Topic 10: Public Sector

Question 1

What is the government budget constraint?

Answer 1

G = T + ΔB + ΔM + asset sales

Question 2

What is the net present value of a government deficit?

Answer 2

Question 3

What is Ricardian Equivalence?

Answer 3

That because the NPV of a government deficit is exactly the amount of that deficit, the public, rationally will save the same amount, so the changes will be meaningless.

Question 4

What is the implication of Ricardian equivalance for keynesian fiscal stimulation?

Answer 4

• Keynesian analysis would suggest at an increased aggregate spending would increase real incoe and interest rates.
• But in RE, nothing changes.

Question 5

What are the assumptions of Ricardian equivalance?

Answer 5

• Consumers are fully anticipating & budgeting for future taxes.
• Rational & forward looking, internally and externally.
• Cross-generational divide does not matter - you care equally for ‘the future’.
• No interest changes.

Very strict assumptions, not likely to hold.

Question 6

What is the evidence like for Ricardian equivalance?

Answer 6

Barrow says it’s not too bad in the long term.

Question 7

Compare the fisher effect with and without taxes on nominal interest rates.

Answer 7

With no taxes ^∂i/_∂π = 1

With taxes:

^∂i/_∂π > 1

Because with inflation, the taxable amount increases, and investors are unlikely to fully absorb this, such that with an increase in inflation, the interest rate must rise by more then that inflation rate to ‘cover’ some of the increase taxes.
(keep the after tax real interest rate from falling).

Question 8

What are the uses and sources of GDP equations?

Answer 8

Sources: C + I + G + X = Y

Uses: C + S + T + M = Y

Exp: C + I + G + M = Y^e

Question 9

Formulate the CAD

Answer 9

Uses - Sources

C + G + I + M - (C + S + T + X) = 0

(G - T) + (I - S) = X - M

Or through absorption:

CAD = Y^e - Y(income)

CAD = C + I + G + M - (C + I + G + X)

CAD = M - X

Question 10

What has the Australian CAD been over the last few years?

Answer 10

6% on average.

Question 11

What has the trend in Australias net external debt as a % of GDP been?

Answer 11

~= 0 in 1980

50% in 2009

Question 12

Give the equation that shows the percentage change in the debt to debt to gdp level.

Answer 12

%Δb = α -b(g + π)

Where b = B/Y

α = CAD/Y

Question 13

Derive the equation for the percentage change in the external debt to gdp ratio.

Answer 13

α = ^{<span>CAD</span>}/_Y = ^ΔB/_Y

b = B/Y

%Δb ~= %ΔB - %ΔY

Δb/b = ΔB/B - ΔY/Y

Δb = b^ΔB/_B - b^ΔY/_Y

Δb = BΔB/BY - bΔY/Y

Δb = ΔB/Y - bΔY/Y

Δb = α - b(g + π)

Question 14

Show the condition for a steady state debt-gdp ratio.

Answer 14

b* = ^α/_{(g + π)}

Question 15

What is Australia’s CAD, growth rate and inflation rate?

Is this sustainable?

Answer 15

α = 6.5%, g = 3.5% π = 2.5%

So b* = 1.083.

We are a little over, but not soo bad.

Question 16

Use a graph to show the equilibrium debt-GDP ratio. Is the equilibrium level stable?

Answer 16

Question 17

What the gross and net debt service?

Answer 17

GDS = payments to foreigners.

= ib

Net debt service

= payments to foreigners after you borrow from them again.

= ib - α

“NDS is how much the borrowing hurts the economy”

Question 18

Show the steady state debt - gdp level with GDS

Answer 18

Question 19

Should Australian monetary policy target the CAD?

Answer 19

• It shouldn’t due so because of fallacies about unsustainability.
• But an excess CAD could mean excess spending (but this really is still targeting inflation).
• Could want to eliminate a reduction in international exposure in the short run.
• When the world will not lend to Australia
• Mostly though, the CAD is a good indicator of issues, but not a good target.