Transcript ch32

Chapter 32
Government
Debt and
Deficits
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
In this chapter you will learn to
1. Describe the relationship between the government’s annual
budget deficit (or surplus) and its stock of debt.
2. Define the cyclically adjusted deficit and how it can be used
to measure the stance of fiscal policy.
3. Explain how budget deficits may crowd out investment and
net exports.
4. Explain why a high stock of debt may hamper the conduct
of monetary and fiscal policies.
5. Explain why legislation requiring balanced budgets may be
undesirable.
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Facts and Definitions
The Government’s Budget Constraint
Government expenditure must be financed by either tax
revenue or by borrowing:
Government
expenditure
=
Tax
revenue
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+
Borrowing
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Facts and Definitions
Government expenditures are composed of:
• purchases of goods and services = G
• debt-service payments = i  D
• transfers
Since T is the government’s net tax revenues, the budget
constraint becomes:
G + i  D = T + Borrowing
(G + i  D) – T = Borrowing
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Facts and Definitions
The government’s annual budget deficit is:
- the government’s borrowing
- the change in the stock of debt
The budget deficit can therefore be written as:
Budget Deficit = D = (G + i  D) - T
If there is a:
- budget deficit  the debt rises
- budget surplus  the debt falls
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Facts and Definitions
The primary budget deficit:
- the deficit on the non-interest part of the budget:
Primary
budget deficit
=
Total budget
deficit
- Debt-service
payments
= (G + i  D – T) – i  D
= G–T
2005-06 fiscal year: debt-service payments = $227 billion
- total budget deficit = $248 billion
- primary budget deficit = $21 billion
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Deficits and Debt in the United States
Between 1980 and 1993, the average budget deficit was
about 4% of GDP.
By 1998, the federal government had its first budget surplus in
almost 30 years.
Four years of budget surplus were followed by a return to a
deficit in 2002.
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Figure 32.1 Federal Government
Expenditures, Revenues, and Deficit,
1962–2005
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Figure 32.2 Federal Government Net Debt
as a Percentage of GDP, 1940–2006
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Two Analytical Issues
The Stance of Fiscal Policy
Fiscal policy is the use of the government’s tax and spending
policies in an effort to influence the level of GDP.
For a given set of tax and spending policies, the budget deficit
is negatively related to real GDP.
 the budget deficit function shows this negative
relationship between the deficit and Y
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Figure 32.3 The Budget Deficit
Function
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Two Analytical Issues
Since changes in Y will lead to changes in the budget deficit,
we cannot infer anything about policy from changes in the
deficit.
Changes in the stance of fiscal policy are shown by changes
in the cyclically adjusted deficit.
The cyclically adjusted deficit (CAD) is the budget deficit that
would exist with the current policies if Y were equal to Y*.
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Figure 32.4 The Cyclically Adjusted
Deficit and Changes in Fiscal Policy
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Figure 32.5 The Actual and Cyclically
Adjusted Deficit, Federal Government,
1962–2006
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Changes in the Debt-to-GDP Ratio
Simple but crucial equation:
d = x + (r – g)  d
Where: d is the debt-to-GDP ratio
x is the government’s primary budget deficit as
a percentage of GDP
r is the real interest rate
g is the growth rate of real GDP
d is the change in the debt-to-GDP ratio
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Changes in the Debt-to-GDP Ratio
Two Implications:
1. If r > g, then d will rise unless there is a sufficient primary
surplus.
2. If r = g, then all that is required to keep d constant is a
primary budget balance.
EXTENSIONS IN THEORY 32.1
Derivation of the Debt-to-GDP Ratio
Equation
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The Effects of Government Debt
and Deficits
We assume in what follows that changes in the
government’s flow of saving are not offset by changes in
private saving:
 changes in the budget deficit lead to changes in
national saving
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Do Deficits Crowd Out Private
Activity?
Crowding out is the reduction in private expenditure caused
by an expansionary fiscal policy:
- higher interest rates (investment)
- appreciated currency (net exports)
The fiscal expansion can be either:
- an increase in G
- a reduction in T
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Figure 32.6 The Crowding Out
of Investment
Consider a closed
economy at Y*.
A fiscal expansion
increases the deficit and
reduces national saving.
Interest rates rise and
investment falls.
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How About in an Open Economy?
In an open economy, as interest rates increase there is an
inflow of foreign financial capital.
This capital inflow leads to an appreciation of the currency
and a crowding out of net exports.
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Do Deficits Harm Future
Generations?
Government debt generates a redistribution of resources
away from future generations toward the current generations.
Whether there is a burden on future generations depends on
the nature of the government spending being financed by the
deficit.
Debt incurred to finance public investment may result in no
burden for future generations.
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Does Government Debt Hamper
Economic Policy?
Government debt can impose costs in the very distant future
 we tend to ignore their importance
Government debt can also cause problems that are more
immediately apparent:
 the conduct of monetary and fiscal policy
become more difficult
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Monetary Policy
To see how government debt can hamper the conduct of
monetary policy:
- consider a very high debt-to-GDP ratio
- creditors may come to expect monetization of debt
 an increase in inflation expectations
 makes monetary policy more difficult
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Fiscal Policy
Fiscal Policy
- governments often try to implement counter-cyclical
fiscal policy
- deficits in recessions and surpluses in booms
- but a high debt-to-GDP ratio may restrict the
government severely
 may be unable to have stabilizing fiscal policy
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Current Budget Surpluses
Since 1998, the federal government has had a budget surplus.
What does our model predict if these are sustained?
- higher national saving
- lower interest rates
- higher investment
- currency depreciation and greater net exports
- enhanced ability for counter-cyclical fiscal policy
should the need arise
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Formal Fiscal Rules?
The potential problem with large public debt leads some
people to consider formal fiscal rules to prevent the
excessive build-up of debt.
What are some possibilities?
APPLYING ECONOMIC CONCEPTS 32.1
Is Foreign-Held Debt a Problem?
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Annually Balanced Budgets?
A balanced budget every year is difficult because:
- a large part of G and T is beyond the control of the
government
- it may be destabilizing on real GDP
For example:
In a recession, tax revenues naturally decline:
 a balanced budget requires a reduction in G or an
increase in T
 real GDP declines further
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Cyclically Balanced Budgets?
An alternative is to require that the government’s budget be
balanced over the course of a full economic cycle.
Desirable in principle, but very difficult to define and
implement.
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Allowing for Growth
Another problem with any formal fiscal rule is the
emphasis on the overall budget deficit:
- but the debt-to-GDP ratio is probably more
important
Some economists view a stable (or falling) debt-to-GDP
ratio as the appropriate indicator of fiscal prudence. This
view permits a deficit as long as the stock of debt grows no
faster than GDP.
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