GOVERNMENT DEBT AND DEFICITS IN CANADA: A Macro Simulation Analysis

Tiff Macklem, David Rose and Robert Tetlow

Staff Working Papers from Bank of Canada

Abstract: This paper examines the macroeconomic implications of rising government debt in Canada and the short-run costs and long-run benefits of stemming the rise. The discussion begins with an evaluation of the long-run consequences of increasing government indebtedness, first based on the simple arithmetic of the government's long-run budget constraint, and then based on simulations of the Bank of Canada's main model of the Canadian economy, which incorporates several channels through which government debt may affect real economic activity. The principal conclusion is that the main economic cost of higher government debt is a lower sustainable level of domestic consumption. Simulations with the full dynamic model highlight the trade-off of short-run loss for long-run gain presented by deficit reduction. There are important short-run costs of stemming a rise in debt. However, the results of this paper show that substantial net gains are obtained from doing so, since the present value of the permanent long-term gains in consumption far outweigh these short-term costs. The simulations also suggest that a fiscal contraction would require an easing of monetary conditions relative to what they would have otherwise been to maintain an inflation target. Les auteurs examinent les repercussions macroeconomiques de l'accroissement de la dette publique au Canada ainsi que les avantages et les inconvenients qui sont lies, a long et a court terme respectivement, a une deceleration de cette derniere. Les auteurs commencent par evaluer les consequences a long terme d'un accroissement de l'endettement du secteur public en s'appuyant d'abord sur un calcul simple de la contrainte budgetaire a long terme du secteur public, puis sur des simulations effectuees a l'aide du principal modele que la Banque utilise pour representer l'economie canadienne. Ce modele incorpore differents mecanismes permettant a la dette du secteur public d'influer sur l'activite economique reelle. La principale conclusion que tirent les auteurs est qu'une baisse permanente du niveau de la consommation interieure constitue le plus important cout economique que peut engendrer l'accroissement de l'endettement du secteur public. Les simulations effectuees a l'aide du modele dynamique complet font ressortir l'arbitrage qui existe entre les pertes a court terme et les gains a long terme decoulant d'une reduction du deficit et indiquent que les couts a court terme d'une deceleration de la dette sont importants. La presente etude montre toutefois qu'un tel ralentissement donne lieu a des gains nets substantiels, etant donne que la valeur actuelle de l'accroissement permanent a long terme de la consommation est de loin superieure aux couts a court terme. Les simulations laissent egalement supposer qu'un resserrement de la politique budgetaire necessiterait des conditions monetaires plus souples que ce ne serait le cas si une cible de reduction de l'inflation etait maintenue.

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