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).
