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Inflation in Canada
1
Inflation in Canada
In this web-based section, we continue the discussion of Canadian inflation policy that
we began in Chapter 30. We begin our study with the inflation of the 1970s. See Figure 1
for the time path of the annual inflation rate in Canada over the past three decades. In
the discussion that follows, it will be useful to refer back to this figure frequently.
The early 1970s witnessed quite expansionary fiscal and monetary policies. The
money supply was expanded rapidly, and an inflationary gap opened up as real GDP
exceeded its potential level. As a result, inflation began to rise. Expansion continued
until early 1974, and inflation rose throughout that period. Then a worldwide recession began, and Canada did not escape its effects. As a recessionary gap began to open
up, the normal expectation was that inflation would diminish. Just then, however, the first
OPEC shock hit. The prices of oil and other petroleum products soared. This negative
supply shock reduced the growth of real GDP and sent inflation into the double-digit
range. The result was stagflation.
The Rise of Inflation: 1975–1980
Rather than viewing the stagflation as the result of rising oil prices, Canadian policymakers interpreted the stagflation as accelerating wage-push inflation in a time of world
recession. Having failed in an attempt to secure the agreement of organized labour in a
voluntary policy of reducing wage demands, the government decided to impose wage and
price controls. An Anti-Inflation Board was set up and given power to control wages and
prices for three years. At roughly the same time, the Bank of Canada adopted the policy
of “monetary gradualism” by announcing its intention to gradually reduce the rate of
growth of the money supply.
wage and price
controls Direct
government intervention
into wage and price
formation with legal power
to enforce the government’s
decisions on wages and
prices.
Canadian CPI Inflation, 1965–2003
FIGURE 1
Annual Percentage Change in CPI
14
12
10
8
6
4
2
0
1965
1969
1973
1977
1981
1985
Year
(Source: Statistics Canada, CANSIM database, Series V735319.)
© 2005 Pearson Education Canada Inc.
1989
1993
1997
2001
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Inflation in Canada
Whether by accident or by design, the two policies made a coherent package.
The monetary policy was meant to reduce the speed with which the AD curve was
shifting upward. Wage-and-price controls were meant to reduce the speed with which
the AS curve was shifting upward. If the upward rush of the two curves could be
slowed at the same rate, the inflation rate could be reduced without having to endure
the stagflation phase, which occurs when the AD curve rises more slowly than the AS
curve.
At first, all seemed to go well. The inflation rate fell in successive years starting in
1975. Then in 1979 and in 1980, a new setback appeared in the form of a substantial supply shock. The cause was another large increase in the world price of oil, due to a second round of OPEC output restrictions. As a result, the 1980 inflation rate became
once again as high as it had been just before wage and price controls were introduced.
The Fall of Inflation: 1981–1984
By the beginning of the 1980s, rapid inflation seemed firmly entrenched, and a major controversy arose over how to reduce it. Most people agreed on the goal of returning to a
much lower inflation rate, but there was disagreement as to the means of achieving
that goal.
Some economists—especially those that believed people’s expectations of inflation
adjust quickly—advocated breaking the entrenched inflation with monetary restraint
in the manner analyzed in Chapter 30. Since they felt that there would be a short Phase
2, they were willing to rely exclusively on monetary policy to bring about the transition from a high- to a low-inflation environment.
Other economists agreed that a low rate of monetary growth was a necessary condition for returning to a low rate of inflation. However, because they felt that Phase 2
would be long—some talked in terms of 5 to 10 years—they were reluctant to use
monetary policy alone during the transition. As a result, these economists advocated
using wage and price controls once again in conjunction with a restrictive monetary policy.
In 1981, with inflation above 12 percent, the Bank of Canada chose to follow the
United States in adopting a highly restrictive monetary policy. A serious recession eventually
moderated wage and price increases. When it came, the fall in inflation was dramatic:
from a peak of 12 percent in mid-1981 to around 4 percent by early 1984. By 1984, the
restrictive monetary policy had thus succeeded in reducing inflation to a level not seen
since the early 1960s. But the sharp reduction in inflation had also contributed to a major
recession with all its attendant costs, including unemployment, lost output, business
bankruptcies, and foreclosed mortgages.
The results came out somewhere between the extremes that had been predicted. Thus,
as so often happens with great debates, neither the extreme pessimists nor the extreme
optimists were right—the truth lay somewhere in between. Whatever the reasons, during the
early 1980s, inflation fell faster than many economists had expected, but the slump was
deeper and more prolonged than many others had expected.
Recovery: 1985–1990
For several years following 1984, the Canadian inflation rate stabilized at around 4 percent, and it was a time of low inflation in the world as a whole. There was no reason
for the inflation rate to rise, since there was no inflationary gap in the Canadian econ-
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Inflation in Canada
omy. Indeed, since there was actually a recessionary gap during this period, the actual
inflation seemed to be purely expectational: People expected a 4 percent inflation rate,
and the Bank validated that inflation rate through a continued monetary expansion.
Thus, inflation persisted at a rate of about 4 percent.
Since there was a recessionary gap during this period, why did inflation not fall further? The answer here seems to be that the weak demand forces that work toward deceleration when there is excess supply were swamped by the forces of expectational inflation
and random shocks.
By 1988, a long period of expansion was bringing Canadian real GDP close to its
potential level. The inflation rate began to creep upward, exceeding 5 percent in 1989 and
reaching 6 percent for a few months in 1990.
As we discussed in Chapter 29, the Bank of Canada in 1988, under the leadership
of Governor John Crow, announced that monetary policy would no longer be guided
by short-term stabilization issues and instead would be guided by the long-term goal
of price stability. This important shift in policy indicated that henceforth the Bank of
Canada would be prepared to fight inflation while more or less ignoring the shortterm pain that such battles would produce.
Disinflation: 1991–1992
In 1989 the Bank of Canada reacted by adopting a restrictive monetary policy. Interest
rates were driven up and the Canadian dollar appreciated, putting tradable-goods producers under heavy competitive pressure. The country’s economic expansion proved
remarkably resilient. The inflationary gap and the high inflation rate persisted for over
a year, in spite of very high interest rates and a strong Canadian dollar. Finally, by the
middle of 1990, the inflation rate began to fall. By autumn, it had returned to the 4 percent plateau from which it had accelerated two years earlier. The Bank, however, persisted in its tight policy.
By late 1990, the economy was clearly into a recession and many who supported the
Bank’s long-term policy of price stability nonetheless called for a little fine tuning to
offset some of the short-term pain associated with monetary restraint. They felt that
the Bank could mitigate the recession by easing up on its tight monetary policy, returning to it once the next recovery had begun. The Bank responded by reiterating the
importance of driving the inflation rate close to zero over a period of a few years.
As a way of formalizing the Bank’s shift in policy away from short-term stabilization and toward long-term price stability, the Bank of Canada and the federal Department
of Finance announced in 1991 a series of inflation-control targets. Beginning in 1992,
the Bank would aim at having the rate of inflation in the 3–5 percent range. The target
range declined gradually so that by the end of 1995 it was 1 to 3 percent.
This policy sparked enormous controversy. Some critics felt that the costs of
reducing the inflation rate below 4 percent, as reflected by the sacrifice ratio, would
be excessive. They preferred to have the economy adjust to that rate rather than
undergo the costs of reducing the rate to 2 percent, let alone to zero. Other critics, while
accepting price stability as the ultimate goal, argued that the policy should not be
pursued when the economy was already in the midst of a serious recession.
Supporters of the Bank’s policy pointed out that 4 percent inflation was a high inflation rate by historical standards. They argued that price stability was the best long-run
goal. To the critics who said, “yes, but not now,” the supporters replied that reducing a
sustained inflation is always costly, and there will always be strong arguments for not
incurring these costs at present. They felt that the commitment to price stability must be
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Inflation in Canada
honoured and the costs accepted, since the longer that attempt was postponed, the more
entrenched would inflation expectations become and, thus, the greater would be the
costs of finally reducing inflation.
In the event, the Bank stuck to its policy. The recession was severe. Canadian interest rates stayed well above U.S. rates, and the Canadian dollar remained high on foreignexchange markets. However, the inflation rate responded as theory predicts and, by the
end of 1992, the Bank was able to declare victory against inflation. Inflation was well
below 2 percent.
A Decade of Low Inflation
The subsequent economic recovery was considered to be a fragile one, at least until
1993. Many people blamed the Bank for the deep recession that Canada suffered, and
much of the disagreement over the Bank’s policy became focused on the governor, John
Crow. In 1994, the minister of finance in the newly elected Liberal government
appointed Gordon Thiessen as the new governor of the Bank of Canada. At the same
time, both the finance minister and Mr. Thiessen affirmed the recent monetary policy
of the Bank and announced that the formal inflation targets of 1 to 3 percent would
continue. So, political considerations dictated a change in the governor while
economic considerations dictated no change in monetary policy.
By 1995, economic growth had picked up considerably, even though the unemployment rate seemed to decline only slowly. The Bank’s main challenge during this
period of recovery was to provide enough growth in the money supply to allow a healthy
recovery while at the same time not expanding so much that inflationary pressures
would build. From 1995 to 1999, the rate of inflation was mostly within the established
1 to 3 percent target range, though in 1998 it temporarily dropped below the bottom of
the range. By early 2000, real GDP was very close to potential GDP, the economy was
growing quickly, and inflationary pressures began to build. The bank began to tighten
monetary policy in an effort to keep inflation from rising.
Beginning in 2001, after several years of strong economic growth and relatively stable inflation, the U.S. and Canadian economies began to slow, and both countries’ central banks embarked on aggressively expansionary policies designed to stimulate growth
and prevent inflation from falling below target levels. In both countries, the short-term
policy interest rates were reduced by over 2 percentage points in the first nine months of
2001. The terrorist attacks in New York and Washington, D.C., on September 11, 2001,
contributed hugely to a lack of confidence in what were already economies showing
lacklustre performance. The U.S. Federal Reserve and the Bank of Canada responded
quickly by lowering their key policy interest rates even further—by one and a half percentage points over the next three months.
Following this considerable monetary stimulation and the economy’s natural healing process, the Canadian economy rebounded more quickly than did the U.S. economy. The Bank of Canada therefore began tightening its policy early in 2002, even while
the Federal Reserve continued on an expansionary path. By 2003, however, growth in
Canada had slowed to below the rate in the United States. In both countries, the growth
rate of real GDP was then below the growth rate of potential output, and both countries’
recessionary gaps were increasing. With continued pressure in both economies for inflation to fall, both central banks were reluctant to raise their short-term policy interest rates
until a healthy growth rate of real GDP appeared to be sustainable.
© 2005 Pearson Education Canada Inc.