1. The federal government budget documents list the average forecasts of private forecasters for the Canadian economy. According to those documents, the average forecast for nominal GDP growth is 4.9% in 1997 and 4.7% in 1998 while for real GDP growth the values are 3.3% in 1997 and 2.9% in 1998.

(a) What are the average forecasts for the inflation rate, measured by the growth rate of the GDP deflator?

(b) Suppose that the natural rate if unemployment is 8% and that the expectations-augmented Phillips Curve is given by:
pi - pi ^e = -2(u - u ^* ).
Given the forecasts in part (a), what inflation rates would accompany 9% unemployment in each year?

2. Read Miles Corak's ``Three Stories About UI and Canada-US Unemployment Rates'' Policy Options, July-August 1996, pp. 33-37 (JL1.P6t, also on reserve). Then answer the following questions: Can Canada's system of unemployment insurance explain the Canada-US unemployment rate gap in the 1990s? Can hysteresis account for the persistence in Canada's unemployment rate?

3. Suppose that the expectations-augmented Phillips Curve is:
pi - pi ^e = -2(u - u ^* ). Suppose also that pi ^e_t+1 = pi _t , so that the forecast of next year's inflation is this year's inflation.
Suppose that initially pi = pi ^e = 5 and u ^* =8.

(a) Suppose that the central bank announces and then carries out a disinflation program, in which the inflation rate is 4% this year, 2% next year, and then 0 thereafter. The announcement does not affect inflation expectations. Find the unemployment rate each year.

(b) Is there any reason why central banks might not be believed when they make such announcements?

(c) In Canada in the 1990s eligibility for employment insurance has declined, as has the duration of benefits. As a result, the proportion of those unemployed who collect insurance has fallen to less than 0.5. Suppose that the government makes these changes at the same time as the change in the inflation rate. What effect does this have on your predictions in part (a)?

4. Read the November 1996 Monetary Policy Report of the Bank of Canada, then answer the following question:

What factors might lead to increased inflation in 1997?

What factors might lead to decreased inflation instead?

5. Suppose the money supply (M1) is $60 billion, currency held by the public is $25 billion, and the reserve-deposit ratio is 0.12.

(a) What is the quantity of bank deposits?

(b) What is the quantity of bank reserves?

(c) What is the quantity of the monetary base?

(d) What is the value of the money multiplier?

6. Recently, the Bank of Canada has reacted to strengthening of the Canadian dollar by making redeposits. Explain how a redeposit works, and why the Bank reacts this way.

7. To help answer this question, see pages 598-600 and Appendix 16A. This question uses the identity:
growth(B / PY) = (primary deficit) / B + i - growth(PY)
to study federal fiscal policy circa 1993.

(a) Suppose that over the next year the growth of nominal GDP is expected to be 4% and the nominal interest rate on federal debt is 6%. The outstanding debt is $600 billion, and the debt-GDP ratio is 0.55. If the primary deficit is zero (primary balance) then what will the debt-GDP ratio be at the end of the year?

(b) Suppose instead that looser monetary policy lowered i to 4.5% and raised expected growth in nominal GDP to 5.5%. Now what will happen to the debt-GDP ratio with the primary balance you found in part (a)? What size of primary deficit could the government run with a stable debt-GDP ratio?

(c) In your opinion, should monetary policy have been looser in Canada in the early 1990s?

1. (a) In 1997 1.6% and in 1998 1.8%.
(b) -0.4; -0.2

2. (a) countercyclical
(b) coincidnet or perhaps lagging
(c) yes

3. (a) 8; then 8.5; 9; 9;
(b) See the discussion of credibility in Chapter 15.
(c) These changes reduce u ^* and so the predicted unemployment rates are lower each year. This deepens the puzzle of explaining persistently high Canadian unemployment rates.

4. Inflation in 1997

There are several factors that could increase the inflation rate in 1997. These include a relatively loose monetary policy and strong economic growth in the latter part of 1996. In contrast, there are also deflationary pressures acting on the economy that will offset upward price shocks. On balance, it is unlikely that inflation will deviate from the Bank of Canada's one-to-three percent target band in 1997.

PART A: Factors Favouring Increased Inflation

A factor that could lead to increased inflation in 1997 is the effect of loose monetary policy. The Bank initiated five reductions in the Bank Rate in 1996 to stimulate the economy. The impact of an expansionary monetary policy is difficult to predict for 1997 since monetary policy operates with "long and variable lags".

Unanticipated commodity price or exchange rate shocks could also raise inflation. An exchange rate depreciation would cause foreign goods to become increasingly expensive. In addition, if expected inflation rises then labour will demand higher nominal wages to compensate for the erosion of purchasing power.

Another potential inflationary pressure is increased spending by the private sector. Expenditure on durable goods, such as housing and capital investment is projected to increase in 1997. Net exports should also expand with growth in the US and European economies. Following the sharp inventory adjustment of 1996, an unexpectedly large increase in final sales will translate into increased production.

PART B: FACTORS MAINTAINING INFLATION WIHIN 1-3%

The strongest deflationary pressure is the output gap entering 1997. In 1996, the Bank of Canada estimated that the output gap stood at 3 to 3.5 percent of GDP. Slack labour markets and an underutilized capital stock reflect the gap. There is likely to be substantial room for growth before inflation resurfaces.

In addition to the output gap, there are also the effects of monetary policy credibility. If the inflation targets are credible, then nominal wage growth should be contained to expected inflation plus productivity growth.

Another risk follows the tightening of monetary policy in the US. The result could be slower economic growth in Canada's largest trading partner. Stricter US monetary policy may also induce higher rates in Canada.

Finally, an unexpected exchange rate depreciation raising domestic prices is unlikely. Canadian "fundamentals" are relatively strong. The external balance is in surplus, inflation is relatively low and fiscal retrenchment is reversing unsustainable borrowing. Persistent deficits have caused the federal-provincial debt-to-GDP ratio to exceed 100 percent.

5. (a) $35 billion
(b) $4.2 billion
(c) $29.2 billion
(d) 2.05

6. In the 1970's, the U.S. and Canada had comparable levels of unemployment, on average. During the 1980's however, not only did the Canadian rate increase significantly, it also began to diverge from that of the U.S.. Along with a persistently high level of unemployment in Canada, the present decade has seen a widening in the gap between the two countries. Although at least some of the differential in the 1980's can be explained by the Canadian UI program it is not clear how much, if any, of the present difference and especially its growth over that of the 80's can be attributed to UI.

The main argument in favour of the UI program in Canada being the cause of this differential has been its relative generosity in comparison to it's U.S. counterpart, especially in light of its variable entrance requirements and regionally extended benefits. Higher unemployment rates in Canada might therefore be due to the fact that it's more in the interest of non-working Canadians to be considered part of the labour force than it is for non-working Americans. Higher benefits should therefore result in higher unemployment rates, especially in regions where qualification periods are lower. Similarly, longer entitlement periods could promote longer durations of unemployment. However, changes to UI in the early 1990's have meant that the difference in generosity between the two programs has narrowed considerably. This should have resulted in a decrease in the unemployment rate differential if generosity was the cause. Instead, it has widened from two to three percentage points in the 80's to three to four points in the 90's. In regards to regionally extended benefits, empirical evidence simply does not seem to support it as an important cause, especially in the 90's when reforms made this aspect of UI even less generous.

It has also been argued that as time goes on, and more people have made use of the program, not only will unemployment increase because individuals learn how UI works and therefore become more likely to take advantage of its relative generosity, but also because the stigma attached to receiving UI is decreasing. While there is some evidence that both incidence and duration may be effected by this process, it clearly does not account for the large U.S.-Canadian unemployment rate differential.

If the unemployment insurance program can't account for the persistently high level of unemployment in Canada then hysteresis may provide some insight. The natural-rate hypothesis holds that "fluctuations in aggregate demand affect output and employment only in the short run. In the long run, the economy returns to the levels of output, employment, and unemployment described by the classical model." Some economists now feel that these effects on output and employment may persist even in the long run. Hysteresis means that changes in the unemployment rate may alter the natural rate of unemployment. A recession, such as that in 1981-82, may therefore have had a significant long term effect on the level of unemployment, by raising the natural rate roughly three percentage points.

Several explanations exist on how this occurs. First, individuals might lose valuable job skills while out of work during a recession, lowering there ability to find employment. Alternatively, long periods of unemployment may reduce an individuals drive to find employment. In either case, a recession could permanently harm the process of job search, thus increasing frictional unemployment. Insider-outsider theory also suggests that recessions can permanently affect the economy by changing the process that determines wages. During a recession, some unionized workers will lose their jobs, thus becoming outsiders. Insiders, those with jobs, will care more about their own wages than the status of the outsiders and will therefore negotiate the highest wages consistent with their own employment. This may push wages to a level where the firm cannot hire back outsiders after the recession. If real wages are pushed above the equilibrium level, higher wait unemployment results. Higher levels of unionization in Canada could therefore account for our persistently higher unemployment.

7. (a) 0.561
(b) 0.544; then if there were to be no growth in the debt-GDP ratio, there could be a primary deficit of 1% of the debt, or $60 billion.