Government expenditures and debt

Question 1

What is the effect of government expenditures in the Mundell-Fleming model?

Answer 1

The central bank doesn’t react

Question 1

What is government expenditure?

Answer 1

Government expenditure is the amount spent on all levels of government for purchases of goods and services, transfer payments (amounts given to households and businesses), and interest payments.

Question 2

What is the effect of government expenditures on the IS-LM-PC model?

Answer 2

The composition of expenditures differs in A and A”:
▶ Lower investment in A” due to a higher real interest rate
▶ Consumption constant

Long/medium run
▶ Changes in government expenditures do not have an effect on
real output
▶ Changes in demand do not change real output, as long as
potential output Yn remains unchanged.

Short run
▶ More demand can increase real output, in particular with slack
capacity
▶ The smaller the effect on inflation, the larger the effect on real
output

Question 3

What is the effect of government expenditures on the neoclassical model?

Answer 3

Crowding out in the neoclassical model: if the government spends one frank more, the private sector spends one frank less.
Permanent increase of (wasteful) government expenditure, Negative wealth effect, No effect on total expenditure/demand

Question 4

Explain the government budget constraint:

Answer 4

real purchases + real transfers = real taxes + real revenue from money creation

and with the assumption that the money supply doesn’t change over time, it’s only:
real purchases + real transfers = real taxes

Question 5

What is Ricardian equivalence and what are its limitations?

Answer 5

Financing government expenditure with real budget deficits or real taxes are equivalent

▶ For a given government expenditure, budget deficits allow the
government to change the timing of taxes
▶ However, taxes eventually have to be levied to finance the
expenditure as there is no free lunch
▶ Financing government expenditure by issuing debt or taxes is
equivalent
▶ A deficit-financed tax that does not increase household wealth
as the present discounted value of real taxes remains the same
▶ If the government wants to change the present value of real
taxes, it has to change the present discounted value of
government expenditure