Deficits And Debt

Question 1

Full repayment in year 2

Answer 1

B2 = (1+r)B1 + (G2-T2)

Replacing B2=0 B1=1
–> T2-G2 = (1+r)1 = 1+r

–> to repay debt fully in year 2, gov must run primary surplus 1+r

Question 2

General rule of debt repayment

Answer 2

(1+r) ^ (t-1)

E.g if fully repaid during year 5, decrease in taxes of 1 in year 1 requires increase in taxes of (1+r)^4

Question 3

What do you pay when debt is stabilised?

Answer 3

Only pay net interest (r)

Question 4

What happens if gov decides to wait t years before increasing taxes to repay initial tax cut?

Answer 4

Full repayment in year t-1 –> Bt-1 = (1+r)^t-2

Full repayment end year t –> Tt - Gt = (1+r)^(t-1) - necessary surplus

Budget constraint in year t –> Bt = (1+r)Bt-1 + (Gt-Tt)

Longer you wait to repay, bigger difference between taxes and spending

Question 5

Debt ratio

Answer 5

(Bt/Yt) - (Bt-1/Yt-1) = (r-g)(Bt-1/Yt-1) + (Gt-Tt/Yt)

Dynamics of debt = tells you how gov can repay (and causes of debt)

Question 6

Budget deficit in year t

Answer 6

Deficit (t) = rBt-1 + Gt - Tt

r = real interest rate
Bt-1 = gov debt end year t-1
(Together = real interest payments)
Gt = gov spending year t
Tt = taxes - transfers during year t

Question 7

Gov budget constraints

Answer 7

= change in gov debt during year t = deficit dung year t

Bt-Bt-1 (deficit (t)) = rBt-1 +Gt-Tt

–> Bt = (1+r)Bt-1+Gt-Tt

Question 8

Necessary surplus in year t to repay debt

Answer 8

Tt-Gt= (1+r)^(t-1)

Longer wait to repay = bigger difference between taxes and spending

If gov spending doesn’t change , decreases taxes must offset increase taxes future

Longer wait increase taxes = higher real interest rate = higher eventual tax

Question 9

To eliminate deficit…

Answer 9

Gov must run primary surplus = interest payments on existing debt - requires higher taxes forever

Question 10

Debt ratio

Answer 10

Increase in ratio debt:GDP will be larger

1. Higher real interest rate
2. Lower growth rate output
3. Higher initial debt ratio
4. Higher ratio of primary deficit:GDP

Question 11

Ricardian equivalence

Answer 11

Neither deficit nor debt has effect on economic activity
Consumers don’t change consumption in response tax cut if present value of after tax labour y = unaffected

–> effect of lower taxes today = cancelled out by higher taxes tomorrow

Question 12

Cyclically adjusted deficit

Answer 12

1. Establish how much lower deficit would be if output = 1% higher
2. Assess how far output = from natural level
   - 1% lower output –> automatically increasing deficit 0.5% GDP

Question 13

Wars and deficits

Answer 13

1. Distributional - deficit finance = pass some burden of war to future
2. Inter generational problem

Question 14

Dangers high debt

Answer 14

Expectations and debt repudiation

Question 15

Debt and deficit 1st eq

(Bt = (1+r)Bt-1 + G - T

Answer 15

Bt - Bt-1 = rBt-1 + G - T

(Change in debt) = Interest payments + Primary deficit