Transcript Budget Deficit - Meltem INCE YENILMEZ

The Government Budget, Foreign Borrowing,
and the Twin Deficit
Chapter 5
Instructor: MELTEM INCE
1
Budget Deficit (and Surplus)


The Structural Deficit is the what the deficit of the
economy would be if the economy were operating at
natural real GDP.
 The structural deficit is sometimes call the Natural
Employment Deficit (NED).
 The CBO uses “Standardized Budget Deficit” for the
structural budget deficit.
The Cyclical Deficit is the amount by which the actual
government budget deficit exceeds the structural deficit.
 The Structural Surplus (or equivalently, the Natural
Employment Surplus (NES)) and the Cyclical Surplus
are the same as the deficit concepts with the signs
reversed.
2
Budget Deficit (and Surplus)
 “Magic Equation” from Chapter 2:


T – G = (I + NX) – S
The Magic Equation suggests 3 ways to finance a
budget deficit (i.e. T – G < 0)
 Private saving (S) can go up
 Investment (I) can fall
 Foreign investment (NX) can fall
Because an increase in the budget deficit increases
the total public debt, persistent budget deficits can lead
to higher taxes in the future.
3
The Arithmetic of Deficits and Debt
The budget deficit in year t equals:
deficit t  rBt 1  Gt  Tt



Bt-1 is government debt at the end of year, t – 1 or, equivalently, at
the beginning of year t ; r is the real interest rate, which we shall
assume to be constant here. Thus rBt-1 equals the real interest
payments on the government debt in year t.
Gt is government spending during year t
Tt is taxes minus transfers during year t.
4
The Arithmetic of Deficits and Debt
deficit t  rBt 1  Gt  Tt
We measure interest payments as real interest
payments rather than as actual interest payments. The
correct measure of the deficit is sometimes called the
inflation-adjusted deficit.
G does not include transfer payments.
5
The Arithmetic of Deficits and Debt

The government budget constraint states that the change in
government debt during year t is equal to the deficit during year t:
B  B  Deficit
t

t 1
t
Using the definition of the deficit
deficit t  rBt 1  Gt  Tt

we can rewrite the government budget constraint as
B  B  rB  G  T
t
t 1
t 1
t
t
6
The Arithmetic of Deficits and Debt
It is often convenient to decompose the deficit into the sum of
two terms:

Interest payments on the debt, rBt-1

The difference between spending and taxes, Gt – Tt. This
term is called the primary deficit (equivalently, Tt – Gt is
called the primary surplus).
7
The Arithmetic of Deficits and Debt
B  B  rB  G  T
t 1
t
Change in the debt
Bt  Bt 1 
t 1
t
t
Interest payments
rBt 1

Primary deficit
Gt  Tt
Primary Deficit
B  (1  r ) B  G  T
t
t 1
t
t
8
Automatic vs. Discretionary Fiscal Policy
Budget surplus = T – G = tY – G
(where t = the average net tax rate)


Automatic stabilization of the budget deficit occurs
because government tax revenues depend on income.
 If Y  T which helps to restrain expansions
 If Y  T which helps to dampen recessions
Discretionary fiscal policy alters tax rates and/or
government expenditures in a deliberate attempt to
influence real output and unemployment.
9
National Saving



National Saving is the sum of private and government
saving: NS = S + (T – G)
Recall the Magic Equation:
T – G = (I + NX) – S
Rearranging yields  S + (T – G) = I + NX
 NS = I + NX
National saving has two components:



(T – G) does not depend on r
S increases with a higher r
In a closed economy, NS = I at equilibrium.
10
Effect of a Fiscal Expansion in a Closed Economy
11
Fiscal Policy in a Small Open Economy



An Open Economy sells exports to other nations, buys
imports, and experiences capital flows in and out of the
country.
 A Small Open Economy (or SOE) is considered too
small for its domestic policies to affect the world
interest rate.
 Therefore, the local r must equal the world interest
rate, rf .
The “Magic Equation” written to reflect changes in its
component parts is: ∆NS = ∆I + ∆NX
 But since r = rf is unaffected by domestic policies 
∆I = 0
 ∆NS = ∆NX
Implication: If G  NS  NX, but I unaffected
12
Effect of a Fiscal Expansion in an Open Economy
13
The Current Account and the BOP



The Current Account (CA) records the nation’s current
international transactions including exports and imports
of goods and services (i.e. NX), net income from abroad
and net unilateral transfer payments.
The Capital Account (KA) records international capital
flows, which consist of purchases and sales of foreign
assets by domestic residents, as well as purchases and
sales of domestic assets by foreign residents.
The Balance of Payments (BOP) is the record of a
nation’s international transactions.
 Algebraically: BOP = CA + KA
14
Foreign Borrowing and Int’l Indebtedness



A current account deficit must be financed either by:
 Net borrowing from foreigners
 This is recorded as a capital account surplus.
 Net borrowing from foreign central banks
 This is recorded as a balance of payments deficit.
A nation’s Net International Investment Position is the difference
between all foreign assets owned by a nation’s citizens and
domestic assets owned by foreign citizens.
∆ Net Int’l Investment Position = CA Balance +
Net Revaluations
(where Net Revaluations is the change in the dollar value of financial assets due to
fluctuations in financial markets and the exchange rate)
15
YN= 10.900 Y=10.600 t=0.16 G= 1890
a.
actual real GDP = 0.16(10,600) = 1,696
natural real GDP= 0.16(10,900) = 1,744
b.
c.
natural employment deficit = 1,744 - 1,890 = -146
actual deficit =1,696 - 1,890 = -194
actual real GDP < natural real GDP
cyclical deficit
cyclical deficit= actual deficit - natural deficit
d.
e.
cyclical deficit= -194 - (-146) = -48
Natural real GDP= 0.14 (10,900) = 1,526
natural employment deficit = 1,526 - 1,890 = -364
16
net exports = 40, TP= 20, NI= -15
current account balance = NX + TP + NI
CAB= 40+20-15
CAB= 45
capital account balance = balance – current account
capital account balance = 10 - 45 = -35
17