4. Budget Deficits & Taxation: Great Recession and Budget Crises Flashcards
What is the governments budget constraint?
Gt + Bt = Tt + qt B(t+1)
What is qt?
What does it represent?
The value of bonds
Represents how much the government is trusted by the market to repay the bond
What is a country’s “default risk”?
2 points
Indicates the level of trust in a country’s government
Can be represented by the value of bonds (qt)
How is rt related to default risk?
2 points
If rt is high then qt will be low => government has to sell a high number of bonds to pay for expenditures/debt
I.e. external financing is difficult
Why did Greece and Portugal suffer more than other countries when the 2008 recession hit?
There interest rates (rt) increased more than other countries, hence their default risk skyrocketed
Give the equation for the value of a bond/default risk
qt = 1/(1+rt)
What are “automatic stabilisers”?
What happens in terms of government debt?
What might this cause?
(4 points in total)
Where a recession starts and government expenditure goes up and taxes fall
Hence primary deficit (G-T) grows
So use of external financing (qtB(t+1)) increases
May cause a “multiple-equilibria and self-fulfilling debt crisis”
What causes a “multiple equilibria and self-fulfilling crisis!?
The use of external finances (qtB(t+1)) because of automatic stabilisers when a recession hits
What is a “multiple equilibria and self-fulfilling crisis”?
3 large points
If the price of bonds qt stays constant, a recession means that the number of bonds to mature next period (Bt+1) increases
If Reinhart and Rogoff are believed then this will cause a reduction in GDP and further debt
This creates “sunspot equilibria” - the country believes that it can’t repay its debts, and this belief is self-fulfilling
What are “sunspot equilibria”?
Where the equilibrium is based on what is expected to happen
What 2 options are there in a “multiple equilibria and self-fulfilling crisis”?
Give a third option
Keep debt low (increase taxes, decrease government expenditure)
Assume that debt is irrelevant in the short run (Ricardian equivalence)
Cut taxes and increase government spending in order to stimulate aggregate demand (this requires belief in tax multipliers)
Why might it be beneficial to cut taxes and increase government spending in a recession?
If one believes in tax multipliers then cutting taxes would stimulate aggregate demand
What determines which option a government would find more appealing in a “multiple equilibria and self-fulfilling crisis”?
Preferred choice depends on whether the policy maker believes in Ricardian equivalence
