Towards a More Complete Debt Strategy Simulation Framework

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An effective technique governments use to evaluate the desirability of different financing strategies involves stochastic simulation. This approach requires the postulation of the future dynamics of key macroeconomic variables and the use of those variables in the construction of a debt charge distribution for each individual financing strategy. Summary measures of the resulting debt charge distributions permit comparison of the alternative financing strategies. To defensibly generate a debt charge distribution for a given financing strategy, however, one must have a good model to simulate the future dynamics of a set of key macroeconomic variables into the future. This paper suggests a reduced-form approach to describe the key elements of the stochastic model used to analyze the Government of Canada's debt strategy problem. To this end, a simple algorithm is proposed for the simultaneous simulation of the business cycle, the government's financial position, and the term structure of interest rates. The approach uses the constant parameter hidden-Markov model introduced by Hamilton (1989) in combination with the class of affine term-structure models.