Chapter 7 Flashcards
3 Main Ways the Government can raise revenue
- Tax
2. Debt - Inflation
If receipts are higher, there is a
budget surplus and the state is saving money
If receipts are lower, there is a
budget deficit that is funded through additional borrowing.
Structural deficit:
fiscal position once the short-term impact that a recession has on spending and taxes has been taken out.
○ Tax system should have 4 maxims:
Proportionality
Certainty
Convenience
Economical
In reality higher taxes reduce the
incentives for working and at some point we would expect people to alter their behavior.
Dynamic Effects of Taxes
- Tax evasion
- Tax avoidance
- Emigrating
- Working Less
Risks of high taxes are unseen effects:
the difference between the amount of activity taking place currently, versus how much would take place in an alternative tax regime. Easiest way to avoid tax is simply by avoiding work.
Bond
debt security - promise to pay a certain amount of money at specified points in the future (usually this will be an annual return)
Supply of bonds is therefore the equivalent of the
demand for loanable funds.
The concept of ‘interest’ provides this reward -
it compensates people for giving up their ownership of resources for a period of time.
Interest rate:
ratio of money in the present with money in the future. It is the price of time.
The balance between consumption and investment is determined in the
market for loanable funds. Some people are patient, have money to spare and are willing to exchange present goods for even greater future goods (savers). Other people want to bring forward their future income and spent it today (borrowers). The supply and demand for loanable funds operate like any market and generate an equilibrium quantity (the amount of lending) and equilibrium ‘price’ (the interest rate).
bond contains
- Principal
- Coupon
- name of gilt
- Maturity
3 Determinants of bond prices
- Inflation expectations
- Interest rate expectations
- Economic confidence
Inflation expectations
- Inflation erodes the value of future payments, so reduces people’s desire to purchase future income streams.
- To protect against this you can buy an index-linked gilt, where the coupon and final redemption payment are tracked to movements in the retail price index (rpi).
Interest rate expectations
- There is an inverse relationship between interest rates and the price of gilts.
2. By contrast, if the interest rates were above the coupon, the gilt would be less attractive and the price would fall below the principal.
Economic confidence
- Government’s ability to repay debt depends on their future tax revenue, therefore people may be less inclined to buy gilts if there’s a slowdown.
current yield
The current yield is the interest rate based on the buying price as opposed to the nominal value. It shows us the return that the bondholder would get if they held it for a certain period of time, and can be calculated as the coupon divided by the market price. If the prices fall the yield will rise (there is an inverse relationship).
yield to maturity
helps us to see what return the bondholder might expect since it incorporates as assumption that coupons are reinvested, and that the bond will be held until it matures.
yield curve
relation between the interest rate (cost of government borrowing_ and the time to maturity. The long the time period the greater the interest rate needs to be to compensate lenders
inverted yield curve
occurs when long term yields fall below short-term yields.
Use bond markets for
- estimate inflation expectations
2. Estimate soverign default risk
Real Variables
quantities and relative prices
- Real GDP
- Capital Stock
- Real Wages
- Real Interest Rate
Nominal Variables
Expressed in money terms
- Money supply
- Price Level
- Inflation
- Wages
- Nominal GDP
3 Main Evolutions in the History of money and banking
- Certificates of deposit
- fractional reserves -> central banks -> volumes of reserves
- fiat money
fiat money
money that isn’t converted into something (gold, precious metals, etc.)
GDP
cash value of final goods and services produced within a given time period
3 ways to calculate GDP
- output approach
- income approach
- expenditure approach
output approach
looks at the final value of goods and services traded
income approach
measures the total amount of income earned
expenditure approach
total amount of money spent
Reasons why GDP diverges from living standards; bad measure to target
- non-traded labour
- under appreciation of leisure
- Government services measured at cost
- ignores opportunity cost
- short time horizon
National Deficit
a) How much government is currently spending in excess of revenue
National Debt
a) Total accumulation of all past deficits
Rivalrous Good
A good is rivalrous if I consumed one more unit of that good there is one less unit of that good for consumption for someone else.
Excludable Good
s it feasible, low cost, for me to prevent people from enjoying the good who do not give up something to get it.
Public Good
Nonexcludable + nonrivalrous
One a public good exists, it exists for anyone to consume. The existence of the good doesn’t depend on anyone paying for it.
Public sector provides the
nonexcludable goods.
taxes create
- Create some amount of deadweight loss
- Reduce consumer/producer surplus
- Increase price of good for buyers, decrease price that sellers receive
Taxes reduce quantity of trade that takes place in the market.
How taxes are counterintuitive
One of the foundational theorems of public finance is that it doesn’t matter who you levy the tax on (buyers or sellers). The end result will be the same.
You cannot tax one side of the market without also affecting the other side of the market.
Taxes are felt by all parties in the market enough if they aren’t the ones that are nominally taxed.
The most efficient tax possible
raises the most amount of revenue for the smallest amount of deadweight loss.
Laffer Curve (Taxes)
- If you’re on the right, you’re not getting as much revenue as you could get.
○ T’ to T*, deadweight loss will fall; more wealth will be created.
○ You can get more revenue from the public sector you create more wealth- If you’re on the left side
○ To maximize revenue, move to T*
In this region, there is the tradeoff of more tax revenue but more deadweight loss inefficiencies.
- If you’re on the left side
You do not necessarily increase tax revenues the higher
the tax rate. You can disincentive, destroys wealth, etc.
DAFT
Deficits are future taxes
When a government runs a deficit
it is borrowing somewhere.
If raised for direct taxation, who is paying? Taxation is then and now.
Deficit finance through bond issuance more popular than taxes. They do like receiving public spending. People like parks, military, etc.
Maturity Mismatch Problem
Banks borrow short and lend long. Banks issue short term liabilities.
Illiquid
Not necessarily inviable, just have cash flow problem
Insolvent
when total liabilities > total assets
