eco 301 ch26

2626C H A P T E RC H A P T E RC H A P T E RC H A P T E R

Prepared by:

Fernando Quijano and Yvonn Quijano

And Modified by Gabriel Martinez

Fiscal Policy:Fiscal Policy:A Summing UpA Summing Up

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

Fiscal Policy: A Summing UpFiscal Policy: A Summing Up

In the short run, a fiscal deficit raises In the short run, a fiscal deficit raises interest rates and output. Therefore the interest rates and output. Therefore the impact on investment is ambiguous.impact on investment is ambiguous.

In the medium run, only In the medium run, only rr rises, so I falls. rises, so I falls. In the long run, lower investment implies a In the long run, lower investment implies a

lower capital stock and lower growth.lower capital stock and lower growth.– However, the S-R increase in output can have However, the S-R increase in output can have

long term social consequences.long term social consequences.


The GovernmentThe GovernmentBudget ConstraintBudget Constraint

26-1

The Arithmetic of Deficits and DebtThe Arithmetic of Deficits and Debt– The budget deficit in year The budget deficit in year tt equals: equals:

defic it rB G Tt t t t 1

is the interest payments on government debt is the interest payments on government debt at the end of year at the end of year tt-1.-1.

In words: The budget deficit equals spending including In words: The budget deficit equals spending including interest payments on the debt, minus taxes net of interest payments on the debt, minus taxes net of transfers.transfers.

rB t 1

is government spending during year is government spending during year tt..G t

is taxes minus transfers during year is taxes minus transfers during year tt..Tt


Fiscal Policy: A Summing UpFiscal Policy: A Summing Up

Notice the difference between Notice the difference between deficitdeficit and and debtdebt– DebtDebt is what the government owes. It is a is what the government owes. It is a

stock, the accumulation of past deficits.stock, the accumulation of past deficits.– DeficitDeficit is the difference between government is the difference between government

outlays and tax revenue. It is a flow, the outlays and tax revenue. It is a flow, the change in the level of debt.change in the level of debt.


The Government Budget The Government Budget ConstraintConstraint

The The government budget constraintgovernment budget constraint states that the change in government debt states that the change in government debt during year during year tt is equal to the deficit during is equal to the deficit during year year tt:: B B B Tt t t t t 1 1 r G

change in the debt interest payments Primary deficit

Debt at the end of year Debt at the end of year tt equals: equals:

B r B G Tt t t t ( )1 1


Current Versus Future TaxesCurrent Versus Future Taxes

Suppose a government moves from a Suppose a government moves from a balanced budget to a deficit by cutting taxes balanced budget to a deficit by cutting taxes in period 1 by an amount of 1bn.in period 1 by an amount of 1bn.– Taxes go back to normal in period 2,unless debt Taxes go back to normal in period 2,unless debt

has to be repaid.has to be repaid.

This means that BThis means that B11 = 1bn. = 1bn. How and when should it repay its debt?How and when should it repay its debt?

– Notice that if B>0, the debt keeps accumulating Notice that if B>0, the debt keeps accumulating even if T=G because of interest payments on even if T=G because of interest payments on the debt.the debt.


Current Versus Future TaxesCurrent Versus Future Taxes

Full Repayment of the debt in year 2:Full Repayment of the debt in year 2:

Replacing Replacing BB22=0bn and =0bn and BB11=1bn=1bn, and , and

rearranging:rearranging:

In words, to repay the debt fully in year 2, the In words, to repay the debt fully in year 2, the government must run a primary surplus equal government must run a primary surplus equal to (1+to (1+rr)bn.)bn.

B r B G T2 1 2 21 ( ) ( )

T G r r2 2 1 1 1 ( ) ( )


Full Repayment in Year 2Full Repayment in Year 2Tax Cuts, Debt Tax Cuts, Debt Repayment, and Debt Repayment, and Debt StabilizationStabilization

(a) If debt is fully (a) If debt is fully repaid during year 2, repaid during year 2, the decrease in taxes the decrease in taxes of 1 in year 1 requires of 1 in year 1 requires an increase in taxes an increase in taxes equal to (1+equal to (1+rr) in year ) in year 2.2.

T G r r2 2 1 1 1 ( ) ( )


Full Repayment in Year 2Full Repayment in Year 2

Suppose the government borrows $1 in Suppose the government borrows $1 in 2011.2011.

In 2012 the debt will be $1(1+r). In 2013, In 2012 the debt will be $1(1+r). In 2013, $1(1+r)$1(1+r)22. In 2014, $1(1+r). In 2014, $1(1+r)33. In year 2015, it . In year 2015, it will be $1(1+r)will be $1(1+r)44..

Debt at the end of year Debt at the end of year tt is given by: is given by:

Debt at the end of year Debt at the end of year tt1 is given by:1 is given by:B rt

t

121( )

1)1( tt rB


Full Repayment in Year Full Repayment in Year tt

Debt at the end of year Debt at the end of year tt1 is given by:1 is given by:

In year t, when the debt is repaid, the budget In year t, when the debt is repaid, the budget constraint is:constraint is:

Debt at the end of year t equals zero:Debt at the end of year t equals zero:

B rtt

121( )

B r B G Tt t t t ( ) ( )1 1

0 1 1 2 ( )( ) ( )r r G Ttt t

which implies that the necessary surplus in which implies that the necessary surplus in year year tt to repay the debt must be: to repay the debt must be:

T G rt tt ( )1 1


Full Repayment in Year 5Full Repayment in Year 5

Tax Cuts, Debt Tax Cuts, Debt Repayment, and Repayment, and Debt StabilizationDebt Stabilization

(b) If debt is fully (b) If debt is fully repaid during year 5, repaid during year 5, the decrease in taxes the decrease in taxes of 1 in year 1 requires of 1 in year 1 requires an increase in taxes an increase in taxes equal to (1+equal to (1+rr))44 during during year 4.year 4.

Notice taxes go back Notice taxes go back to “normal” level of to “normal” level of zero in year 2, and zero in year 2, and then rise in year then rise in year tt to to pay the debt.pay the debt.


Debt Stabilization in Year 2Debt Stabilization in Year 2

Tax Cuts, Debt Tax Cuts, Debt Repayment, and Repayment, and Debt StabilizationDebt Stabilization

(c) The government (c) The government doesn’t want to repay doesn’t want to repay the debt. It just wants the debt. It just wants to keep it constant.to keep it constant.

If debt is stabilized If debt is stabilized from year 2 on, then from year 2 on, then taxes must be taxes must be permanently higher by permanently higher by rr from year 2 on. from year 2 on.

B r B G T2 1 2 21 ( ) ( )

1 1 2 2 ( ) ( )r G T

T G r r2 2 1 1 ( )

B B2 1 1


ConclusionsConclusions

From the preceding arithmetic of deficits and From the preceding arithmetic of deficits and debt we can draw these conclusions:debt we can draw these conclusions:– If government spending is unchanged, a If government spending is unchanged, a

decrease in taxes must eventually be offset by decrease in taxes must eventually be offset by an increase in taxes in the future.an increase in taxes in the future.

– The longer the government waits to increase The longer the government waits to increase taxes or the higher the real interest rate, the taxes or the higher the real interest rate, the higher the eventual increase in taxes.higher the eventual increase in taxes.


ConclusionsConclusions

From the preceding arithmetic of deficits and From the preceding arithmetic of deficits and debt we can draw these conclusions:debt we can draw these conclusions:

The legacy of past deficits is higher government The legacy of past deficits is higher government debt.debt.

To stabilize the debt, the government must To stabilize the debt, the government must eliminate the deficit.eliminate the deficit.

To eliminate the deficit, the government must run a To eliminate the deficit, the government must run a surplus equal to the interest payments on the surplus equal to the interest payments on the existing debt.existing debt. I.e., raise taxes or cut spending.I.e., raise taxes or cut spending.


The Arithmetic of theThe Arithmetic of theDebt to GDP RatioDebt to GDP Ratio

The The debt-to-GDP ratiodebt-to-GDP ratio, or debt ratio gives , or debt ratio gives the evolution of the ratio of debt to GDP.the evolution of the ratio of debt to GDP.

B

Yr

B

Y

G T

Yt

t

t

t

t t

t

( )1 1

B

Yr

Y

Y

B

Y

G T

Yt

t

t

t

t

t

t t

t

1 1 1

1

1( )

B

Y

B

Y

Y

Yt

t

t

t

t

t

1 1

1

1

Divide 26.3 by Yt

Notice that

Then


The Arithmetic of theThe Arithmetic of theDebt to GDP RatioDebt to GDP Ratio

The The debt-to-GDP ratiodebt-to-GDP ratio, or debt ratio gives , or debt ratio gives the evolution of the ratio of debt to GDP.the evolution of the ratio of debt to GDP.

B

Yr

Y

Y

B

Y

G T

Yt

t

t

t

t

t

t t

t

1 1 1

1

1( )

B

Yr g

B

Y

G T

Yt

t

t

t

t t

t

1 1

1

1( )

Y

Y g

+ r

+ gr gt

t

1 1

1

1

11, and

B

Y

B

Yr g

B

Y

G T

Yt

t

t

t

t

t

t t

t

1

1

1

1

( )

It turns out that

So we can simplify

And reorganize


The Evolution of theThe Evolution of theDebt to GDP RatioDebt to GDP Ratio

The change in the debt ratio over time is the The change in the debt ratio over time is the difference between the real interest rate and difference between the real interest rate and the growth rate of GDP times the initial debt the growth rate of GDP times the initial debt ratio, plus the ratio of the primary deficit to ratio, plus the ratio of the primary deficit to GDP.GDP.

If G=T and B grows at a rate If G=T and B grows at a rate rr. But if GDP . But if GDP grows (grows (gg increases), the ratio of debt to increases), the ratio of debt to GDP will grow more slowly (at a rate equal GDP will grow more slowly (at a rate equal to to rrgg).).

B

Y

B

Yr g

B

Y

G T

Yt

t

t

t

t

t

t t

t

1

1

1

1

( )


The Evolution of the Debt-to-The Evolution of the Debt-to-GDP Ratio in OECD CountriesGDP Ratio in OECD Countries

We can use the equation above as a useful We can use the equation above as a useful guide to the evolution of the debt-to-GDP ratio guide to the evolution of the debt-to-GDP ratio over the last four decades in the OECD over the last four decades in the OECD countries. The debt to GDP ratio will be larger:countries. The debt to GDP ratio will be larger:– the higher the real interest ratethe higher the real interest rate– the lower the growth rate of output,the lower the growth rate of output,– the higher the initial debt ratio,the higher the initial debt ratio,– The higher the ratio of the primary deficit to GDP.The higher the ratio of the primary deficit to GDP.

B

Y

B

Yr g

B

Y

G T

Yt

t

t

t

t

t

t t

t

1

1

1

1

( )



In the 1960s, GDP growth was strong. In the 1960s, GDP growth was strong. As a result, As a result, rrgg was negative. Countries was negative. Countries were able to decrease their debt ratios were able to decrease their debt ratios without having to run large primary without having to run large primary surpluses.surpluses.

In the 1970s, In the 1970s, rrgg was again negative due was again negative due to very low interest rates, leading to a to very low interest rates, leading to a further decrease in the debt ratio.further decrease in the debt ratio.

B

Y

B

Yr g

B

Y

G T

Yt

t

t

t

t

t

t t

t

1

1

1

1

( )



In the 1980s, real interest rates increased In the 1980s, real interest rates increased and growth rates decreased, thus, debt and growth rates decreased, thus, debt ratios increased rapidly.ratios increased rapidly.

Throughout the 1990s, interest rates Throughout the 1990s, interest rates remained high and growth rates low. remained high and growth rates low. However, most countries ran primary However, most countries ran primary surpluses sufficient to imply a steady surpluses sufficient to imply a steady decline in their debt ratios.decline in their debt ratios.

B

Y

B

Yr g

B

Y

G T

Yt

t

t

t

t

t

t t

t

1

1

1

1

( )


Four Issues inFour Issues inFiscal PolicyFiscal Policy

26-2

The idea of The idea of Ricardian EquivalenceRicardian Equivalence, further , further developed by Robert Barro, and also known as developed by Robert Barro, and also known as the the Ricardo-Barro propositionRicardo-Barro proposition, is the , is the argument that, once the government budget argument that, once the government budget constraint is taken into account, neither deficit constraint is taken into account, neither deficit nor debt has an effect on economic activity.nor debt has an effect on economic activity.– Consumers do not change their consumption in Consumers do not change their consumption in

respond to a tax cut if the present value of after-tax respond to a tax cut if the present value of after-tax labor income is unaffected. The effect of lower taxes labor income is unaffected. The effect of lower taxes today is cancelled out by higher taxes tomorrow.today is cancelled out by higher taxes tomorrow.

1


Deficits, Output Stabilization,Deficits, Output Stabilization,and the Cyclically Adjusted Deficitand the Cyclically Adjusted Deficit

Although protracted budget deficits have Although protracted budget deficits have adverse effects, they can be used for adverse effects, they can be used for stabilization.stabilization.

This implies that deficits during recessions This implies that deficits during recessions should be offset by surpluses during booms.should be offset by surpluses during booms.

The deficit that exists when output is at the The deficit that exists when output is at the natural level of output is called the natural level of output is called the cyclically adjusted deficitcyclically adjusted deficit– Other terms used are Other terms used are midcycle deficitmidcycle deficit, , standardized employment standardized employment

deficitdeficit, , structural deficitstructural deficit, or , or full-employment deficitfull-employment deficit..

2


Deficits, Output Stabilization,Deficits, Output Stabilization,and the Cyclically Adjusted Deficitand the Cyclically Adjusted Deficit

A reliable rule of thumb is that a 1% A reliable rule of thumb is that a 1% decrease in output leads automatically to an decrease in output leads automatically to an increase in the deficit of 0.5% of GDP.increase in the deficit of 0.5% of GDP.

If output is, say 5% below its natural level, If output is, say 5% below its natural level, the deficit as a ratio of GDP will therefore be the deficit as a ratio of GDP will therefore be about 2.5% larger than it would be if output about 2.5% larger than it would be if output was at the natural level of output.was at the natural level of output.– G>T encourages economic activity.G>T encourages economic activity.

This effect of the deficit on economic activity This effect of the deficit on economic activity has been called the has been called the automatic stabilizerautomatic stabilizer..


Wars and DeficitsWars and Deficits

The economic burden of a war affects consumers The economic burden of a war affects consumers and firms differently depending on how the war is and firms differently depending on how the war is paid for.paid for.

If the government relies more on deficit financing If the government relies more on deficit financing and less on tax increases, the decrease in and less on tax increases, the decrease in consumption will be smaller and the decrease in consumption will be smaller and the decrease in investment will be larger.investment will be larger.– If the government relies less on deficit financing and If the government relies less on deficit financing and

more on tax increases, the decrease in consumption will more on tax increases, the decrease in consumption will be larger and the decrease in investment will be smaller.be larger and the decrease in investment will be smaller.

3


Reducing Tax DistortionsReducing Tax Distortions

Very high tax rates can lead to very high Very high tax rates can lead to very high economic distortions. People will work less, economic distortions. People will work less, and engage in illegal, untaxed activities.and engage in illegal, untaxed activities.

Tax smoothingTax smoothing is the idea that it is better to is the idea that it is better to maintain a relatively constant tax rate, to maintain a relatively constant tax rate, to smooth taxes.smooth taxes.

Tax smoothing implies large deficits when Tax smoothing implies large deficits when government spending is high and small government spending is high and small surpluses the rest of the time.surpluses the rest of the time.


The Dangers of Very High DebtThe Dangers of Very High Debt

The higher the ratio of debt to GDP, the The higher the ratio of debt to GDP, the larger the potential for catastrophic debt larger the potential for catastrophic debt dynamics.dynamics.

Expectations of higher and higher debt give Expectations of higher and higher debt give a hint that a problem may arise, which will a hint that a problem may arise, which will lead to the emergence of the problem, lead to the emergence of the problem, thereby validating the initial expectations.thereby validating the initial expectations.

B

Y

B

Yr g

B

Y

G T

Yt

t

t

t

t

t

t t

t

1

1

1

1

( )( )

4


The Dangers of Very High DebtThe Dangers of Very High Debt

Suppose G=T and r>g. B/Y rises over time.Suppose G=T and r>g. B/Y rises over time.– Eventually, rB could get so large that Eventually, rB could get so large that

government goes bankrupt.government goes bankrupt.– Fearing this, lenders require a higher Fearing this, lenders require a higher r. This r. This

raises rB.raises rB.– A self-fulfilling prophesy arises.A self-fulfilling prophesy arises.

Debt repudiationDebt repudiation consists of canceling the consists of canceling the debt, in part or in full.debt, in part or in full.

B

Y

B

Yr g

B

Y

G T

Yt

t

t

t

t

t

t t

t

1

1

1

1

( )( )


The U.S. BudgetThe U.S. Budget26-3

The government uses its own accounting The government uses its own accounting system to present and discuss the budget system to present and discuss the budget in Congress.in Congress.

An alternative and more economically An alternative and more economically meaningful accounting system is provided meaningful accounting system is provided in the national income and product in the national income and product accounts (NIPA).accounts (NIPA).

The two systems differ in how they treat The two systems differ in how they treat assets and government investment.assets and government investment.

Table 25-2 U.S. Federal Budget Revenues and Expenditures, Fiscal Year 2001 (Percent of GDP)

Revenues 20.1

Personal taxes 10.0

Corporate profit taxes 2.0

Indirect taxes 1.0

Social insurance contributions 7.0

Expenditures, excluding interest payments 16.2

Consumption expenditures 5.0

Defense 3.3

Nondefense 1.7

Transfers

(note: here, part of G; in the book, a part of T) 8.1

Grants to state/local governments 2.6

Other spending 0.5

Primary surplus (1) (+ sign: surplus) 3.9

Net interest payments (2) 2.4

Real interest payments (3) 1.7

Inflation components 0.7

Official surplus: (1) minus (2) 1.5

Inflation adjusted surplus: (1) minus (3) 2.2

Memo item. Debt to GDP ratio 31.0Source: Survey of Current Business, December 2001. Tables 3-2 and 3-7.


The U.S. BudgetThe U.S. Budget

The budget has gone into deficit because:The budget has gone into deficit because:– Tax cuts and slower U.S. economy, leading to Tax cuts and slower U.S. economy, leading to

lower tax revenues.lower tax revenues.– Increased government spending since Increased government spending since

September 11, 2001.September 11, 2001. Many economists believe that larger surpluses Many economists believe that larger surpluses

would be desirable. The U.S. private saving rate would be desirable. The U.S. private saving rate is 16.5% of GDP, or 4.5% below the average for is 16.5% of GDP, or 4.5% below the average for OECD countries. Higher surpluses mean higher OECD countries. Higher surpluses mean higher public saving.public saving.


Surpluses and the Aging of Surpluses and the Aging of AmericaAmerica

Entitlement programsEntitlement programs are programs that require are programs that require the payments of benefits to all who meet the the payments of benefits to all who meet the eligibility requirements established by the law.eligibility requirements established by the law.

Table 26-3

Projected Spending on Social Security, Medicare, and Medicaid, 1998-2060 (Percent of GDP)

1998 2010 2040 2060

Social Security 4.0 5.0 7.0 7.0

Medicare 2.0 3.0 6.0 7.0

Medicaid 1.0 2.0 3.0 3.0

Total 7.0 10.0 16.0 17.0Source: “The Economic and Budget Outlook, Fiscal Years 1998-2060.” Congressional Budget Office, January 1999. Table 2-5.


Surpluses and the Aging of Surpluses and the Aging of AmericaAmerica

Entitlement spending to GDP is projected to Entitlement spending to GDP is projected to increase for these reasons:increase for these reasons:– The Aging of America: The old age dependency The Aging of America: The old age dependency

ratio—the ratio of the population 65 years old or ratio—the ratio of the population 65 years old or more to the population between 20 and 64 years oldmore to the population between 20 and 64 years old—is projected to increase from about 20% in 1998 —is projected to increase from about 20% in 1998 to above 40% in 2060.to above 40% in 2060.

– The steadily increasing cost of health care.The steadily increasing cost of health care.

Even if all expenditures other than transfers Even if all expenditures other than transfers were eliminated, projected entitlement were eliminated, projected entitlement spending would still exceed revenues.spending would still exceed revenues.

eco 301 ch26

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