Question

In the aftermath of the global COVID-19 crisis, Canadian Government rans unprecedented budget deficits, yet interest rates in Canada fell sharply, and stayed low for quite some time.

4. Does this make sense? Explain why, or why not.

Answer 1

Yes this indeed makes sense if you think about the complete impact of covid-19 on the Canadian economy. The pandemic triggered a huge lockdown and containment kind of state in not only Canada but across the world. The implications of this are that - A fall in consumption expenditure by the general public - in terms of reduced fuel costs, reduced expenses due to going out and traveling in general At the same time many firms and shops had to shut down and so planned investment had also fallen. Further since as there are travel restrictions and loss of communication in terms of import-export - a fall in net export could also have been the case. However candian imports have fallen as well so we will consider a neutral impact of it. This describes the impact of covid-19 on the economy.

Now consider the budget deficit. A deficit means government spends more than it earns in taxes. This happens because of high public medical and insurance cost incurred by the governmet. Along with this to fight the economic downturm many fiscal boosts are being provided by the government primarily in terms tax credits and deferals. So there is a rise in G component of the aggregate expenditure. Also note that tax collections would have reduced during pandemic due to lack of aggregate demand for goods and services.

Now lets consider the combined effect here. Due to covid there is a huge fall in aggregate demand due to fall in C and I. This would shift the IS curve to the left by a large amount. While the rise in government expenditure does raise AD and shifts IS to the right, its not enough to raise interest rate. Theoritically it should still be way below the pre-covid level. So this does make sense.

I have drawn a simple I-LM illustration to explain the case. ISo, r0 is pre-covid level;IS1,r1 is due to the demand shock due of the pandemic and IS2,r2 (<r0) is the after fiscal deficit due to rise in G.