At the risk of being thought "cavalier", I don't like what Bank of Canada governor Stephen Poloz is reported as saying by Kevin Carmichael.
Inflation targeting is supposed to be inflation forecast targeting. The Bank of Canada is supposed to do what is needed to ensure that its own internal forecast of future inflation (at a roughly 2-year horizon), conditional on the Bank's information, remains at the 2% target.
Inflation targeting is supposed to be symmetric. The Bank is supposed to respond to new information about any shock to Aggregate Demand to prevent that shock affecting its forecast of inflation, whether that shock is positive or negative.
The Bank of Canada is not supposed to follow any simple instrument rule, like a Taylor Rule, if that simple rule leaves out any information that might be relevant for the Bank's internal inflation forecast. For example, the only information in the Taylor Rule is the output gap (the difference between current output and potential output) and the inflation gap (the difference between current inflation and target inflation). Using a Taylor Rule implies ignoring any information the Bank of Canada might have about shocks to the natural rate of interest. [I say this notwithstanding the internal inconsistency, like the Cretan Liar Paradox, of the Bank's own Totem model assuming that its own future actions will follow a slightly-modified Taylor Rule.]
The whole point of inflation forecast targeting is that the Bank of Canada does not "accommodate" any shock to Aggregate Demand that would change its internal forecast of future output and hence future inflation. And that includes fiscal policy shocks. The Bank of Canada is supposed to offset any such shock, 100%. It makes no sense for the Bank of Canada to provide any estimate of fiscal policy "multipliers" other than zero. Even calculating a hypothetical "multiplier", for how output would respond if the Bank did "nothing", makes no sense, because the definition of "doing nothing" is arbitrary. Even if we agree that "doing nothing" means "doing nothing with the nominal rate of interest", that leaves open the question of how long the Bank holds the nominal rate of interest constant. And "forever" is not a meaningful answer to that question, because standard New Keynesian models (and the Bank is New Keynesian) tell us that monetary systems will either explode or implode if the central bank holds the nominal interest rate constant forever. [The Bank says it does accommodate the "first-round effect" of short-run supply-side or price shocks, like changes in indirect taxes, but that's not what we are arguing about here.]
When we talk about the Bank of Canada offsetting rather than accommodating changes in fiscal policy, it is important to understand that we are talking about changing the nominal interest rate relative to what it would have been otherwise without the fiscal policy change, and not relative to what the nominal rate was in the past. It's a statement about counterfactual conditionals, not about changes over time. For example, if the Bank gets new information that leads it to expect inflation will fall below target unless it cuts the overnight rate of interest, and at the same time gets new information about fiscal policy, the Bank might decide to leave the rate of interest where it is. The Bank offsets the change in fiscal policy by cancelling a planned cut to the overnight rate.
If the Bank of Canada does what it is supposed to do, and what it says it does, then a temporary increase in the fiscal deficit will cause a temporary rise in the nominal and real interest rate (and nominal and real exchange rate), relative to what would have happened otherwise. [See my old post.] It will have zero effect on the Bank's expectation of the output gap and zero effect on the Bank's expectation of inflation. The Bank's expectations will almost certainly be wrong, of course, because it lacks a true crystal ball model of the economy. But those errors could go in either direction.
I want to interpret Senior Deputy Governor Carolyn Wilkins in Kevin Carmichael's interview as saying:
"Yes I agree with all that, and we welcomed the change in fiscal policy because it meant we could keep forecast inflation on target without having to cut interest rates, which we would otherwise have done. This is a good thing because needing to cut interest rates would have increased the risks to financial stability." That would be an internally consistent thing for the Bank of Canada to say.
If she had added: "Plus, even though we are currently above the Effective Lower Bound on nominal interest rates (which is probably below 0%) we are worried that the margin of safety is getting a bit small, and are pleased that fiscal policy is making that margin of safety a bit bigger than it otherwise would be" that would also be an internally consistent thing for the Bank of Canada to say.
I don't get this bit though:
"Fiscal policy at low interest rates is also just more effective."
You can get that from a model where the Bank of Canada holds the money stock constant, and the demand for money gets increasingly interest-elastic at lower interest rates so the LM curve gets flatter. But the Bank of Canada does not hold the money stock constant. If the Bank of Canada held the nominal interest rate constant the LM curve would be horizontal. If the Bank of Canada adjusts the interest rate and/or money stock to keep output at potential, and inflation on target, then it tries to make the LM curve vertical at potential output.
Back to marking exams.