7: The Government Sector

Canadian governments directly buy about 25 percent of GDP according to the national accounts data in Table 4.5. They also spend about 17 percent on transfer payments to persons and business (old age security, childcare allowances and subsidies) including interest payments to holders of government bonds. Governments in most industrial economies make purchases on about the same scale. Government spending is financed mainly by taxes and, when governments run budget deficits, by borrowing through bond sales. In this chapter, we extend our model to include the government sector. The government sector adds an important new dimension to our model, namely fiscal policy. A government can use its taxing and spending powers to provide public services. But it can also structure and manage its budget to stabilize aggregate demand and reduce business cycle fluctuations in real GDP and employment.

In late 2008 and early 2009 strong recessionary conditions led to an international call for fiscal stimulus. Many countries, including Canada, introduced substantial increases in government expenditures and reductions in tax rates to offset broad-based declines in aggregate demand. This was an important revival of fiscal policy. However, over time, governments must also manage their budgets in ways that control the size of their debt relative to GDP. Until very recently, Canadian governments have been more concerned about government budget surpluses, deficits, and debt than about demand management when designing fiscal policy. To explain the role of government in macroeconomic analysis and policy, we start with a brief look at the data on the size of the government sector in Canada.