Chapter 11 - Fiscal Policy Flashcards
Ricardian Equivalence
An economic theory that suggests that when a government tries to stimulate economy (increasing debt-financed gov spending), demand remains unchanged!
- Public saves excess money to pay for expected future tax increases that will be used to pay off government debt
Public sector is divided into 3 sectors
name and describe them
1) Central government
- in charge of: defence, judicial system, higher education and research, national transport systems
2) Local government
- in charge of: local schools, roads, transport systems
- health care and social assistance shared between 1 and 2
3) Social security funds
- consists primarily of the public pension scheme
What does it mean when public sector accounts are consolidated?
This means that the internal transactions between subsections are cancelled out
How large is the public sector?
- divided into 3 sides + transfers
Income Side: consists of taxes and social security fees that households and firms pay to gov
- 2009 OECD figures, 50-60% Scandinavian countries, low 30% for Australia and USA
User Side: includes C + I but excludes transfers (around 20-30% most countries)
- used for consumption such as health care and education
- Scandinavian w/ high shares and the US on the low side w/ 17%
- more important role in these countries rather than US or Switzerland
- In OECD countries 50% of gov revenue used for transfers such as pensions and social assistance (income > user)
Production Side: subset of the user side which includes goods actually produced by government
- excludes government consumption or investment if it was produced by private sector
- purchases many g’s and s’s produced by the private sector
Income Side > User Side > Production Side
Sustainable Government Finances (Definition)
Government net debt does not grow faster than GDP
Sustainable government finances…
Explain intuition behind this equation
∆𝐷(t+1) =𝐺 −𝑇 +𝑟𝐷
G = gov expenditure, T = tax revenues (transfers), D = gov debt
RHS of equation (G-T) = primary deficit
- this adds to the stock of government debt next period
rDt - interest payments in period t in real terms
- Dt is real net government debt at beginning of period t
- r = real return
- adds to the REAL stock of gov debt next period
∆ in level of debt depends on:
- whether gov is in primary surplus/deficit
- size of interest payments
primary surplus: T>G
as long as surplus is > interest payments…
(T-G) > rD debt will fall
∆in debt to GDP ratio, as a function of:
- government’s budget balance
- IR
- GR of economy
- overall debt ratio
Start with debt-to-GDP ratio
𝑑𝑡 = 𝐷𝑡/𝑌𝑡
- use rule of thumb for growth rates
- substitute and rearrange
- use formula for
∆𝐷(t1) =𝐺 −𝑇 +𝑟𝐷
in order to get…
Δ 𝐷/Y =( 𝐺 − 𝑇)/Y + (𝑟 − 𝑔) 𝐷/Y
for nominal terms replace
𝑟 = 𝑖 − 𝜋
- this equation is useful to understand how the government debt ratio evolves over time
Nominal equation for change in debt-to-GDP ratio
as a function of IR, overall debt ratio, GR, gov’s budget balance
Δ 𝐷/Y = (𝐺 − 𝑇 )/Y + 𝑖 𝐷 − (𝜋 + 𝑔) 𝐷/Y
- LHS = debt ratio
- RHS = 3 terms all expressed as a fraction of GDP
- first 2 terms raise the debt ratio (primary deficit and interest payments on debt)
- third terms tends to reduce debt ratio for growing economies, nominal GR of economy times the debt ratio
When calculating nominal government surplus or deficit (given a value of net government debt e.g. 100%)
Rearrange nominal equation for Δ in debt-to-GDP ratio and put overall surplus/deficit on the left
(𝐺 − 𝑇 )/Y+ (𝑖 𝐷)/Y = (𝜋 + 𝑔) 𝐷/Y
Calculating (as a share of GDP) the public sector deficit
(G+I-T+iD)/Y
Calculating (as a share of GDP) the primary deficit
(G+I+Tr-T)/Y
Tr = transfers T = tax revenue
What is fiscal stimulus?
Increasing government consumption or transfers or lowering taxes.
- this means increasing the rate of growth of public debt (as it is financed by higher government borrowing)
Main points from graphs (in workshops) showing levels of government debt
- level of government debt cannot be seen as a single measure of financial stability of a country’s public sector
- China and India have both maintained stable levels of GD
- rapid EG in those countries not financed by excessive public spending
how to: calculate the primary government deficit/surplus required to keep the debt-to-GDP constant
real IR: r = 𝑖 − 𝜋
Stable debt ratio is given by:
0 = (𝐺 − 𝑇 )/Y+ (𝑟 − 𝑔) 𝐷/𝑌
Rearrange to get:
(𝑇 − 𝐺)/Y = (𝑟 − 𝑔) 𝐷/Y
negative = run a deficit positive = run a surplus
What causes deviations from Ricardian Equivalence?
Myopic and credit constrained consumers:
- Myopic: doesn’t care about future outcomes and consumes all of the extra income
- credit constrained: wishes to borrow but cannot, therefore cut in taxes = consumes the extra income
Reduced borrowing costs:
- gov can normally borrow at lower rates than private individuals, if they borrow on behalf of individuals, cost of borrowing falls & increases consumption
Finite Lives: consume extra income as they may not be around when taxes do eventually rise to pay for extra borrowing
Lack of knowledge about how tax cut is financed:
- consumers have little idea about state of gov finances
- might believe finances are sustainable or it is a reduction in future government expenditure
