Transcript Introduction

Chapter 14
The Government Budget
Introduction
• Static Analysis :
Analysis of how the economy behaves at a
given point in time.
• Dynamic Analysis :
The study of how the economy behaves at
different points in time.
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Introduction
• Although static analysis can go a long way
toward answering questions that interest
economists and policy maker, some issues in
macroeconomics are explicitly dynamic.
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The Government Budget
Neoclassical and Endogenous Growth Theory
Unemployment, Inflation and Growth
Rational Expectations
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Introduction
• The General Theory
- Keynesian economists advocated a policy of
stabilization.
if u < u*  G↓ ; if u > u*  G↑
• Following WWII, the pursuit of these policies
made deficits grow as the government found it
politically more expedient to increase spending
than to raise taxes.
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Introduction
• Difference equations enable us to know how
these deficits accumulated and led to a crisis in
the early 1990s that cause the government to
raise taxes to balance the budget.
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The Relationship of Debt and Deficits
Bt
Nominal value of
new government debt
 Bt 1  (1  i )  Dt
Nominal value
of oustanding
government debt
One plus
Primary
the nominal
interest rate
government
budget deficit
• The primary deficit is equal to the value of
government expenditures plus transfer
payments minus the value of government
revenues.
• The reported deficit is equal to the value of
the primary deficit plus the value of interest
payments on outstanding debt.
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Table 14.1
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The Debt and the Deficit
The U.S. evidence
-- the government’s budget was on average
approximately balanced from 1940 through
1970.
-- the national debt grew dramatically in the
1980s.
-- policymakers in the mid-1990s were
concerned with the debt and the deficit.
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The Debt and the Deficit
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The Debt and the Deficit
• Figure 14.1 overstates how important this
problem really was.
• Because the ultimate source of the government’s
ability to repay is its ability to tax GDP, the
appropriate measures of debt and the deficit of
the U.S. are relative to GDP.
-- 1946, WWII
-- 1980, peace time
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The Debt and the Deficit Measured Relative to GDP
Figure 14.2
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Using the GDP as a Unit of Measurement
Bt  Dt  (1  i )  Bt 1
Bt
Dt
Bt 1
 N  N  (1  i )  N
Yt
Yt
Yt
N
t 1
N
t
Dt
Bt 1 Y
 N  (1  i )  N
Yt
Yt 1 Y
1 i
 bt  d 
 bt 1
1 n
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Using the GDP as a Unit of Measurement
1 i
bt  d 
 bt 1
1 n
The debt-to-GDP ratio grows for two reasons:
1. The government must issue debt to cover a
primary deficit. ( d )
2. The government must pay interest on
existing debt.( (1+i)/(1+n) )
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Using the GDP as a Unit of Measurement
1 i
bt  d 
 bt 1
1 n
• Suppose that the primary deficit is equal to
zero, ( d = 0 )
if i > n  the debt-to-GDP ratio will grow.
if i < n  the debt-to-GDP ratio will shrink.
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Solving a Difference Equation
1 i
bt  d 
 bt 1
1 n
state var.
parameters
past value
• A difference equation describes how a (state)
variable that changes over time depends on
its own past value and on a number of
parameters.
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Solving a Difference Equation
1 i
bt  d 
 bt 1
1 n
• The solution to a difference equation is a list
of values for the state variable, one for each
date in the future, given the initial value of
the debt-to-GDP ratio.
• Then we can predict what policy changes are
necessary.
• By Iterations.
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Steady State Solution
1 i
bt  d 
 bt 1
1 n
• A steady state solution is a value of the state
variable that satisfies the government budget
equation and that is independent of time.
• Condition : bt  bt 1
1 i
1 n
bd
b  b
d.
1 n
n i
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How To Solve a Difference
Equation with a Graph
Figure 14.3
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Stable and Unstable Steady State
• If the steady state is stable, the state variable
moves closer toward the steady state over
time, regardless of where it starts from.
• Conditions :
-- Stable : (1  i ) /(1  n)  1
-- Unstable : (1  i ) /(1  n)  1
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Stable and Unstable Steady States
Figure 14.4A
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Stable and Unstable Steady States
Figure 14.4B
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The Nominal Interest Rate and the Nominal Growth
Rate in the United States, 1940–2000 (%/Year)
Figure 14.5
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Table 14.2
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The Sustainability of the Budget Deficit
• 1946-1979 Budget Equation
At the end of WWⅡ, debt was equal to
120% of GDP.
For 30 years thereafter, the debt-to-GDP
ratio fell steadily because i < n.
• d=-1.2%, n=7.5% > i=4.1%,

b b
t
(1  n)
b
d  0.38  1.2
(n  i )
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The Dynamics of the Budget, 1946–1979
Figure 14.6
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The Sustainability of the Budget Deficit
• The Budget Crisis of the 1980s
The Fed raised the interest rate to control
inflation through 1993.(monetary policy
tightens)
The debt-to-GDP ratio in 1979 was 30%.
• d=0.7%, n=6.8 < i=7.5%,
 bt move farther away from b .
(1  0.068)
b
0.007  1.068  0.3
(0.068  0.075)
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The Dynamics of the Budget, 1979–1993
Figure 14.7
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The Sustainability of the Budget Deficit
• The Budget Surplus Since 1993
In 1993, Congress passed the Omnibus Budget
Reconciliation Act in an attempt to get deficit
under control. (fiscal policy tightens)
The Fed also began to lower the interest rate.
• d=-1.9%, n=5.5% > i=4.9%.

b b
t
(1  0.055)
b
(0.0019)  0.334  0
(0.055  0.049)
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The Budget Surplus Since 1993
Figure 14.8
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Different Perspectives on Debt and Deficits
• Ricardian Equivalence
- If government spending is financed by debt,
household will choose to hold all of this increased
debt without reducing the amount of saving that
they devote to investments.
- The reason is that they anticipate that they will
need extra wealth in the future to pay increased
taxes.
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Different Perspectives on Debt and Deficits
• The relationship between the Budget and the
Rate of Interest
After 1979,
- the productivity growth slowed down. ( n↓ )
- the world capital markets are linked and a high
deficit in the U.S. influenced the interest rate
throughout the world economy. ( i↑ )
- n<i
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Homework
Question 5, 7, 11, 12
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