Debt Sustainability

Question 1

How did the Government deal with the COVID pandemic?

Answer 1

• COVID was both a demand and supply side shock
• AD fell, and the main priority was to ensure protection of firms and households
• Used Fiscal and Monetary Policy to mitigate shocks
• Furlough scheme, income support, UC increased, Reduced VAT and other tax breaks

Question 2

What was the largest concern with Government economic management of COVID?

Answer 2

• Schemes cost £169bn
• Output was also lost
• So the question becomes how do they pay?

Question 3

Why were the UK Government okay with taking on so much debt?

Answer 3

• COVID would only be short term
• The alternative of allowing a sector to be destroyed would be worse
• They had to do something, and they didn’t have the reserves for this

Question 4

Why was Debt-Financing used by the Government?

Answer 4

• Preferred during COVID because of public opinion and cost of living
• Debt level is often already high, so questions around affordability
• Limits the size of the fiscal response
• But, if IR fall, it becomes cheaper to provide support
• Before pandamic, yield on 10yr Govt. bonds was 0.354% (LOWWW), rose to around 4%

Question 5

State and Explain the sustainability formula

Answer 5

• d(t) = [1+r] / [1+g] x d(t-1) - s(t)
• d is debt:GDP ratio
• Based on existing debt, multiplied by the relative change in interest rate by growth of output
• Minus the primary surplus of the year
• Primary Surplus = Budget surplus - Interest Payment

Question 6

What is the link between greater GDP Growth and debt sustainability?

Answer 6

• If g>r, Government can offset the debt:GDP by running a primary deficit
• If g>r, coefficient of s(t) is negative
• If s(t) > 0, d(t) = d(t-1) won’t grow
• Debt can be sustainable if there is a great enough primary surplus
• i.e. Post War Debt:GDP ratio was over 200%; but Avr. GDP growth was about 3.5% p.a.
• Eventually the Debt:GDP fell to 35%

Question 7

What is the Crowding Out Effect? How does Blanchard and Cochrane view contradict?

Answer 7

• Higher G means higher C & less capital
• Reduces savings & supply of loanable funds
• Investors don’t want to hold more debt, so IR increase
• However, maybe good at 0 lower bound at the moment (Blanchard)
• Cochrane questions whether the Government Bonds will always be the safest (1972 and 1980 [-ve beta value])- will this mean no funds?

Question 8

What does Blanchard say about Debt Sustainability?

Answer 8

• Following COVID, the protection of the public was the reason for taking on a debt burden
• To avoid Explosive Debt, the Primary Surplus must be sufficient enough to service the debt
• If r>g, the primary surplus must be greater than 0, hence the debt can be sustainable if the surplus can be generated
• This also reduces the country’s welfare because the Government crowds out capital accumulation and thus output falls
• If r<g, the primary surplus can be less than 0 and the debt can be services
• The burden would be on current investors
• If Eπ is low, i* is low and the lower interest rate bound is engaged; r* cannot be achieved as QE and EXR may not be enough, and global savings glut means that demand for the loanable funds is lower.
• To counteract this, increased spending is necessary, r<g means that the debt is sustainable and not costly in the long run

Question 9

What does Cochrane say about Low Interest Rates and Government Debt?

Answer 9

• The best explanation for low IR is low growth due to low MPK
• MPK is declining because increased taxes and competition stifle innovation
• Disagrees with Blanchard saying that r<g is fairly irrelevant with the fiscal issues in nations, as there is an exponential increase in debt
• To increase r, you must create strong supply-side growth to encourage increased growth

Question 10

What does MRU say about Crowding Out?

Answer 10

• Where Expansionary Fiscal Policy decreases Private Sector Investment when the economy is at full capacity
• Increases in Government Spending mean resources must be taken away from Private Sectors and would not (SR) stimulate the economy
• Similarly, D for LF increases, r increases and private consumption and investment falls
• However, if the economy is not at full capacity and the increase in investment boosts GDP, the private sector will not be crowded out