Public Debt Sustainability Flashcards
the change in real debt depends on what?
the total real interest payments on existing debt and the primary deficit
What will happen to debt when we run
a. primary deficits
b. primary surpluses
a. debt will increase over time
b. debt will decrease over time
How will the real interest rate affect debt?
if the real interest rate is negative, debt will decrease over time
How will a real growth in GDP affect real debt?
A real growth in GDP will cause a given level of real debt to decline as a percentage of GDP
What does the change in the debt-to-GDP ratio depend on?
The growth adjusted real interest payments on existing debt.
The primary deficit relative to GDP
How can the the debt ratio change over time?
If we run primary deficits (relative to GDP), the debt ratio will increase over time.
If the growth adjusted real interest rate is negative, the debt ratio will decrease over time.
What is the cyclically adjusted deficit?
The deficit that would exist if output was at its natural level.
What is the important condition for debt sustainability?
The important condition is that the level of debt is stabilised at a level where interest payments can be financed
What is the relevant condition is for stabilising debt?
the change in real debt = 0
therefore the primary surplus (T - G) is equal to the real interest rate * real debt => (i - pi)B^R
if the real interest rate is negative, what can the government do?
Run a primary surplus
If the primary growth rate exceeds the real interest rate?
the government can run a primary deficit forever without causing the debt ratio to explode
What can the conditions for constant real debt and real debt to GDP ratio tell us and not tell us?
They can tell us what is required to have a constant level of real debt or debt ratio
They do not state what the amount of real debt or the value of the debt ratio should be in the first place
Describe the Ricardian Equivalence
the proportion that tax finance and bond finance have equivalent effects on private expenditure.
proposition based on alternative assumption to Keynesian that households base their expenditure decisions on the present discounted value of income and taxation into the infinite future.
It doesn’t matter if government spending in the current period is financed by debt or current taxes.
According to the Ricardian Equivalence -
There is limited effect of fiscal policy on economic activity
Since private saving (Y - C - T) plus public saving (T - G) = Investment, if taxes decrease by 1 unit, public saving falls by 1 unit. Total saving remains the same
- consumption does not respond to the fall in taxes
- Investment does not change as total saving stays the same
Where does the Ricardian Equivalence break down?
- if there are imperfections in financial markets
- if newly issued debt is assumed to last beyond the lifetime of current taxpayers
- if taxes are distortionary
Why do the conditions which break down the Ricardian Equivalence provide justifications for debt finance?
- current taxes will affect households’ disposable income and welfare, if they don’t have perfect access to financial markets
- if newly issued debt lasts beyond the lifetime of current taxpayers, then debt finance provides a way to share costs between generations
- if taxes are distortionary, it is optimal to smooth tax rates across time and use debt finance to cover short term fluctuations in government expenditure. I.e war, banking crisis.
What are some other reasons to use debt finance?
- debt finance is a way to spread costs of large infrastructure projects across generations
- infrastructure generates economic benefits over long periods i.e. hospitals, railways, schools
- future generations benefit
- government spending on infrastructure, health and education will increase future output and generate tax revenues which will finance extra debt so there is an economic case for debt finance.
What are the 4 dangers of running high debt
Tax distortions:
to stabilise debt to GDP, a country must maintain a primary surplus to cover interest payments. Higher debt requires larger surpluses, leading to higher taxes and therefore more tax distortions
Risk of default:
High or rising debt to GDP ratio raises default expectations, increasing borrowing costs. Higher costs make debt stabilisation harder, perpetuating default fears
Money financing and hyperinflation:
Governments unable to borrow may print money, increasing inflation. Excessive money creation can result in hyperinflation.
External financing risks:
Many emerging markets and developing countries depend on foreign investors to buy government debt.
Default fear can lead to sudden stops, where investors sell bonds and refuse to buy new bonds. This may lead to large movements in exchange rates, trade, and GDP, and require rapid changes to monetary and fiscal policy.
