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Explain why the Bank of Canada had a credibility problem during the 1970s.
Answer: In the early 1970s, the Bank of Canada accommodated inflationary shocks by raising
the rate of growth of monetary aggregates, thereby forming expectations of rising inflation.
When in 1975 the Bank of Canada adopted a gradual anti-inflation policy, the public had no
reason to believe in such a policy. This reduced the credibility of the Bank of Canada in the eyes
of the public.
Diff: 2 Type: SA Page Ref: 631
Skill: Recall
Objective List: 26.2 Characterize the discretionary versus nondiscretionary and rules versus
discretion policy debates
Describe how the Bolivian government managed its hyperinflation by introducing credibility.
Answer: In the first half of 1985, the Bolivian economy faced inflation of 20,000 percent. In
August 1985, the Bolivian president announced his anti-inflation program, the New Economic
Plan. To rein in money growth and establish credibility, the new government reduced the budget
deficit by shutting down state owned enterprises, eliminated subsidies, freezing public sector
salaries and collecting a new wealth tax. The budget was balanced on a day-by day-basis. The
Finance minister would not authorize spending in excess of the amount of tax revenue that had
been collected the day before. The Bolivian inflation was stopped within one month and output
loss was less than 5 percent of GDP.
Diff: 2 Type: SA Page Ref: 632
Skill: Recall
Objective List: 26.2 Characterize the discretionary versus nondiscretionary and rules versus
discretion policy debates
How did Canada win the battle against inflation?
Answer: The Bank of Canada battled against double digit inflation and stayed the course over
two major recessions in the 1980s. By the end of 1983, inflation had fallen to less than 5 percent.
In 1988, the Bank of Canada and federal government announced jointly a series of inflation
targets.
Diff: 2 Type: SA Page Ref: 632 - 633
Skill: Recall
Objective List: 26.2 Characterize the discretionary versus nondiscretionary and rules versus
discretion policy debates
Provide some alternate approaches to establishing credibility.
Answer: To achieve credibility, the central bank may announce inflation targeting or exchange
rate targeting that allows a country to peg its exchange rate to an anchor country that has a strong
nominal anchor. Another method is to appoint central bankers who have a strong version to
inflation.
Diff: 2 Type: SA Page Ref: 633
Skill: Recall
Objective List: 26.2 Characterize the discretionary versus nondiscretionary and rules versus
discretion policy debates