[7] Fiscal Policy: Government Debt and Budget Deficits

Question 1

Budget Deficit: Measurement Problems [4]

Answer 1

Inflation
Capital Assets
Uncounted Liabilities
Business cycles

Question 2

Inflation x1 explanation of measuring problem

Answer 2

Correcting the deficit for inflation can make a huge difference, especially when inflation is high.

Question 3

Capital Assets

how is deficit measured?
whats a better way?

What is the problem with this ‘better’ way?

Answer 3

Currently, deficit = change in debt
Better, capital budgeting:
deficit = (change in debt) – (change in assets)

Example: Suppose the govt sells an office building and uses the proceeds to pay down the debt.
- under current system, deficit would fall
- under capital budgeting, deficit unchanged, because fall in debt is offset by a fall in assets
Problem with capital budgeting: determining which government expenditures count as capital expenditures.

Question 4

explanation of measuring problem: Uncounted Liabilities

x3 examples of what liabilities the deficit omits

Answer 4

The current measure of the deficit omits important liabilities of the government:

• future pension payments owed to current govt workers
• future Social Security payments
• contingent liabilities, such as covering federally insured deposits when banks fail

Question 5

explanation of measuring problem: business cycles

Answer 5

The deficit varies over the business cycle due to automatic stabilizers (the income tax system).
These are not measurement errors but do make it harder to judge fiscal policy stance.
Example: Is an observed increase in the deficit due to a downturn or an expansionary shift in fiscal policy?
Solution: cyclically adjusted budget deficit (full-employment deficit) based on estimates of what government spending and revenues would be if the economy were at the natural rates of output and unemployment.

Question 6

Traditional view of an increase in budget deficit?

Answer 6

Short run: ^C, ^spending, ^Y, v U

Long run:
Y and u back at their natural rates
closed economy: ^r, v I
open economy: ^ε, v NX 
(or higher trade deficit)
Very long run:
slower growth until the economy reaches a new steady state with lower income per capita

Question 7

What is the Ricardian View of a rise in budget deficit?

Answer 7

According to Ricardian equivalence, a debt-financed tax cut has no effect on consumption, national saving, the real interest rate, investment, net exports, or real GDP, even in the short run.

Question 8

Logic/Reasoning behidn the Ricardian view? 4 chains

Answer 8

Consumers are forward-looking, know that a debt-financed tax cut today implies an increase in future taxes,
that is equal—in present value—to the tax cut.

The tax cut does not make consumers better off, so they do not increase consumption spending.

Instead, they save the full tax cut in order to repay the future tax liability.

Result: Private saving rises by the amount public saving falls, leaving national saving unchanged.

Question 9

x3 Problems with the Ricardian equivilence?

Answer 9

Myopia: Not all consumers think so far ahead; some see the tax cut as a windfall.

Borrowing constraints: Some consumers cannot borrow enough to achieve their optimal consumption, so they spend a tax cut.

Future generations: If consumers expect that the burden of repaying a tax cut will fall on future generations, then a tax cut now makes them feel better off, so they increase spending.

Question 10

SUMMARY:
Standard figures on the deficit are imperfect measures of fiscal policy because they: x4

In the traditional view, a debt-financed tax cut __ consumption and __ national saving. In a closed economy, this leads to ___ interest rates, __ investment, and a ___ long-run standard of living. In an open economy, it causes an exchange rate __ and a __ in net exports (or an increase in the trade deficit).

The Ricardian view holds that debt-financed tax cuts do not affect ___ or __ __ and therefore do not affect __ rates, __, or net __.

Answer 10

• are not corrected for inflation.
• do not account for changes in government assets.
• omit some liabilities (such as future pension payments to current workers).
• do not account for the effects of business cycles.

increases, reduces
higher, lower, lower
appreciation, fall

consumption, national saving
interest, investment, exports