Government Debt

Stocks & Flows

Flow – measured over a period of time(annual, monthly)

Stock – measure at a point in time

Income vs. wealthInvestment vs. capitalGov’t debt vs. deficit

Gov’t deficit and debt

Deficit G – TEach year adds to the debt

How big is the deficit and debt?Debt $400b?Measure as a percent of GDP

Debt Problems

How can you tell if a corporation is in danger of defaulting on its debt?

- balance sheet info?- bond yields

Same for gov’ts.

Debt Crisis

What happens if government debt is too high?• Must pay high interest rates

– Higher risk– Increases the deficit/debt

• “Solutions”– Repudiation

• Gov’t refuses to pay• Time consistency problem

– Borrow from the Fed (central bank)• Inflation• Seingorage – profit to gov’t from inflation

Lending and inflation• One good – pens• price of pens today is $0.20• The bank loans Jane $10 at 10% interest to be paid

next year.• During the year inflation is 25% - the price of pens

rises $0.25• Jane makes the loan payment of $11.What’s the point?• The $10 today could buy 50 pens• The $11 a year later buys 44 pens.• The payment the bank gets is worth less than the

loan.• To gain value the bank must lend at a rate higher

than inflation.

Real Interest Rates

The real interest rate is adjusted for inflation. We use expected inflation since future inflation will affect debts agreements.

ir = i – pe =nominal rate – expected inflation

The real interest rate is a more accurate measure of the cost of borrowing.

U.S. Real and Nominal Interest Rates

1953-04-01

1954-08-01

1955-12-01

1957-04-01

1958-08-01

1959-12-01

1961-04-01

1962-08-01

1963-12-01

1965-04-01

1966-08-01

1967-12-01

1969-04-01

1970-08-01

1971-12-01

1973-04-01

1974-08-01

1975-12-01

1977-04-01

1978-08-01

1979-12-01

1981-04-01

1982-08-01

1983-12-01

1985-04-01

1986-08-01

1987-12-01

1989-04-01

1990-08-01

1991-12-01

1993-04-01

1994-08-01

1995-12-01

1997-04-01

1998-08-01

1999-12-01

2001-04-01

2002-08-01

2003-12-01

2005-04-01

2006-08-01

2007-12-01

2009-04-01

2010-08-01-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00

8.00

10.00

12.00

Real 10 year bond yield

Series1

How much Gov’t debt is too much?

• Hard to judge– Japan (2009)

• 200% Debt/GDP ratio• Real interest rates under 2%

– Argentina repudiated (2002)• Debt/GDP ratio peaked near 150%

• Expected probability of repudiation– Many factors involved– Trust in the gov’t– Future deficit/debt

• Healthcare• Social security

Retirement and Medical Care

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

Table 26-3 Projected Spending on Social Security, Medicare, and Medicaid, 1998-2060 (Percent of GDP)

2004 2010 2030 2050

Social Security 4.2 4.2 5.9 6.2

Medicare/Medicaid 4.1 4.8 8.4 11.5

Total 8.3 9.0 14.3 17.6

Source: “The Long-Term Budget Outlook,” Congressional Budget Office, December 2003.

Debt Dynamics

D(debt/GDP) = (r – g) (debt/GDP)

+ deficit/GDP

r – real interest rateg – growth rate of real GDP

If g > r ....

Policy

What is the effect of an increase in G on debt/GDP?• Higher deficit (raises debt/GDP)

– higher r• possible exceptions

– liquidity trap– hysteresis (De Long)– Higher productivity – g rises (lowers debt/GDP)

Policy

What is the effect on debt/GDP of an increase in T?• Lower deficit (& lower r)• possible exceptions

– rates already very high– wrong side of the Laffer curve– lower productivity – g falls (raises debt/GDP)

Gov’t debt• 30% - 50% of GDP is OK• Too high - crisis

– interest rates rise– inflation and/or repudiation– how high is too high

• Pay down debt– low deficits, surplus– growth– the higher the debt, the harder it is

• Liquidity trap? Labor supply?

Long Run Growth

Deep History

Real GDP in the U.S.

Long Run

Short run – fluctuations around potential GDP

Medium run - adjustment to potential GDP- changes in potential GDP

Long run- What determines the growth rate trend of potential GDP?

AS-AD

• SR fluctuations – AD shifts• MR – adjustment to Yn

• LR – What changes Yn ?

Which of these matters for LR growth?

Table 10-1 The Evolution of Output per Capita in Five Rich Countries Since 1950

Annual Growth RateOutput per Capita (%)

Real Output per Capita(1996 dollars)

1950-1973 1974-2000 1950 20002000/1950

France4.0 1.8 5,519 22,371 4.1

Japan7.4 2.3 2,417 24,671 10.2

United Kingdom2.4 1.8 7,641 22,188 2.9

United States2.4 2.1 10,601 33,308 3.1

Average4.1 2.0 6,544 25,634 3.9

The standard of living has increased significantly since 1950.

Growth rates of output per capita have decreased since the mid-1970s.

Convergence for much (not all) of the world.

Aggregate Production

• Output depends on capital and labor• Output per worker depends on capital per

worker• Productivity

Increase in capital – movement along the production function

Increase in productivity – shift in the production function

Determinants of Growth

Savings• build capital through investment• needed for development• can the saving rate be too high?

Productivity• technology and human capital• determines long run growth rate for GDP• What improves productivity?

Long Run Policy

• Improve savings/investment– Financial system

• Savings– Safety– Return

• Borrowing (firms)– Contracts– Available loans

– Developing countries• International aid• FDI

Long run policy

• Improve productivity– R&D

• Tax breaks• Patents

– Education/Training– Property rights

Summary

LR• productivity matters• S/I/capital matters

– particularly for developing countriesSR• Productivity still matters

– & other supply shocks• Demand shocks

– Autonomous spending• I – “Animal Spirits”• C

• Financial shocks

Summary / Policy

• Fiscal policy– Gov’t spends on public goods– Increase productivity

• Monetary Policy– Target inflation– and output/unemployment?

• LR balanced budget– stable debt/GDP ratio (30-50%)– SR implications - difficult

– affect G & T changes on growth– liquidity trap – Laffer curve

Review Problem

• Show the effect of an increase in autonomous consumption on expenditure, IS-LM and AS-AD. Show the medium run adjustment on the AS-AD graph.

Review Problem

The Fed acts to raise interest rates. Starting from natural rates, show the short and medium run effect of this policy change on graphs of S&D for Money, IS-LM, AS-AD and the Phillips Curve.

Final Review Questions

2007 2008

Good Quantity Price Quantity Price

Cars 100 $20 120 $30

Houses 40 $100 44 $100

Given the above information about a country’s output, find the following using 2007 as the base year.

a)Growth rate of nominal GDP.

b)Growth rate of real GDP.

c) Implied rate of inflation.

Review Problem

Show the effect of an increase in consumer confidence on an

• Expenditure diagram• IS-LM graph• AS-AD

– Start from the natural rate of output.– Show short and medium run effects.– What are the effects on equilibrium output and

prices?

Review Problem

Show an inflationary gap on graphs of AS-AD and IS-LM. Show the result of passive policy on the graphs.How could monetary policy help to close the gap?How could fiscal policy help? Show the changes in the graphs in the case of active fiscal policy.

Review Problem

Show an inflationary gap on an AS-AD graph and the graph of the Phillips Curve.

If the Fed wants to lower/avoid inflation what does it do?

Show the resulting changes on graphs of money supply and demand, IS-LM as well as the AS-AD and PC graphs.

Review Problem

Starting from the natural rate of output, show how an increase in the markup affects the graphs of the wage and price setting equations, IS-LM, AS-AD and the Phillips Curve. Give two examples of reasons the markup might increase.

Problem

One analyst says a fall in GDP is due to a fall in productivity, while another says the cause is a decrease in investment spending. Show a separate AS-AD graph for each scenario. What are the implications for a policy response?