# **1 Introduction**

The aftermath of the 2008-09 Great Recession triggered renewed interest on the impact of fiscal policy changes on the economy. In response to the global recession, countries typically implemented a two-phase approach to fiscal policy. First, the sudden economic collapse led fiscal authorities in many advanced economies, including Canada, to introduce stimulus packages to revive their economies. Following the stimulus, fiscal authorities shifted gears, adopting adjustment plans to reduce public debt and ensure long-term fiscal sustainability and sustained growth.

Stimulus measures in Canada, introduced through Canada’s Economic Action Plan, were projected at 3.2 percent of GDP in the 2009 federal budget while the ARRA was estimated at 7 percent of GDP. As a result, the federal net debt-to-GDP ratio was expected to increase from 28.6 percent in the 2008-09 fiscal year to 32.1 percent by 2010-11. As the economy started to recover, the Canadian government introduced adjustment plans to tackle high deficits and increased public debt. The federal expenditures-to-GDP ratio, which rose from about 13 percent before the crisis to 16 percent in 2009-10, declined to 14 percent in 2011 and was projected in the 2012 budget to return to the pre-crisis level by 2014-15. The 2012 budget also projected that adjustment measures would bring the federal net debt-to-GDP ratio back to the pre-crisis level by 2014-15, while the consolidated net debt-to-GDP ratio (including federal, provincial and local administrations) was projected to fall to 36.3 percent of GDP (IMF Fiscal Monitor, April 2013).<sup>1</sup> Therefore, examining the size of the fiscal multiplier is important to informing the effectiveness of such policy measures in reviving or not economic activity.

While extensive analysis has been conducted on the U.S. economy, only a few studies (Perotti (2004), Corsetti and Müller (2006), Ravn et al. (2007) and Monacelli and Perotti (2010)) have investigated the impact of fiscal policy changes in Canada. One challenge when studying the effects of fiscal policy changes is to disentangle the automatic fiscal stabilizers to business cycle fluctuations from changes attributed to discretionary policy decisions. This is even more important in a small open economy such as Canada<sup>2</sup> , which is subject to foreign shocks that affect key macroeconomic variables as well as fiscal variables. To identify exogenous changes in fiscal policy, it is important to control for the effects of foreign shocks. Canada is highly integrated with the U.S. through trade and financial links. The U.S. accounts for about 75 percent of total Canadian exports, and American ownership of Canadian assets was valued at more than 50 percent of Canadian GDP in 2009.<sup>3</sup> Any demand shock affecting the U.S. may have a spillover effect on the Canadian

> 1The total net debt, according to the IMF’s Fiscal Monitor, rose from 22.4 percent of GDP in 2008 to 34.6 in 2012, and is projected to start falling in 2016 from 36.3 percent. Meanwhile, the total gross debt rose from 71.3 percent of GDP in 2008 to 85.6 percent in 2012, and was projected to fall in 2014 to 84.6 percent of GDP, reaching 78.2 percent in 2018.

> 2The term small open economy here refers not to the size of the Canadian economy, but to its exposure to foreign shocks mainly from the US, its main trading partner while the reverse does not hold.

> 3According to Statistics Canada.

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