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EC201 - MACRO TERM 1 > TERM 1: Twin deficits > Flashcards

TERM 1: Twin deficits Flashcards

1
Q

National saving is a combination of…

A

S = Sp + Sg

Private saving and government saving

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2
Q

Formula for Sp (p1)

A

Sp = Q1 + r0B0p - C1 - T1

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3
Q

Formula for Sg (p1)

A

Sg = T1 + roB0g - G1

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4
Q

What does the twin deficits hypothesis state?

A

Fiscal deficit causes CA deficit.

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5
Q

What happened 1980s USA?

A

Reagan fiscal deficits & CA deficits: both fell by $100bn 1981 to 1984

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6
Q

3 important fiscal episodes

A
  1. Large fiscal deficits WW2: G up, but no CA deficit
  2. Fiscal surpluses Clinton: T up, G down, but CA down
  3. Fiscal deficits Great Contraction: but CA steady/increasing
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7
Q

Gov asset holdings. If < if > …

A

Btg
If Btg < 0 - gov indebted
If Btg > 0 - gov a creditor

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8
Q

Does G need to = T in every period?

A

NO G≠T can be financed through asset holdings

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9
Q

Gov use of funds (2)

A
  1. Gov spending Gt

2. Interest service on debt -rt-1Bt-1g

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10
Q

Gov sources of funds (2)

A
  1. Tax rev, Tt

2. Issue new debt, -(Btg - Bt-1g)

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11
Q

Primary fiscal deficit =

A

G1 - T1

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12
Q

Secondary fiscal deficit =

A

G1 - T1 - r0B0g

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13
Q

Gov savings =

A

The secondary fiscal deficit

-S1g = G1 - T1 - r0B0g

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14
Q

Change in S1g =

A

Change S1g = change T1 + change r0B0g - change G1

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15
Q

Period 1 BC gov

A

G1 - r0B0g = T1 - (B1g - B0g)

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16
Q

Period 2 BC gov

A

G2 - r1B1g = T2 - (B2g - B1g)

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17
Q

Intertemporal BC gov

A

G1 + G2/(1+r1) = T1 + T2/(1+r1) + (1+r0)B0g

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18
Q

HH P1 BC

A

C1 + (B1p - B0p) = (1+r0)B0p + Q1 - T1

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19
Q

HH P2 BC

A

C2 + (B2p - B1p) = (1+r1)B1p + Q2 - T2

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20
Q

HH intertenporal BC

A

C1 + C2/(1+r1) = (1+r0)B0p + Q1 - T1 + (Q2 - T2)/(1+r1)

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21
Q

Slope of budget line - why?

A

= -(1+r1) still

Taxes are like an income change so shift BL and change optimal C*, but don’t change slope of BL.

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22
Q

Optimality condition consumption

A

U1(C1,C2) / U2(C1, C2) = (1+r1)

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23
Q

Aggregate resource constraint

A

C1 + C2/(1+r1) + G1 + G2/(1+r1) = (1+r0)(B0p+B0g) + Q1 + Q2/(1+r1)
- Taxes disappear!!!

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24
Q

small open economy implies about IR

A

r1=r*

Gov sector doesn’t change this - fiscal deficits do not increase IR in small open economies.

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25
Q

5 endogenous variables

A

C1, C2, r1, T1, T2

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26
Q

7 exogenous parameters

A

G1, G2, r*, Q1, Q2, B0p, B0g

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27
Q

4 equilibrium conditions (just describe, not formula)

A
  1. HH BC
  2. Optimal consumption
  3. r1=r*
  4. Gov BC
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28
Q

Are there actually 5 unknowns?

A

NO - T1 + T2/(1+r1) counts as ONE unknown. We can only determine the PDV of total taxes, not T1 and T2 separately.

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29
Q

reduce to 3 equilibrium conditions. How does this compare to for endowment economy without gov?

A
  1. C1 + C2/(1+r1) = Y tilda
  2. U1(C1, C2) = U2(C1, C2)(1+r1)
  3. r1=r*

Same except Y tilda ≠ W

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30
Q

Zero assets

A

B0p + B0g = 0

31
Q

Formula for economy BC with C2 as subject

A

C2 = (1+r*)(Q1 - C1 - G1) + (Q2 - G2)

32
Q

How does the economy resource constraint depend on T1 and T2?

A

It does NOT depend on T1 and T2

33
Q

What does Ricardian equivalence theorem state?

A

The timing of taxes is irrelevant for C*.
Tax cuts have no real effects - no change in consumption.
Because consumers know fall T1 today means rise T2 tomorrow = no change in lifetime income, so save the tax cut.

34
Q

Ricardian equivalence test: how do we change T and G?

A

change in T1 < 0 - tax cut
change in G1 = change in G2 = 0
Gov spending left unchanged.

35
Q

expression for change in T1 using gov intertemporal BC and assuming B0g=0

A

G1 + G2/(1+r1) = T1 + T2/(1+r1)
Use r1=r*
change G1 + change G2/(1+r) = change T1 + change T2/(1+r)
Change G1 = change G2 = 0
So:Change T2 = -(1+r*)change T1
A tax cut must leave PDV of taxes unchanged if gov spending not changed.

36
Q

How does change in taxes affect HH intertemporal BC?

A

It doesn’t - as change T2=-(1+r*)change T1

so the effects cancel each other out

37
Q

How does tax cut affect private saving?

A

change S1p = -changeT1 > 0

HH saves the entire tax cut = private savings rise

38
Q

What consumption allocation do HH choose after tax cut under ricardian equivalence?

A

The SAME as before - use saving to allow them to achieve same allocation

39
Q

How is CA1 affected by tax cut? Why?

A

CA1 = S1
Change CA1 = change S1p + change S1g = -change T1 + change T1 = 0
National saving unchanged as fall in gov saving offset by equal rise in private saving = no change in CA.

40
Q

What does Ricardian equivalence mean for twin deficits hypothesis?

A

When RE holds and the fiscal deficit the result of a tax cut and no change in gov spending, the twin deficits hypothesis FAILS.

41
Q

Does ricardian equivalence explain Reagan 1980s?

A

Tax cuts in 1980s –> fiscal deficit
BUT national savings fell, so CA deficit
= either fiscal deficit not caused by tax cut, or RE fails

42
Q

How does higher G1 affect consumption?

A

Endowment economy so higher G1 = fewer resources for HH = equivalent to temporary fall in income = BC shifts inwards.
C1 falls but by less than rise in G1 as smooth consumption.

43
Q

How does higher G1 affect TB1?

A

TB1 = Q1 - C1 - G1

Rise in G1 > fall in C1 so TB1 falls but partly offset

44
Q

How does higher G1 affect CA1?

A

CA1 = r0B0* + TB1 - as TB1 falls, CA deteriorates

45
Q

Does higher G1 lend support to twin deficits?

A

YES - fiscal deficit –> CA deficit

46
Q

Does higher G1 explain Reagan 1980s? What else could explain it?

A

Increased military spending 1.5% GDP
In theory, change in CA1 < 1.5%
But change CA1 = 3%
Other 1.5% could be explained by tax cuts IF RE does NOT hold.

47
Q

name 3 reasons for failure of RE

A
  1. borrowing constraints
  2. intergenerational effects
  3. distortionary taxes
48
Q

Period 1 BC for HH assuming Bop=0 and with borrowing constraints

A

C1 + B1p = Q1 - T1
Borrowing constraint: B1p=0
C1 = Q1 - T1
i.e. can only consume your disposable income in that period as cannot borrow/lend across periods

49
Q

How does borrowing constraints affect RE?

A

HH must now consume entire tax cut - old max infeasible
change C1 = -changeT1 > 0
change S1p = 0
No rise in private saving to offset fall in gov saving, therefore change CA1<0

50
Q

What must be the case for a tax cut to cause a rise in C1 of the SAME magnitude?

A

100% of HH benefitting from tax cut must be borrowing constrained.

51
Q

What are intergenerational effects?

A

Generation benefitting fro tax cut ≠ generation paying for tax rise

52
Q

Period 1 generation BC

A

C1 = Q1 - T1

change C1 = -changeT1

53
Q

Period 2 generation BC

A

C2 = Q2 - T2

Change C2 = -change T2

54
Q

Impact of intergenerational effects on twin deficits

A

change S1p = 0, so no rise in private saving to offset fall in gov saving = CA deficit

55
Q

What might stop intergenerational effects from causing CA deficit?

A

Intergenerational altruism / myopia

56
Q

HH BC P1 with proportional taxes

A

(1+tow1)C1 + B1P = Q1

57
Q

HH BC P2 with proportional taxes

A

(1+tow2)C2 = Q2 + (1+r1)B1p

58
Q

HH PDV BC with proportional taxes

A

(1+tow1)C1 + [(1+tow2)/(1+r1)]C2 = Q1 + Q2/(1+r1)

59
Q

Optimality condition for consumption with proportional taxes.

A

U1(C1, C2)/U2(C1, C2) = (1+tow1)/(1+tow2). Now a wedge between MRS and MC,

60
Q

How does a change in tow1 relative to tow2 affect C?

A

Fall in tow1 relative to tow2 = changes optimality. Sub C2 for C1 as relatively cheaper. C1 rises; C2 falls = SE.

61
Q

Does fall tow1 lead to an income effect as well? Proof.

A

NO: economy RC
C1 + C2/(1+r1) = (Q1-G1) + (Q2-G2)/(1+r1)
Tows disappear therefore no affect on BL = = no income effect.

62
Q

How does a change in tow1 relative to tow2 affect CA1?

A

C1 rises, but Q1 & G1 unchanged
TB1 = Q1 - C1 - G1
TB1 falls by changeG1 = CA deficit

63
Q

2 alternative views on cause of Reagan 1980s CA deficit

A
  1. Global savings glut: ROW increase saving

2. Twin deficits: US increased borrowing

64
Q

3 reasons why ROW increased saving during 1980s

A
  1. Us safe heaven - K flight from L.America
  2. developing countries debt crisis reduced demand for borrowing
  3. Financial deregulation e.g. Japan = easier to hold US assets
65
Q

Why did US want to borrow more 1980s?

A

US wanted foreign countries to buy more US gov bonds due to fiscal deficit.

66
Q

Which view is correct?

A

during 1980s US real IR rose = supports view 2 twin deficits hypothesis US wanted to borrow more.

67
Q

How does a benevolent gov set tow1&2?

A

Sets where utility highest, given G1 & G2.

68
Q

An equilibrium is…(3)

A
  1. A consumption allocation
  2. A tax policy
  3. An IR
69
Q

An equilibrium satisfies…(3)

A
  1. HH max U
  2. Gov satisfies BC
  3. No arbitrage r1=r*
70
Q

4 initial equilibrium conditions for Ramsey problem

A
  1. HH BC with proportional taxes
  2. optimal C* with tax wedge
  3. Gov BC with proportional taxes
  4. r1=r*
71
Q

What is the less constrained problem? Step by step.

A 
Combine HH &amp; gov BC &amp; sub in r1=r*
From economy RC, let Y = Q1 - G1 + (Q2 - G2)/(1+r*).
C2 = (1+r*)(Y - C1)
Max U(C1, (1+r*)(Y-C1)) 
FOC: U1 = (1+r*)U2 - sub into BC
72
Q

Is the solution to less constrained problem also solution to Ramsey?

A 
Yes because we use r1=r*
If tow1=tow2, original optimality holds
Consumer BC holds if:
tow1 = (Q1 + Q2/(1+r*))/(C1 + C2/(1+r*))-1 = tow2
Gov BC also holds
73
Q

How to Ramsey optimal allocation compare to where gov uses lump-sum taxes?

A

It’s the same problem we’re solving.

same real allocation.

EC201 - MACRO TERM 1 (9 decks)

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