TERM 1: Twin deficits Flashcards
National saving is a combination of…
S = Sp + Sg
Private saving and government saving
Formula for Sp (p1)
Sp = Q1 + r0B0p - C1 - T1
Formula for Sg (p1)
Sg = T1 + roB0g - G1
What does the twin deficits hypothesis state?
Fiscal deficit causes CA deficit.
What happened 1980s USA?
Reagan fiscal deficits & CA deficits: both fell by $100bn 1981 to 1984
3 important fiscal episodes
- Large fiscal deficits WW2: G up, but no CA deficit
- Fiscal surpluses Clinton: T up, G down, but CA down
- Fiscal deficits Great Contraction: but CA steady/increasing
Gov asset holdings. If < if > …
Btg
If Btg < 0 - gov indebted
If Btg > 0 - gov a creditor
Does G need to = T in every period?
NO G≠T can be financed through asset holdings
Gov use of funds (2)
- Gov spending Gt
2. Interest service on debt -rt-1Bt-1g
Gov sources of funds (2)
- Tax rev, Tt
2. Issue new debt, -(Btg - Bt-1g)
Primary fiscal deficit =
G1 - T1
Secondary fiscal deficit =
G1 - T1 - r0B0g
Gov savings =
The secondary fiscal deficit
-S1g = G1 - T1 - r0B0g
Change in S1g =
Change S1g = change T1 + change r0B0g - change G1
Period 1 BC gov
G1 - r0B0g = T1 - (B1g - B0g)
Period 2 BC gov
G2 - r1B1g = T2 - (B2g - B1g)
Intertemporal BC gov
G1 + G2/(1+r1) = T1 + T2/(1+r1) + (1+r0)B0g
HH P1 BC
C1 + (B1p - B0p) = (1+r0)B0p + Q1 - T1
HH P2 BC
C2 + (B2p - B1p) = (1+r1)B1p + Q2 - T2
HH intertenporal BC
C1 + C2/(1+r1) = (1+r0)B0p + Q1 - T1 + (Q2 - T2)/(1+r1)
Slope of budget line - why?
= -(1+r1) still
Taxes are like an income change so shift BL and change optimal C*, but don’t change slope of BL.
Optimality condition consumption
U1(C1,C2) / U2(C1, C2) = (1+r1)
Aggregate resource constraint
C1 + C2/(1+r1) + G1 + G2/(1+r1) = (1+r0)(B0p+B0g) + Q1 + Q2/(1+r1)
- Taxes disappear!!!
small open economy implies about IR
r1=r*
Gov sector doesn’t change this - fiscal deficits do not increase IR in small open economies.
5 endogenous variables
C1, C2, r1, T1, T2
7 exogenous parameters
G1, G2, r*, Q1, Q2, B0p, B0g
4 equilibrium conditions (just describe, not formula)
- HH BC
- Optimal consumption
- r1=r*
- Gov BC
Are there actually 5 unknowns?
NO - T1 + T2/(1+r1) counts as ONE unknown. We can only determine the PDV of total taxes, not T1 and T2 separately.
reduce to 3 equilibrium conditions. How does this compare to for endowment economy without gov?
- C1 + C2/(1+r1) = Y tilda
- U1(C1, C2) = U2(C1, C2)(1+r1)
- r1=r*
Same except Y tilda ≠ W
Zero assets
B0p + B0g = 0
Formula for economy BC with C2 as subject
C2 = (1+r*)(Q1 - C1 - G1) + (Q2 - G2)
How does the economy resource constraint depend on T1 and T2?
It does NOT depend on T1 and T2
What does Ricardian equivalence theorem state?
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.
Ricardian equivalence test: how do we change T and G?
change in T1 < 0 - tax cut
change in G1 = change in G2 = 0
Gov spending left unchanged.
expression for change in T1 using gov intertemporal BC and assuming B0g=0
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.
How does change in taxes affect HH intertemporal BC?
It doesn’t - as change T2=-(1+r*)change T1
so the effects cancel each other out
How does tax cut affect private saving?
change S1p = -changeT1 > 0
HH saves the entire tax cut = private savings rise
What consumption allocation do HH choose after tax cut under ricardian equivalence?
The SAME as before - use saving to allow them to achieve same allocation
How is CA1 affected by tax cut? Why?
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.
What does Ricardian equivalence mean for twin deficits hypothesis?
When RE holds and the fiscal deficit the result of a tax cut and no change in gov spending, the twin deficits hypothesis FAILS.
Does ricardian equivalence explain Reagan 1980s?
Tax cuts in 1980s –> fiscal deficit
BUT national savings fell, so CA deficit
= either fiscal deficit not caused by tax cut, or RE fails
How does higher G1 affect consumption?
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.
How does higher G1 affect TB1?
TB1 = Q1 - C1 - G1
Rise in G1 > fall in C1 so TB1 falls but partly offset
How does higher G1 affect CA1?
CA1 = r0B0* + TB1 - as TB1 falls, CA deteriorates
Does higher G1 lend support to twin deficits?
YES - fiscal deficit –> CA deficit
Does higher G1 explain Reagan 1980s? What else could explain it?
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.
name 3 reasons for failure of RE
- borrowing constraints
- intergenerational effects
- distortionary taxes
Period 1 BC for HH assuming Bop=0 and with borrowing constraints
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
How does borrowing constraints affect RE?
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
What must be the case for a tax cut to cause a rise in C1 of the SAME magnitude?
100% of HH benefitting from tax cut must be borrowing constrained.
What are intergenerational effects?
Generation benefitting fro tax cut ≠ generation paying for tax rise
Period 1 generation BC
C1 = Q1 - T1
change C1 = -changeT1
Period 2 generation BC
C2 = Q2 - T2
Change C2 = -change T2
Impact of intergenerational effects on twin deficits
change S1p = 0, so no rise in private saving to offset fall in gov saving = CA deficit
What might stop intergenerational effects from causing CA deficit?
Intergenerational altruism / myopia
HH BC P1 with proportional taxes
(1+tow1)C1 + B1P = Q1
HH BC P2 with proportional taxes
(1+tow2)C2 = Q2 + (1+r1)B1p
HH PDV BC with proportional taxes
(1+tow1)C1 + [(1+tow2)/(1+r1)]C2 = Q1 + Q2/(1+r1)
Optimality condition for consumption with proportional taxes.
U1(C1, C2)/U2(C1, C2) = (1+tow1)/(1+tow2). Now a wedge between MRS and MC,
How does a change in tow1 relative to tow2 affect C?
Fall in tow1 relative to tow2 = changes optimality. Sub C2 for C1 as relatively cheaper. C1 rises; C2 falls = SE.
Does fall tow1 lead to an income effect as well? Proof.
NO: economy RC
C1 + C2/(1+r1) = (Q1-G1) + (Q2-G2)/(1+r1)
Tows disappear therefore no affect on BL = = no income effect.
How does a change in tow1 relative to tow2 affect CA1?
C1 rises, but Q1 & G1 unchanged
TB1 = Q1 - C1 - G1
TB1 falls by changeG1 = CA deficit
2 alternative views on cause of Reagan 1980s CA deficit
- Global savings glut: ROW increase saving
2. Twin deficits: US increased borrowing
3 reasons why ROW increased saving during 1980s
- Us safe heaven - K flight from L.America
- developing countries debt crisis reduced demand for borrowing
- Financial deregulation e.g. Japan = easier to hold US assets
Why did US want to borrow more 1980s?
US wanted foreign countries to buy more US gov bonds due to fiscal deficit.
Which view is correct?
during 1980s US real IR rose = supports view 2 twin deficits hypothesis US wanted to borrow more.
How does a benevolent gov set tow1&2?
Sets where utility highest, given G1 & G2.
An equilibrium is…(3)
- A consumption allocation
- A tax policy
- An IR
An equilibrium satisfies…(3)
- HH max U
- Gov satisfies BC
- No arbitrage r1=r*
4 initial equilibrium conditions for Ramsey problem
- HH BC with proportional taxes
- optimal C* with tax wedge
- Gov BC with proportional taxes
- r1=r*
What is the less constrained problem? Step by step.
Combine HH & gov BC & 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
Is the solution to less constrained problem also solution to Ramsey?
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
How to Ramsey optimal allocation compare to where gov uses lump-sum taxes?
It’s the same problem we’re solving.
same real allocation.
