Ch. 16: Fiscal Policy and The Government Deficit Flashcards
How many components is government spending made up of? What are they?
Government spending is made up of 4 components:
1) Government Purchases (Gi + Gc)
a. Government Investment (Investment in infrastructure, anything that increases the capital stock of the economy)
b. Government Consumption
2) Grants in Aid
Grants in Aid refers to the aid that the Federal Government provides to state and local governments
3) Transfer Payments
- Transfer payments are payments the government has to make to individuals such as Social Security benefits, Welfare payments, Unemployment insurance etc. - Transfer payments are considered spending in which the government receives nothing in return.
- They are also known as entitlements
4) Net Interest Payments
Net Interest payments are the payments made to U.S bond holders minus the interest payments made to the government for things like federal student loans.
How many components is government Tax revenue made up of? What are they?
Government Tax revenue is made up of 5 main components.
1) Personal Income Taxes
- Personal income taxes are taxes on the income of individuals as well as property taxes.
- Federal income taxes are the main source of revenue for the federal government
2) Corporate Taxes
- Corporate taxes are the taxes on the profits of businesses.
3) Grants in Aid
- For state and local governments, the aid that they receive from the Federal government is considered income.
- Whereas for the federal government, it is regarded as spending.
- Grants in aid don’t change the balances in the government spending budgets as they basically move from one pocket to another in the same account.
4) Contribution to Social Security taxes
- These are primarily social security taxes that are paid to the federal government.
- They are most often a fixed percentage of an earners income
- Half of it is paid by the individual earner, while the other half is paid by the employer
5) Taxes on Production and imports
- This includes taxes on production, which are referred to as Sales Tax.
- Sales tax revenue is major source of revenue for state and local governments
- As well as taxes on imports, which are known as tariffs.
How do you calculate the amount of a budget Deficit? What is the full form of the equation given by the textbook?
Budget Deficit = Government Spending - Tax Revenues
Full form of equation given by the textbook for a budget deficit:
(G + Interest + Transfer Payments) - Taxes
What is a government budget constraint? What is the formula for a budget constraint?
A government budget constraint is defined as the change in the capital stock of government bonds (∆B = Deficit is the Gov. Budget Constraint)
- This is because when the government is in a budget deficit, it has to finance its spending by selling government bonds. As the budget gets steeper, the number of bonds sold would increase, adding to the stock of government bonds outstanding, ∆B
What is the debt-GDP ratio? How can it change?
The debt-GDP ratio measures the amount of nominal debt a country holds as a percentage of its nominal GDP.
It can change if a country’s budget deficit increases and the amount it owes increases, and assuming that nominal GDP is held constant, the debt-GDP ratio would increase.
It could decrease if the country’s GDP increases, with the nominal debt held constant.
What is a sovereign debt crisis?
A sovereign debt crisis refers to a situation where a country has an increasing debt-GDP ratio. The probability of default increases, so public investors sell off the country’s bonds which the decrease their prices. So, the government has to increase the interest rates bonds offer in order to attract investors. This drives up the amount the government owes in the future, which continue to increase the country’s probability of default.
⬆️ debt-GDP ratio –> ⬆️ probability of default –> ⬆️ Interest payments –> ⬆️ Default –> (a cycle)
What are reasons for why high government debt may NOT be a burden?
- Government debt is not a burden because if it was used to invest in human capital, then it would be spending on things like education and work training programs, that would in turn increase the productivity of workers and consequentially increase wage, which would increase taxes revenue.
- It’s not a burden because if it were to invest in government capital, in things like highways, buildings infrastructure etc, it could increase the productivity of the economy.
What are reasons for why high government debt may be a burden?
- Reductions in National Savings
During the presence of a high budget deficit, there may be a decrease in investment and Net exports. When there is a loss of private investment, due to a reduction in national savings caused by a budget deficit is known as Crowding Out. When there is a loss of private investment, it leads to the loss of capital stock in the economy, which leads to decreased production of goods and services in the economy. - Value of Government Capital Investment
High government debt may be burden because not the majority of government spending is spent on consumption and not investment. Even the investments, not all investments are good ones that have high rates of return. - Debt to Foreigners
A reduction in national savings caused by a high budget deficit could lead to the reduction in Net Exports. Negative net exports are financed by the purchase of government bonds by foreign governments. So, high budget deficits that cause a reduction in national savings can lead to indebtedness to a foreign country. - Negative Incentive Effects
When a country has a high budget deficit, one thing it can do is increase taxes. If taxes are raised too high, then the willingness to work decreases, so the output of the economy decreases, which could lead to distortions in the economy, which are inefficiencies in the economy.
Rising capital gains tax too high also decrease the amount of investment in the economy which would decrease the country’s capital stock.
Tax wedges = difference between what a worker earns after taxes and what they earn before paying taxes
How Do Tax Cuts and Increased Government Spending affect the Aggregate Demand Curve?
Tax cuts and increased government spending will shift the aggregate demand curve up and to the right. Output will move back up to potential output, and inflation starts rising.
This is because tax cuts will increase disposable income and lead to higher consumption. Increased government spending directly adds to aggregate demand.
What is the equation for the Expenditure Multiplier?
The expenditure multiplier is the change in the equilibrium output divided by the change in government spending:
Expenditure Multiplier = ∆Y / ∆G
What is the equation for the Tax Multiplier?
The tax multiplier is the change in equilibrium output dived by a change in Taxes
∆Y / ∆T
- MPC / (1 - MPC)
When is the Fiscal multiplier much larger with regards to the Zero Lower Bound?
The fiscal multiplier is much larger when interest rates are at the zero lower bound, than when they are above the zero lower bound.
- What happens when interest rates are ABOVE the zero lower bound, during expansionary fiscal policy?
- What happens when interest rates are AT the zero lower bound, during expansionary fiscal policy?
- When interest rates are above the zero lower bound, and the government enacts expansionary fiscal policy (government spending/reducing taxes), there would be a rise in inflation, which is when the fed raises interest rates, which would lead to a decrease in investment in the economy, and overall would lead to Output growing at a smaller amount.
- When interest rates are at the zero lower bound, and the government enacts expansionary fiscal policy, inflation will rise and the federal reserve will keep policy rates fixed at zero. This will decrease real interest rates, leading to an increase in investment and causing an increase in output by a much greater amount
- What are the two parties that can possibly finance the governments budget deficit by buying bonds? What is the equation for these two parties financing the budget constraint?
- What if private investors don’t want to buy all the bonds, and the central bank has to step in? What does the equation become?
- What is this transaction of money between the Central bank and the federal government know as?
- Two parties that can finance the governments budget deficit is the Central bank and private investors.
Deficit = ∆B = ∆B(investors) + ∆B(central bank) - If it’s the central bank financing the budget constraint, it buys the bonds and issues the cash to the government. The equation becomes:
Deficit = ∆B(investors) + ∆M - When the central bank issues cash to the federal government in exchange for the government’s bonds, it is known as seignorage. This is also known as “monetizing debt” because the bank is literally buying government debt
During seignorage (printing money), how does it affect inflation? The relationship between inflation and the money supply?
What does this say about large deficits financed by seignorage?
During seignorage, in the long run, inflation will rise at the very closely with the growth rate of the money supply.
π = ∆M / M
Large budget deficits that are financed by seignorage (printing money) will lead to high inflation.
