708 PA R T V I I Monetary Theory Our historical review of Bank of Canada policymaking in the Web Appendix to Chapter suggests that the Bank has not always done what it set out to In the early 1970s, the Bank accommodated inflationary shocks by raising the rate of growth of monetary aggregates, thereby forming expectations of rising inflation When in 1975 the Bank adopted a gradual anti-inflation policy, the public had no reason to believe in such a policy As Robert Lucas of the University of Saskatchewan argues, For various reasons, including the caution of the Bank in moving too quickly for fear of generating large increases in the unemployment rate in the transition to lower inflation, the policy was a failure Such episodes reduced the credibility of the Bank of Canada in the eyes of the public and, as predicted by the new classical and new Keynesian models, had serious consequences For example, when the Bank embarked on a very restrictive monetary policy in the summer of 1981, following the Federal Reserve Board of the United States, it was successful in generating a significant decline in the inflation rate (from 12% to 4%), but it initiated the most severe recession in the post World War II period Clearly, unless some method of restoring credibility to anti-inflation policy is achieved, eliminating inflation will be a costly affair because such policy will be unanticipated Recently, however, the Bank of Canada acquired considerable credibility When the Bank and the Department of Finance jointly announced inflation targets in 1991, they were clearly credible In fact, as David Johnson of Wilfrid Laurier University argues, this particular announcement had little effect on the level of inflation in the short run, but the subsequent revision of inflation targets and the 1993 change in governor (from Governor Crow to Governor Thiessen) were handled in such a way that the Bank s anti-inflation policy turned out to be successful.9 The Canadian government can play an important role in establishing the credibility of anti-inflation policy We have seen that large budget deficits may help stimulate inflationary monetary policy, and when the government and the Bank of Canada announce that they will pursue a restrictive anti-inflation policy, it is less likely that they will be believed unless the federal government demonstrates fiscal responsibility Another way to say this is to use the old adage Actions speak louder than words When the government takes actions that will help the Bank of Canada adhere to anti-inflation policy, the policy will be more credible Unfortunately, this lesson has sometimes been ignored by politicians in Canada and other countries Robert F Lucas, The Bank of Canada and Zero Inflation: A New Cross of Gold? Canadian Public Policy 15 (1989): 84 93 David R Johnson, Expected Inflation in Canada 1988 1995: An Evaluation of Bank of Canada Credibility and the Effect of Inflation Targets, Canadian Public Policy 23 (1997): 233 258 APP LI CAT IO N Credibility and Budget Deficits The Reagan administration in the United States was strongly criticized for creating huge budget deficits by cutting taxes in the early 1980s In the Keynesian framework, we usually think of tax cuts as stimulating aggregate demand and increasing aggregate output Could the expectation of large budget deficits have helped create a more severe recession in 1981 1982 after the Federal Reserve implemented an anti-inflation monetary policy?