Impacts of Rising Prices from Monetary and Fiscal Policies

According to the OECD[ii], Canada’s debt-to-GDP ratio went from 106.9% in 2018 to 130.5% in 2022.  It is widely accepted that, ceteris paribus, a lower ratio is better.  There are a few mechanisms that can reduce the ratio: GDP could grow, inflation can rise, the government can use tax revenues to pay down debt, or the government can default on debt[iii].  We will focus on the 2^nd and 3^rd options in this article.

In the article Using inflation to erode the U.S. Public Debt[iiii] the authors wrote, “inflation can rise, eroding the real value of the debt held by creditors and the effective debt ratio.  With foreign creditors holding a significant share of the dollar-denominated U.S. Federal debt, they will share the burden of any higher U.S. inflation along with domestic creditors.”  The Canadian Department of Finance indicates about 24% of Government of Canada market debt was held by Foreign (non-Canadian) investors[v], roughly the same percentage that the U.S. Federal debt market had in 2009 when the article was written. 

So, there is some fiscal motivation for higher inflation as it shifts a portion of the burden to foreign creditors.  However, you’ll notice that more than ¾ of the debt is held by Canadian investors, so this strategy does not completely solve the problem as far as Canadian taxpayers are concerned because they still experience the bulk of the effect.

Government spending increases demand-pull inflation for a couple of reasons.  First, the spending will increase demand for labour and materials, which will increase the cost for labour and materials in the broad market. Second, the cash provided to labourers and businesses will increase the funds available to consumers and businesses to purchase their own goods and services.  The increase in available funds will increase prices via demand-pull inflation.

The Government of Canada has also increased the money supply by roughly 31.5% since the beginning of 2020[vi].  This increase of nearly $600 billion dollars has increased funds available to businesses and consumers, which increases demand-pull inflation as businesses and consumers increase spending.  Simultaneously, because such a significant amount of additional dollars is existing to purchase the same goods and services, the value of each dollar has accordingly decreased, pushing prices higher[vii]. 

As discussed in Part 1, wages are increasing as labourers demand higher pay to keep up with the cost of living.  In Canada, we pay income taxes as a percentage of our income on a graduated basis, where the marginal percentage tax rate increases as our income increases. Higher wages result in higher government tax revenues on a dollar basis and businesses are also dealing with increasing costs associated with statutory deductions, which are effectively another tax.

For example, if you were earning $50,000 and paying 30% income tax, you would pay $15,000 in taxes. If your wage grew by 10% to $55,000, your taxes would increase by the same proportion to $16,500, assuming no change in applicable tax rates.  If the government were to apply that extra $1,500 towards the debt, it would reduce the debt-to-GDP ratio.  This is the third option listed above.