Government Debt in an Open Economy

This paper introduces the CORE model, a prototype for a new quarterly model of the Canadian economy, designed for projections and policy analysis with focus beyond the very short run. The model has a clearly defined equilibrium and explicit adjustment mechanisms, primarily through relative prices, that are dynamically stable. Overlaid on a neo-classical growth model are shorter-term dynamics, roughly calibrated to reflect the Canadian data. Careful distinction is drawn between dynamics that arise from adjustment costs and other rigidities in the economy and dynamics that arise from the perceptions and expectations of economic agents. The model's properties are illustrated through simulations of the effects of two fiscal policy changes: an increase in the level of government spending, relative to total spending, with the debt-to-income ratio held fixed such that the extra spending must eventually be financed by taxation; and an increase in the debt-to-income ratio with the spending ratio held fixed such that there is a decline in taxation in the short term. The focus of these experiments is the path taken by private agents in their consumption and debt decisions and the macro adjustments that take place in national net foreign debt and the exchange rate.