3- Government Borrowing

Question 1

What does government expenditure cover?

Answer 1

Purchases of goods and services; items such as public spending on consumption and investment

Question 2

What is the equation for the primary deficit?

Answer 2

PD = G - T

Primary Deficit = Real government expenditure - Real government taxation revenue

Question 3

If government debt is denoted as B, what expression shows the interest it must pay?

Answer 3

iB

Question 4

What is the total deficit?

Answer 4

The primary deficit plus interest payments

D = PD + iB

Question 5

What are the necessary conditions for reducing debt?

Answer 5

The primary surplus must exceed interest payments:

T - G > iB

Question 6

What does debt as a share of GDP depend on?

Answer 6

The primary deficit and the difference between the interest rate and economic growth:
∆b = pd + (i-y)b

Question 7

When can an economy run a primary deficit without increasing debt?

Answer 7

If economic growth exceeds the interest rate

Question 8

How is the equilibrium debt ratio (b*) derived?

Answer 8

When ∆b = 0:

b* = (g-t)/(y-i)

Question 9

What are the 3 main ways in which government spending can be financed?

Answer 9

• Raising taxes
• Borrowing
• Central bank increasing monetary base

Question 10

Given money financing, how does the government budget constraint change?

Answer 10

T + ∆B + ∆M0 = G + iB

Question 11

What happens when the government increases spending by increasing the monetary base in an environment where the central bank fixes interest rates.

Answer 11

The IS curve shifts right but as the LM curve is flat, only Y increases

Question 12

How is a change in the monetary base represented as a share of GDP?

Answer 12

∆M0/Y = (∆M0/M0)(M0/Y) = µ0m0

Question 13

What is the equation for the growth rate of debt (∆b) when taking into account money financing?

Answer 13

∆b = pd - µ0m0 + (i-y)b

Question 14

Explain 2 main pros of money financing

Answer 14

• Provides an alternative source of funding to the bond market, in particular for projects that the bond market does not favour, eg long-term projects that gradually increase productivity and hence increasing y
• There are concerns that QE has increased inequality, by boosting the prices of financial assets, held largely by the rich. MF can be seen as an extension of QE in which the Central Bank issues reserves in order to finance investment in social capita and infrastructure, likely to benefit those who do not own financial assets

Question 15

Explain 2 main cons of money financing

Answer 15

• Excessive reliance of MF leads to increased inflation, with well-known cases of hyperinflation
• If MF is used to finance unproductive but politically favoured projects, then y may fall