Transcript Figure 5-1 Real Government Expenditures, Real Government

Robert J. Gordon,
Macroeconomics, 10th edition,
2006, Addison-Wesley
Chapter 5:
National Saving, the Government Budget,
Foreign Borrowing and the Twin Deficits
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The pervasive effects of the government budget
 Crowding out of net exports
 The IS-LM model emphasized that a fiscal expansion is likely to
crowd out domestic private investment. In addition, a fiscal
expansion can crowd out net exports. Note:
T - G ≡ ( I + NX ) – S
 Government surplus is the excess of domestic investment I and
foreign investment NX over private saving S, or government
surplus is available to finance excess investment over private
saving (I-S) or to lend foreigners (positive NX).
 If T<G, there will be 3 ways to finance the deficit,
1. S can go up
2. I can go down
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
3.
Foreign investment can go down (in case of being negative
we will borrow)
 Impact on future generations
 Persistent budget deficits have another implication. It raises the
public debt, future generations will be obliged to pay higher
taxes so the government can pay the interest on the debt.
 Persistent deficit have pervasive consequences on private
investment, foreign investment or borrowing and the wealth of
future generations.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The structural budget
 There are two types of changes in budget deficit;
1.
2.
Cyclical surplus or deficit
Structural surplus or deficit; which is what the surplus or deficit
remains will be if the economy is operating at its natural (not
actual) level.
 Automatic stabilization
 If T can rise when Y is high and fall when Y is low, we can
express net taxes T as:
T = tY
 This implies that:
Budget surplus = T-G = tY-G
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 There are two main sources of change in the surplus or deficit:
1.
2.
Automatic stabilization (changes in Y).
Discretionary fiscal policy (changes in G and t).
 Automatic stabilization
 In an economic expansion, T rises (R rise and benefits fall),
which helps to restrain the boom.
 In a recession T falls (R fall and Benefits rise) which help to
restrain the recession and boast the economy.
 See figure 5-2. BB is the budget line which illustrates the
automatic stabilization relationship between the budget and Y,
its slope is t0. at B the economy would move to A as the
government is running a deficit equals the vertical distance
between B and A.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 5-2 The Relation Between the Government Budget Surplus or Deficit and
Real Income
Slope is to
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Discretionary fiscal policy.
 Comes from alterations in G and t.
 How discretionary changes affect budget line.
 Look at figure 5-3. If G is higher, deficit will be larger at Y0.
There are 3 ways to reduce the deficit:
1.
2.
3.
Increase Y to YN movement from C to D.
A movement from C to B which reduces G (less deficit).
Increase t0 which shifts the budget line upward (more tax).
 Note that changes in budget deficit is not a necessary indication
of specific discretionary fiscal policy actions, since the actual
budget deficit can also change as real income increases or
decreases with no change in tax rates or government
expenditures as from C to D or B to A.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 5-3 Effect on the Budget Line of an Increase in Government Expenditures
Higher taxes push
BB up, higher G
pushes BB down
Cyclical deficit at BB0
Cyclical deficit at BB1
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The natural employment surplus or deficit
 The natural employment surplus (NES) and Deficit (NED) are




those levels that would occur if actual real GDP Y equals natural
real GDP YN. Hence NES is:
NES = tYN – G
Look at figure 5-3. For original BB0, NED is zero. While NED
for BB1 is AD.
Note that:
structural deficit is another name of NED. It changes whenever
there is a change in G or t.
Cyclical deficit is the difference between actual and natural
employment deficit. The cyclical deficit is the vertical distance
between A and B on BB0 and D and C on BB1.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Automatic stabilization is represented by the slope of the budget
line (t).
 National Saving and the consequences of the government budget
 Fiscal policy and national saving
 National saving NS consists of private saving S and government
saving (T-G), which is available to finance domestic investment I
and foreign investment NX, i.e.,
S+(T-G) ≡ I+NX, or NS = I+NX
 Crowding out in a closed economy
 We know that an increase in G or a reduction in T reduces NS.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 In a closed economy NX is zero. Now Look at figure 5-5.
National saving is composed of S and budget surplus (T-G).
Government saving does not depend on r, but S does.
 Since Ca is negatively related to r, for any level of Yd, as r
increases S, will increase.
 Therefore, NS (private + government (does not depend on r)) are
positively related to r.
 According to figure the economy is in equilibrium at point E0,
where investment demand Id crosses NS.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 5-5 National Saving and Domestic Investment in a Closed Economy
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Now look at figure 5-6.
 What happens when G increase by ∆G, as shown in the figure,
NS sifts from NS0 to NS1. the new equilibrium is at E1, there will
be a decline in I from I0 to I1, which is the crowding out effect of
the fiscal policy expansion.
 Note also that the change in NS is less than the increase in G, this
is the result of the positive effect of higher r on S, and the change
in NS is ( ∆NS = ∆S - ∆G)
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 5-6 Effect of a Fiscal Expansion in a Closed Economy
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Fiscal policy in a small open economy
 Small economies are those whose domestic policy changes have




no influence on world interest rates.
Domestic r in these countries is the world one (rf) which is not
affected by fiscal policy.
An increase in G or decrease in T that reduces S has no effect on
r or on I; NX decline by the exact amount of the increase in
national saving. Note that
∆NS = ∆I + ∆NX
In a small open economy with a fixed r, we can solve for the
change in NX as
∆NS = ∆NX
Where ∆I = 0 because r is fixed. Look at figure 5-7.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Change in NS is caused by the change in G. Since r = rf there will
be no crowding out ∆I = 0 . The new equilibrium of the economy
will be the same point E1 as the original E0. the increase in G is
exactly balanced by a decline in NS that equals the decline in NS
(∆G = ∆NS = ∆NX).
 It is borrowing from foreigners that allows domestic investment
to remain unchanged despite a change in NS.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 5-7 Effect of a Fiscal Expansion in an Open Economy (1 of 2)
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Fiscal policy in a large open economy
 Changes in monetary and fiscal policy can alter foreign interest
rate. Suppose that the world consisted half of the US and half of
foreign countries.
 A fiscal stimulus in US will put pressures on rf. Look at figure 58. fiscal stimulus causes an increase in rf by half as much as
domestic fiscal stimulus in a closed economy (figure 5-6).
 There is a partial crowding out, but not as much as the closed
economy case.
 To summarize we can use the magic equation
∆(T-G) = ∆I + ∆NX - ∆S
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 5-8 Effect of a Fiscal Expansion in an Open Economy (2 of 2)
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 5-4 A Comparison of the Actual Budget and the Natural Employment
Budget, 1960–2004
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 5-8 Components of Net Saving and Investment, 1960–2004
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
International Perspective Saving, Investment, and Government Budgets Around
the World
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
International Perspective Saving, Investment, and Government Budgets Around
the World (1 of 3)
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
International Perspective Saving, Investment, and Government Budgets Around
the World (2 of 3)
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
International Perspective Saving, Investment, and Government Budgets Around
the World (3 of 3)
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
International Perspective Saving, Investment, and Government Budgets Around
the World
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 5-1 Real Government Expenditures, Real Government Revenues, and the
Real Government Budget Deficit, 1900–2005 (1 of 2)
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 5-1 Real Government Expenditures, Real Government Revenues, and the
Real Government Budget Deficit, 1900–2005 (2 of 2)
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 5-1 Real Government Expenditures, Real Government Revenues, and the
Real Government Budget Deficit, 1900–2005
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University