Transcript Unit 8
CHAPTERS IN ECONOMIC POLICY Part. II Unit 8 The dynamics of debt to GDP ratio The Arithmetic of Deficits and Debt –The budget deficit in year t equals: deficit t rBt 1 Gt Tt rBt 1 is the interest payments on the debt Gt is government spending during year t. Tt is taxes minus transfers during year t. In words: The budget deficit equals spending, including interest payments on the debt, minus taxes net of transfers. - Note that 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 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: Bt Bt 1 deficitt •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). The Arithmetic of Deficits and Debt Bt Bt 1 change in the debt rBt 1 interest payments Gt Tt Primary deficit Bt (1 r ) Bt 1 Gt Tt The debt to GDP ratio - In an economy in which output grows over time, it makes sense to focus on the ratio of debt to output -The debt-to-GDP ratio, or debt ratio gives the evolution of the ratio of debt to GDP. The Arithmetic of the Debt Ratio Bt Bt 1 Bt 1 Gt Tt (r g ) Yt Yt 1 Yt 1 Yt It is possible to demonstrate that the change in the debt ratio over time is equal to the sum of two terms. - The first term is the difference between the real interest rate and the growth rate times the initial debt ratio. - The second term is the ratio of the primary deficit to GDP. The Evolution of the Debt Ratio in OECD Countries Bt Bt 1 Bt 1 Gt Tt (r g ) Yt Yt 1 Yt 1 Yt This equation implies that the increase in the ratio of debt to GDP will be larger: - the higher the real interest rate, - the lower the growth rate of output, - the higher the initial debt ratio, - the higher the ratio of the primary deficit to GDP The Evolution of the Debt-to-GDP Ratio in OECD Countries Bt Bt 1 Bt 1 Gt Tt (r g ) Yt Yt 1 Yt 1 Yt - In the 1960s, GDP growth was strong. As a result, rg was negative. Countries were able to decrease their debt ratios without having to run large primary surpluses. - In the 1970s, rg was again negative due to very low (and even negative) real interest rates, leading to a further decrease in the debt ratio. The Evolution of the Debt-to-GDP Ratio in OECD Countries Bt Bt 1 Bt 1 Gt Tt (r g ) Yt Yt 1 Yt 1 Yt - In the 1980s, real interest rates increased and growth rates decreased, thus, debt ratios increased rapidly. - Throughout the 1990s, interest rates remained high and growth rates low. However, most countries ran primary surpluses sufficient to imply a steady decline in their debt ratios. - So far, during the 2000s, real interest rates are low, but many countries are running primary deficits, and their debt ratios are again going up. - High public debt and economic policy Let’s start from the equation: [(Bt /Yt) (Bt-1 /Yt-1)] = (rg)(Bt-1 /Yt-1)+(GtTt)/Yt Let’s assume r = 3%; g = 2% Bt-1 /Yt-1 = 100% • -In order to have a constant debt/GDP ratio, a 1% primary surplus is sufficient Let’s assume now that, to counteract speculation in the currency market, the central bank is forced to increase domestic interest rate As a consequence, the real interest rate is likely to increase (e.g to 5%) and the GDP growth rate to decrease (e.g. to 1%) In order to have a constant debt/GDP ratio, a 4% primary surplus is now needed This however implies a severely restrictive fiscal policy which could bring to a recession (g0) In this context debt to GDP ratio is likely to increase, fuelling adverse expectations in the financial markets As a consequence: increase of interest rates to compensate the investors of the risk of default Likely outcame: default