Fortin.qxd 24/05/01 9:33 AM Page 113 View metadata, citation and similar papers at core.ac.uk brought to you by CORE provided by Research Papers in Economics Interest Rates, Unemployment and Inflation: The Canadian Experience in the 1990s Pierre Fortin 113 THE REVIEW OF ECONOMIC PERFORMANCE AND SOCIAL PROGRESS | 2001 INTRODUCTION The performance of the Canadian econ- omy in the 1990s regarding unemployment he Canadian economy did poorly in looks particularly bad when compared to that the 1990s, particularly in the first half of the United States. Chart 1 depicts the time Tof the decade. Table 1 considers decade path of the Canada-US unemployment rate averages for Canada since 1920. It shows that differential (Canadian unemployment minus in the 1990s per capita real GDP never grew US unemployment). It rose sharply to 4.5 more slowly, and unemployment was never percentage points in 1993 from 2.2 points in higher on average, since the decade of the 1989, reflecting the comparative depth and 1930s. An offsetting factor was the marked length of the Canadian recession. Then it deceleration in consumer prices. Inflation, began to shrink after the Canadian recovery according to the Consumer Price Index, was finally took hold in 1997, but going into at its lowest level since the 1930s. Table 2 2001 it was still 2.7 points — above the extends the comparison to the eight largest 1989 level. In contrast, as shown in Chart 2, economies of the OECD over the 1990s. the Canada-US CPI inflation differential was Canada had the lowest growth rate of all almost consistently negative, indicating that countries for per capita GDP. Its average inflation was higher in the United States unemployment rate (of nearly 10 percent) than in Canada every year except in 1991, was not too far below those observed in when the goods and services tax was intro- France and Italy. Again, Canada’s CPI infla- duced in Canada. Over the nine-year period tion rate was on the low side, exceeding only 1992-2000, the CPI inflation rate averaged those of France and Japan. This review will 2.7 percent in the United States and 1.6 per- focus on the last two dimensions of Canada’s cent in Canada. economic performance in the 1990s — In this broad description of events, the unemployment and inflation. The first key observation is the negative correlation dimension — the trend growth of per capita between inflation and unemployment out- real GDP — is left for others to discuss. comes. The inflation rate was the lowest in Fortin.qxd 24/05/01 9:33 AM Page 114 Pierre Fortin TABLE 1 THE MONETARY TRANSMISSION Growth, Unemployment and CPI Inflation in MECHANISM Canada, Decade Averages 1920s-1990s Growth rate of Unemployment CPI In assessing the role played by mone- real per capita rate inflation tary policy in the events of the 1990s, it is Decade GDP (%/year) (%) rate (%/year) useful to first clarify the framework for dis- 1920s 4.31 3.52 -0.6 cussion. I will rely on the usual three-step 1930s -0.6 13.1 -1.8 “transmission mechanism” of monetary pol- 1940s 3.8 3.2 4.7 1950s 2.4 4.2 2.4 icy (see Thiessen 1995). Consider the case 1960s 3.2 5.0 2.5 of the Bank of Canada tightening monetary 1970s 3.0 6.7 7.3 conditions. The first step is for the Bank to 1980s 1.7 9.4 6.5 withdraw cash from the financial system. 1990s 1.1 9.6 2.2 114 With less cash in circulation, the cost of Note: The growth rate of real GDP per capita is the borrowing and short-term interest rates annual percentage change in the ratio of GDP in con- stant dollars to the total population; the unemployment increase. An immediate consequence is that rate is the average proportion of the labour force who more foreign capital is attracted to are without work; the CPI inflation rate is the annual per- Canadian-dollar assets and that the centage change in the all-items CPI. The standard defi- nition of decades is 1920-29 and so on. For growth and exchange rate of the Canadian dollar appre- inflation, the calculated averages are compounded aver- ciates. These simultaneous increases in age rates of changes over the decade. interest rates and in the value of the 1 Average for 1926-29. 2 Average for 1921-29. Canadian dollar are exactly what is meant Source: Statistics Canada. TABLE 2 six decades, falling below the US rate. In Growth, Unemployment and CPI Inflation in contrast, the unemployment rate was the the Eight Largest OECD Countries, 1990s highest in six decades, exceeding the US rate Averages by a significant margin. This naturally raises Growth rate of Unemployment CPI the following question: If there is a genuine real per capita rate inflation negative trade-off between inflation and Country GDP (%/year) (%) rate (%/year) unemployment, were the policy choices made United 2.0 5.8 3.0 to influence the actual outcomes for inflation States and unemployment in that trade-off the best Japan 1.4 3.1 1.2 Germany 1.6 7.5 2.5 in the circumstances? France 1.2 11.3 1.9 In the following sections, I argue that Italy 1.4 10.6 4.2 Canadian interest and unemployment rates United 1.6 8.2 3.7 were too high and that inflation was too low. Kingdom Canada 1.1 9.6 2.2 I attribute a large share of responsibility for Spain 2.3 19.9 4.2 these outcomes to excessively restrictive monetary policy. I suggest various ways in Note: See definitions in the note to Table 1. Unemployment rates are based on the standardized def- which Canadian monetary policy could be initions used by the OECD. welfare-improving in the future. Source: OECD. Fortin.qxd 24/05/01 9:33 AM Page 115 Interest Rates, Unemployment and Inflation: The Canadian Experience in the 1990s by a “tightening of monetary conditions.” CHART 1 The second step in the transmission mecha- The Canada-US Unemployment Rate nism is that higher interest rates and the Differential: Canadian Unemployment Minus appreciated Canadian dollar both depress US Unemployment, 1989-2000 Percentage points aggregate spending and output. Higher 5.0 interest rates discourage consumption and 4.5 investment, and the appreciated dollar slows down exports and stimulates imports. Lower 4.0 sales and profits then induce firms to reduce 3.5 output and employment. The third step is that weaker profits and higher unemploy- 3.0 ment induce firms and workers to be more 2.5 prudent in setting wages and prices. Wage 115 2.0 growth and price inflation both decline. 89 90 91 92 93 94 95 96 97 98 99 00 Two important characteristics of this mech- Source: Statistics Canada; US Bureau of Labor Statistics. anism are that it takes up to two years to unfold and that it operates in an uncertain economic environment. expectations and gives a clear signal to pub- The following arrow diagram summa- lic and private sector agents as to what rizes the transmission mechanism: monetary policy is up to and how it is going Higher interest rates to react under various circumstances, thus reducing uncertainty. Since 1995 in Canada, the official inflation target has been 2 per- Higher Canadian dollar cent, which is the midpoint of the official target range of 1 to 3 percent. Lower spending, output The arrow diagram clarifies the nature and employment of the policy conflict between the objectives of low unemployment and low inflation. Lower wage growth Increasing interest rates and the value of the and inflation dollar raises unemployment and reduces inflation; decreasing interest rates and the Within this framework, the mandate value of the dollar reduces unemployment of Canadian monetary policy since the and raises inflation. There is a trade-off, and beginning of the 1990s has been to achieve a policy choice cannot be avoided. I will a specified inflation target at least cost in accordingly consider three broad questions terms of lost output and employment. concerning the conduct of monetary policy Setting an inflation target within a speci- in the 1990s. First, have interest rates been fied range is, in my view, a reasonable way too high? Second, have output and employ- of conducting monetary policy in a country ment been too low? Third, has the inflation operating under a regime of flexible rate been too low? My answers to these ques- exchange rate. It helps to stabilize inflation tions will be: yes, yes and yes. Fortin.qxd 24/05/01 9:33 AM Page 116 Pierre Fortin CHART 2 stalling...an outbreak of inflation and getting The Canada-US CPI Inflation Rate the rate of inflation down to lower levels than Differential: Canadian Inflation Minus had prevailed in the 1980s.” He admits that US Inflation, 1989-2000 the Bank of Canada and other forecasters Percentage points 2 were then taken by surprise by the swift reac- tion of the economy: “Although the consen- 1 sus forecast at the time was for a soft landing of the economy, the downturn in 1990-91 0 was much deeper than had been anticipated, -1 the rate of inflation came down much faster than planned, and the recovery was slower -2 than expected.” 116 Freedman attributes the first two occur- -3 89 90 91 92 93 94 95 96 97 98 99 00 rences to the US recession and a sharp decline in commodity prices. He then explains the Source: Statistics Canada; US Bureau of Labor Statistics.