the bank rate.
To expand the money supply, it would reduce the bank rate.
The Bank of Canada sets a range for the overnight interest rate by using the
bank rate as the upper limit. The overnight interest rate is the rate banks charge
each other for one day loans. The bankers deposit rate is set at the bank rate
minus one-half of one percentage point. This is the rate paid to chartered banks
on their reserve deposits.
Demand and Supply for Money
Demand for money varies inversely with the interest rate. The higher is the
interest rate, the higher is the opportunity cost of holding money. The demand for
money also varies with the level of income. The more income we have the more
money we spend and thus the more transactions that are undertaken that require

money. Also the higher is the price level, the more money is needed
purchase items.

to

Supply of Money on the other hand is largely controlled by the Bank of Canada.
Supply of money is almost perfectly inelastic with respect to interest rate.
Changes in money supply shift the supply curve right if its expansionary or left if
its contractionary.
Money Market Equilibrium occurs where the two curves intersect. At the
equilibrium point, nominal interests are at a point where money demanded
equals money supplied. There is an inverse relationship between interest rates
and the price of bonds. When the price of bonds rises (falls) the interest rate falls
(rises).
Bank of Canada Targeting
Since 1992, the Bank of Canada has attempted to target inflation at 1 to 3%.
The interest rate is the Bank of Canadas key policy variable. It uses monetary
policy to first and foremost target this inflation level. However, when inflation is
under control, the Bank of Canada can use monetary policy to stimulate output
even if this results in some increases inflation level. When there is a
recessionary gap, the Bank of Canada lowers the interest rate which leads to
greater investment spending. Increase demand shifts curve to the right. This
results in greater growth rates in GDP and a higher price level. Recession is
eliminated and growth in real GDP is equal to potential. .
Contractionary monetary policy is used when the economy is beyond full
employment. The economy is overheating and he Bank of Canada is concerned
about inflation. As a result, the Bank of Canada use monetary policy to reduce
the supply of money on the market. This causes an increase in interest rates
which forces investment expenditure to fall, shifting the AD curve to the left. This
results in growth rates in GDP to fall, thus returning GDP back the potential level
of output.
The reasons why it makes sense to target inflation can be seen by the evaluation
of both the short run an long run Phillips curve.
The short run Phillips curve in downward sloping. Unemployment is inversely
related to the level of inflation in the economy. In the short run therefore some
inflation can lead to less unemployment. Some may argue that given this short
term relationship that some inflation is good for the economy. However, the short
run Phillips curve exists given price and wages stickiness suggests that some
inflation have a real effect on the economy. In the long run however, when
wages and prices and fully adjust, no tradeoff exists between inflation and
unemployment. As a results, the long run Phillips curve is vertical. It thus follows
that achieving a policy where prices are as low as possible is best given higher

price levels in the economy do not produce a better conclusion as it relates to

level of unemployment in the economy.
Difficulties in applying monetary policy:
Conducting monetary policy involves a significant time lag. The effects of
monetary policy can occur between 18 and 24 months. Within this time frame,
many thing can happen that would have impacted the monetary policy decision
has it been known.
Coordinated Fiscal and Monetary Policy:
In order to have a larger impact on the economy, governments often conduct
fiscal and monetary policy at the sale time. Fiscal policy in Canada is controlled
by the Minster of Finance while monetary policy by the Bank of Canada.
However, when different policy objectives are trying to be met by both these
participants, policy can lack coordination and can result in a final outcome that is
far from optimal.
SECTION SUMMARY
Money is something we use on a day to day basis without thinking much about
what it is. It is neither static nor easy to define. It has taken many forms and
continues to evolve today. This lesson highlights the role of the central bank and
the tools it has at its disposal to impact the economy. We will also discuss some
of the difficulties the Bank of Canada has when conducting policy.