3. Budget Deficits & Fiscal Policy: Government Budgets & Deficits Flashcards
What is the equation for the most basic primary deficit?
What does this come from (give eqn)?
Tt-Gt
Comes from simple government budget constraint with no external finance
Gt = Tt
What is the government BC commonly used today?
give verbal explanation
Gt + Bt = Tt + qtBt+1
Uses of government funds = Sources of funds
Give 2 uses and 2 sources of government funds
Uses:
- Expenditures
- Repaying bonds
Sources:
- Tax receipts
- Receipts from sales of bonds
What is a discount bond?
(4 points)
What is is also known as?
A bond that is issued for no more than its face value / trades for less than its face value on the secondary market
Has a lower interest rate than the current market, so not considered to be worth as much
The maximum amount that will be paid for it is its face value
aka Zero-coupon bonds
What is the formula for the relevant price of a discount (zero-coupon) bond?
qt = (Face value)/(1+rt)^n
where n=no of periods before maturity
Outline the discount bond that we assume to be the only type that the government can issue
Face value = 1
No of periods until maturity (n) = 1
i.e. price:
qt = 1/(1+rt)
How are the interest rate and the market price related in the model?
Negatively related => the lower the interest rate, the higher the market price will be
Express the primary (government) deficit through the BC.
Explain.
Tt - Gt = Bt - qtBt+1
I.e. the primary deficit is financed through debt accumulation
How can you iterate the government BC forward?
What does this eventually obtain?
The government BC is faced in each period, so iterate it forward by rearranging it for Bt+1 and substitute it into the BC, and then impose a “No Ponzi” condition
The intertemporal (long-term) budget constraint
What is the “No Ponzi condition”?
Give a formula
States that in the infinite time period a country cannot have positive debt (i.e. the government cannot “die” with debt)
lim(t→∞) q_(0,t) B_(t+1) ≤0
What is a Ponzi scheme?
3 points
Where the government can issue debt and roll it over forever
The issuer always obtains the funds to pay off due debts by issuing new debt
This allows the government to exceeds the original PV of its lifetime resources
What is the formula for the intertemporal (long-term) budget constraint?
Explain each term
∑(t=0)^∞ q(0,t)G_t +B_0 = ∑(t=0)^∞ q(0,t) T_t
First term = PV of government expenditures
2nd term = initial level of debt
3rd term = PV of tax revenue
What is the theoretical limit to deficits?
If the intertemporal (long term) BC applies then all debt must eventually be paid back => the no ponzi condition
Where can the “initial debt” in the intertemporal BC come from?
When countries become independent debt is shared from the previous state
What 4 things should be considered when thinking about this theoretical construct?
- Measurement error in Gt and Tt (happen at different times, so inflation might be an issue)
- Predictable and unpredictable changes in gov expenditure paths
- The paths of future taxation / bond prices are unclear
- The theory says that the current priary deficit is irrelevant because only the long run matters, i.e. “debt doesn’t really matter” this seems strange
