Nov. 30, 2005
The current strategy of Canada and most G7 countries appears to focus on trade as the engine of growth of the domestic economy.
This can be analysed by using the conventional Keynesian and neo-classical macro-economic equation of
C+ I + G-T + X-M = GDP. where C is consumption, I is investment, G is government expenditures, T is tax revenures and X is exports and M imports. Currently the Government of Canada is running a budgetary surplus. This means that G-T is negative.
To offset this the Government is counting on exports X to exceed M imports and for investment I to be larger because they believe that a surplus guarantees low interest rates because they believe in the theory of loanable funds. Lower rates means higher I investment and therefore the combination of higher I and a booming export industry translates into faster economic growth and lower unemployment.
But what if the Bank of Canada does not co-operate and raises interest rates?
Look what happens. A rate rise leads to less investment, that is I declines and higher rates mean a stronger Canadian dollar. A stronger Canadian dollar in the absence of offsetting gains in productivity through increased use of technology or lower wages means less competitive exports and the gap between X and M diminishing. All of this adds up to slower growth and not as big a rise in the GDP.
Now if the surplus is used to retire outstanding debt the return of funds to bondholders may offset some of the pressure of rate rise but it also complicates the problem of translating these returned savings no longer in asset form but in cash form into investments. At the same time taxes which exceed spending subtracts purchasing power from the economy. So the strategy of putting too many eggs into the export led growth strategy without at the same time ensuring a supportive fiscal and monetary policy could backfire. That is why the tax cuts and the new program expenditures are so important. More on this in future blogs.
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