In Canada, and indeed in most western economies, separate institutions control monetary and fiscal policies. Elected governments determine tax rates and levels of government spending on things like roads, sewers, social assistance, pensions, health care spending. Central banks are in charge of decisions about the size of the money supply and the level of interest rates. The headsof central banksarenotelectedbutare, rather, appointed. The independenceofthe Governorof theBank ofCanadatoset interestratesandthemoneysupplyat levelsthe Governordeemsappropriateis unchallenged. Since 1988,thestatedgoalof the Bank of Canadahasbeen to maintain amore orlessconstantrateofinflation.Forour purposes,we willassumethis isequivalentto a goal of holding the price level constant.Very recently, the federal government (and quite a number of provincialgovernments)have been introducing large spending increases.

Sketch a well labelled diagramshowinganaggregate demandcurveintersecting a long run aggregate supply curve and a short run aggregate supply curve at some price level (call it Po). To keep things manageable let's assume a closed economy with notrade.Use this set upto examine the macroeconomicimplicationsofthe Bank of Canadapursuingagoalof price stability while at the same time the federal government pursues an expansionary fiscal policy (increasing levels of spending). Using your diagram as an aid, explain what will happen to each of the following economic variables when the federal government increases spending while at the same time the Bank of Canada seeks to maintain price stability:

? The money supply

? The position of the aggregate demand curve

? The price level

? Output

? The interest rate

? Private-sector investment

Conclude your answer withsomecomments on (a) theimplicationsof yourfindingsfor the long-termcapital acquisition goals of your firm, (b) the implications for

Resulting Macroeconomic Factors: Variables Federal Government Increases Spending Expansionary policies increase the money supply. With an increase in the money supply comes an increase in interest rates, and a decrease in exports. Spending and GDP both rise from the new money _ available. These measures would push the demand curve to the right due to the _ increase in GDP resulting from the increase in spending The price level would increase as a result of the increased money available in the economy, which would in turn increase the total output to maximize returns I Output increases from the greater availability of money to both rms and consumers, and for the benet of increased prots if the expenditures remain constant. I As consumers have a greater money supply, this encourages an increase in private-sector investment due to the potential of increased returns. Since spending and output increase, interest rates increase to meet increased demand. As rates continue to increase it starts to have a _ negative effect on spending and output due to the increases cost. Aggregate Demand & Supply Curves Price Level LRAS - 1 Legend SRAS - 1 AD - Aggregate Demand LRAS - Long Run Aggregate Supply SRAS - Short Run Aperezate Supply R- Interest Rate P Y - GOP Po AD - 1 AD - 2 Yo Y1 Output or Income (GDP) Aggregate Demand & Supply Curves Interest Rate LRAS - 1 Legend SRAS - 1 AD - Aggregate Demand LRAS - Long Run Aggregate Supply SRAS - Short Run Aggregate Supply R- Interest Rate R1 Y - GOP Ro AD - 1 AD - 2 Yo Y1 Output or Income (GDP)Bank of Canada Seeks to Maintain Price Stability The Bank of Canada will decrease the supply of money and always aims to stabilize ination. They will do so by selling bonds. The demand curve would shift to the left from the increased interest rates, lower demand, and lower price levels. Price levels decrease from the resulting decrease in demand from Variables higher interest rates. Producers will not increase prices as to attract more buyers. reducing consumer borrowing. Due to the higher borrowing costs privatesector investment Aggregate Demand & Supply Curves Price Level LRAS - 1 Legend SRAS - 1 AD - Aggregate Demand LRAS - Long Run Aggregate Supply SRAS - Short Run Aggregate Supply R - Interest Rate Y - GDP Po P1 AD - 1 AD - 2 Y1 Yo Output or Income (GDP) Aggregate Demand & Supply Curves Interest Rates LRAS - 1 Legend SRAS - 1 AD - Aggregate Demand LRAS - Long Run Aggregate Supply SRAS - Short Run Aggregate Supply R1 R- Interest Rate Y - GDP Ro AD - 2 AD - 1 Y1 Yo Output or Income (GDP)Aggregate Demand & Supply Curves Price Level LRAS - 1 Legend . AD - Aggregate SRAS - 1 Demand . LRAS - Long Run Aggregate Supply . SRAS - Short Run Aggregate Supply . P - Price . Y - GDP Po AD - 1 Yo Output or Income (GDP)