Government Debt and Budget Deficits

Question 1

How is a deficit financed?

Answer 1

Borrowing, from the private sector (dom/foreign) or foreign governments

Question 2

What is the process

Answer 2

Governments sell bonds called gilts

Question 3

Debt definition

Answer 3

the accumulation (stock) of past deficits (flow)

Question 4

Link to debt and events

Answer 4

Debt-to-GDP ratio increases during wars (since wars high spending)

Question 5

Deficits relationship with the business cycle

Answer 5

Automatic stabilisers imply it is procylical - deficit increases in a recession, improves during a boom (since lots of tax revenue)

Question 6

Example of automatic stabiliser suggesting this

Answer 6

in a recession, more people unemployed, so unemploymenent benefits payments increases. (G increases) at the same time tax revenue falls.

hence why procyclical, deficit increases in a receission

Question 7

Keynes vs Neoclassical view on running deficits

Answer 7

Keynes - running deficits are natural/expected if procyclical

Neoclassical- any deficit is bad (harm future gens with higher tax etc) and surpluses should not be run too (it means people are paying too much tax)

Question 8

So what is the solution

Answer 8

calculate the cyclically adjusted budget balancd

Question 9

Cyclically adjusted budget balance diagram (pg3)

analyse points A+ A- A₀

Answer 9

Fiscal profile line FP

A+ gov finances looks better than they are - tax rev>gov spending, Neo would say gov are taxing too much, shouldnt be collecting more than they need. Keynesian says this is natural since economy is strong.

A- : looks worse than they really are we have a recession and a deficit - Neoclassical would see as a problem, Keynesian would say this is natural i.e gov should increase deficit to intervene and help

A₀ : balanced budget, balanced economy

point X is bad as you shouldnt need to be in a deficit in a boom. and when the economy weakens, deficit will be even worse

Question 10

What is the deficit called if it persists even after a recession?

Answer 10

structural deficit (point X - running deficits when shouldn’t have to)

Question 11

Balanced budget, and government then cuts taxes and makes up the shortfall in revenue by borrowing.

What’s this called.

Answer 11

This is a deficit-financed tax cut (financed by borrowing)

Question 12

How would consumers react to the deficit financed tax cut, under the ‘TRADITIONAL VIEW OF GOVERNMENT DEBT’?

Answer 12

Spend more, since tax is cut.

Keynesian consumption function (just to show consumption is a function of income)

Question 13

Ricardian view of government debt

Answer 13

Forward looking consumers base consumption on expected future income too.

They predict the government borrowing today implies higher taxes in future.

So, government debt=future tax=current tax if consumers are forward looking

Question 14

So what is the Ricardian equivalence

Answer 14

Gov spending by debt is equivalent to funding by taxes.

Therefore a deficit financed tax cut is will have no effect on consumption under Ricardian consumers.

Question 15

What would happen in terms of saving (public and private)

Answer 15

An increase in private saving (since they do not spend the extra income gained from tax cuts) offsets the decrease in public (gov) saving.

So national saving is unchanged.

Question 16

Does the Ricardian equivalence suggest fiscal policy can never change consumption.

Answer 16

Fiscal policy CAN change consumption.

By changing present or future government spending.

e.g if taxes fall, and there are plans to reduce G as well. if consumers believe them, they will increase spending today. (since government is not borrowing to finance the tax cut to try keep their speninding the same - making the tax cut not a fake one)

Question 17

Counter arguments to Ricardian

Answer 17

Myopia - consumers are not as forward looking as assumed. so may consume despite a disingenious debt financed tax cut

Borrowing constraints - Ricardian consumer uses expected lifetime income. However current income more important for or liquidity constrained consumers (who can’t borrow). So they still may consume following tax cut since it opens opportunities that may not of been available (she was not maximising her consumption anyways since borrowing constraints)

Future generations - future tax goes to future generations. Fair to leave to kids deal with problem?

Question 18

Deficit equation

Answer 18

G + iB - T

i nominal interest rate
B is interest repayments due on debt (nominal bonds, interest they need to pay when selling the gilts)

Question 19

primary deficit

Answer 19

G - T

Question 20

Case 1: assume money supply constant

What is the budget constraint with an independent central bank

Answer 20

ΔM=0 (Ms constant)

T + ΔΒ = G + iB

So the sources of income is tax revenue T and issuing bonds B

Then expenditure is G and interest from issued bonds iB

Question 21

How can we show that the deficit = ΔB

Answer 21

rearrange this equation by making ΔB subject.

we get ΔΒ= G + iB - T which is the original deficit equation

Question 22

What happens when we hold debt constant

Answer 22

Debt is constant when deficit (ΔB) =0

T - G = iB

So to hold debt constant, government needs to run a surplus to be able to pay of the interest.

Question 23

Divide by nominal GDP. What assumption do we make, and what is the main reason we do this?

Answer 23

Nominal GDP is py. Assume P=1 (no inflation)

t + ΔB/Y = g + ib

where t = T/Y etc.
ΔB/Y is the deficit as a share of GDP!!! (IMPORTANT)

Question 24

Maastricht criteria

Answer 24

ΔΒ/Y Maastricht critera should be <=3% and B/Y<=60

Question 25

How can we find that the change in government deficit (as share of GDP) (ΔB/Y) is a function of income? (It depends on income)

Answer 25

ΔB = YΔb + bΔY

Rearranges by dividing by Y
ΔB/Y = Δb + b(ΔY/Y)

(ΔY/Y) is GDP growth rate - we define this = 𝛾

Question 26

Then we can sub this equation into 2 to get debt/GDP ratio

Answer 26

Δ𝑏 = 𝑔 − 𝑡 + (𝑖 − 𝛾)𝑏

And p=1 (no inflation) so i=r (fisher)

Rearrange to get

b*= g-t/𝛾-r

Question 27

Using this equation what does the debt-to-GDP ratio (b*) depend on?

Answer 27

Primary deficit (g-t) : rises with this

Falls with as GDP increases (y)

Falls as interest rate increases

Question 28

Case 2: Now add money financing and inflation. Government now controls the central bank.

What is the new budget constraint on the bank?

Answer 28

𝑇 + Δ𝐵 + Δ𝑀 = 𝐺 + 𝑖𝐵

Since we now have the monetary base. Government can create money, since now control central bank. (Most attractive option in the short run since others wont like increasing tax, and bonds owe interest)

Question 29

Divide by nominal GDP.

Answer 29

Nominal GDP is py. P is not constant at 1 now!!!

t + ΔB/PY + ΔM/PY = g + ib

Question 30

Now dividing by NGDP gives us ΔΒ/PY…

What is ΔB equation, and what can we do with this

Answer 30

ΔΒ= PY∆b + bY∆P + bP∆Y

Divide by PY
ΔΒ/PY= ∆b + b∆P/P + b∆Y/Y

Which is

ΔΒ/PY= ∆b + b(𝜋 + 𝛾)

Function of inflation (𝜋) and GDP growth (𝛾)!!!

Question 31

We also have ΔM/PY

Answer 31

Rearrange to
ΔM/M (M/PY) to get μm

μ is money growth rate (ΔM/M)!!!
m is M/PY

Question 32

Then we can use our new expressions for ΔB/PY and ΔM/PY to find the debt-to-GDP

Answer 32

Sub into the equation where we divided by NGDP initially

∆𝑏 = 𝑔 − 𝑡 − 𝜇𝑚 + (𝑖 − 𝜋 − 𝛾)𝑏

Or as real interest rate
∆𝑏 = 𝑔 − 𝑡 − 𝜇𝑚 - (y-r)𝑏

Set = 0 to get
b= g-t-μm / y-r

Question 33

So what is the effect on the ratio if μm increases

Answer 33

Debt falls (since increasing money creation reduces debt)

Question 34

Why might government be tempted to increase inflation?

Eval

Answer 34

To reduce real debt burden, since debt is issued in nominal terms.

Eval: if inflation is unexpected, usually debtors (win since money owe is worth less), debtor is government. They can just print their way out of trouble. (Not good in long term though)

Question 35

What happens when government prints money

Answer 35

Seignorage μ(M/P).

This money creation can lead to inflation tax. π(M/P)

μ=π (money growth rate = inflation rate)

Question 36

Why should we limit printing money in order to pay off debts (it is bad in long run)

Answer 36

Since higher inflation reduces money demand (since spend their money before prices increases, and do not want to hold in cash)