An increase in a government deficit can have two effects: short-term stimulation of aggregate demand and employment, and long-term contraction of potential output. In this paper, these effects are illustrated using a dynamic, macroeconomic simulation model. The model is not a forecasting tool; it is intended to bridge the gap between Keynesian and supply-side economics and to improve our knowledge of the process by which an increase in the government deficit can crowd out investment in the economy. A closed-economy model was chosen for simplicity.

The model is a fairly conventional synthesis of the traditional Keynesian IS-LM model and the Solow-Tobin neoclassical growth model. A neoclassical production function, a neoclassical investment equation, and an expectations-augmented Phillips curve are introduced into the static IS-LM model. The Phillips curve, with adaptive expectations, links the (Keynesian) demand-determined model of output and employment in the short run and the (monetarist) supply-determined model of output and employment in the longer run.

The literature on debt financing identifies two issues that are critical to understanding the macroeconomics effects of government deficits. The first issue is the risk that the government may lose control over its mounting deficit as a result of the compounding effect of escalating interest payments; the other is the question of whether households regard government debt as net wealth.

This model deals with the prospect of uncontrolled deficit expansion by assuming that the government reacts to changes in its inflation-adjusted interest bill by making offsetting changes in its tax and expenditures programs. The authors believe that, although arbitrary, this simulation rule yields greater insight into the process of debt accumulation than a rule that would permit uncontrolled expansion of government debt.

The question of whether households make allowance in their consumption/saving decisions for the future taxes required to finance the public debt is not answered here. Rather, the authors simulate the model under three alternative assumptions: full allowance (as advocated by Professor Barro), partial allowance (as advocated by Professor Modigliani), and no allowance at all.

If households see the value of government debt as exceeding the discounted value of their future tax liabilities arising from that debt, then deficit financing can cause significant crowding out of capital formation. Some crowding out can also result from an increase in government spending, regardless of how the additional expenditure is financed, if the marginal propensity to consume is less than one. To separate these two effects, simulations were run for both a tax cut and an increase in spending.

The results of the study are strictly theoretical since they are based on a fairly crude model of a very simple economy. These results indicate that, under full allowance for future tax liabilities, but low marginal propensity to consume out of disposable income (60 per cent), an increase in spending equivalent to 1 per cent of GDP would cause a 2.5 per cent contraction in potential output over the long run. Under the Keynesian assumption of no allowance for future tax liabilities, the same increase in spending would cause a 7 per cent reduction in potential output: 2.5 per cent relating to the expenditure increase, and 4.5 per cent relating to the deficit financing.

Simulations were done with the model, which used coefficients based on a wide range of empirical studies relating to Canada, to illustrate the time path of responses to various tax and expenditure shocks under different conditions. They showed that the duration of the Keynesian expansionary effect of an increase in a budget deficit is relatively short and that its magnitude is much smaller than the long-run contractionary effect on potential output. The expenditure multiplier in the model peaks at 0.6 to 0.7 in the second year, becomes negative after five years and, depending on the allowance households make for future taxes, grows to between -2.5 and -7 near equilibrium; real interest rates increase by about 0.3 percentage points in the case of full allowance for future taxes and by about 1 percentage point in the case of no allowance at all.

The study suggests that the cost of deficit financing can be very large in this model; it would be larger still if the labour supply was allowed to contract as a result of lower after-tax real wages. But it should be noted that the results are critically dependent on an assumed production elasticity of capital (the capital share) that the authors recognize may be too high.

The authors also present partial model simulations to illustrate the nature of the supply constraint in the model. They show that the pure Keynesian multiplier in their model is about 2, when money wages are exogenous and monetary policy is accommodative.