Final answer:
Increasing government deficit spending in Canada to achieve full employment will likely increase real interest rates, reduce domestic investment, and may lead to inflationary measures to manage the debt, which can undermine economic growth and financial stability.
Step-by-step explanation:
When the Canadian government increases its deficit spending to restore full employment, it can affect the real interest rates in the country. As the government borrows more to spend, the demand for financial capital increases, shifting the demand curve from Do to D1. This increased demand can lead to a higher equilibrium interest rate, moving from an original 5% to potentially 6% or higher as per the provided reference figures. Moreover, an increase in government deficits can also place upward pressure on long-term interest rates, with studies suggesting that a 1% increase in budget deficits could lead to a 0.5-1.0% rise in these rates.
This change in interest rates can have various consequences. It can pull resources away from domestic investment, leading to lower investment in human and physical capital, which are essential for economic growth. Moreover, the increased cost of financing government debt can pressure the government to enact spending cuts and tax increases, which can have a contractionary effect on aggregate demand in the economy and could potentially derail economic recovery efforts.
Furthermore, if a rising percentage of debt to GDP creates market uncertainty, a country might resort to inflationary measures to reduce the real value of the debt. This can decrease real wealth and undermine confidence in the government's fiscal management.