High Debt Flashcards
Why do economists worry so much when governments accumulate debt quickly?
What is primary deficit?
Government Spending - Taxes (G-T)
How is a primary deficit positive?
If G > T
What is a cyclically adjusted deficit?
- Measures the deficit if output were at its natural level
- Adjusts deficit for the current point of the economy on the business cycle
What is the inflation adjusted deficit?
The deficit measured in real terms
Denote the budget deficit formula.
rBt-1 + Gt - Tt
Where:
- B is bonds and bills issued by gov. and held by priv sector
- r is real interest rate
- rBt-1 is real interest paid on gov. bonds in circulation
- Gt is government spending on goods and services
- Tt are taxes
Assume only means of deficit financing is selling securities to private investors:
Bt - Bt-1 = Deficit t
Denote the Government Budget Constraint formula.
Bt = (1+r)Bt-1 + (Gt - Tt)
where:
Bt - issued bonds and bills at time t
(1+r)Bt-1 - interest payments
Gt - Tt - primary deficit
What happens to government deficit if they run a deficit/surplus?
Deficit - Government debt increases
Surplus - Government debt decreases
Given B0 = 1 and B1 = 0, show how the budget constraint becomes T1 - G1 = (1+r) if government have to repay debt in 1 year
B1 = (1+r)B0 + (G1 - T1)
T1 - G1 = (1+r)B0
=> T1 - G1 = (1+r)
How can government repay debt in 1 year
- Government must create a primary surplus in year 1 equal to (1+r) units of goods
- An increase in taxes of the initial cut in tax plus interest rate on debt
What if the government must repay after t years?
Governments must create a primary surplus equal to (1+r)t units of goods - waiting to repay raises the required increase in taxes
What is the government budget constraint in terms of GDP?
(Bt / Yt - Bt-1 / Yt-1) = (r-g) (Bt-1 / Yt-1 + (Gt - Tt) / Yt)
What does the government budget constraint tell us.
The change in debt ratio is equal to the sum of
- the difference between the real interest rate and the rate of growth of GDP multiplied by the debt ratio at the end of the previous period
- The ratio of the primary deficit to GDP
What are the dangers of a very high public debt?
- Increasing primary surplus means an increase in taxes which is unpopular
- Political uncertainty arises which increases both risk premium and interest rates
- Fiscal tightening induced by the first increase in rates generates an even deeper recession
- The increase in rates and lower growth result in higher r-g, making it more difficult to stabilise the debt ratio
How can you reduce high debt?
- Generate sufficient primary surpluses
- Monetary financing by the central bank - purchase government bonds
- Repudiate the debt
