Topic 7 - Fiscal Policy: Government Debt and Budget Deficits

Question 1

How do you calculate a government budget deficit and what is it?

Answer 1

Amount of new debt a govt needs to finance its operations

Calculated:
Govt spending - Govt revenue

Question 2

What are the problems with measuring the deficit? (PT 1)

Answer 2

1. Inflation
   Correcting the deficit for inflation can make a huge difference, especially when inflation is high.
2. Capital Assets
   Currently, deficit = change in debt
   Better, capital budgeting:
   deficit = (change in debt) – (change in assets)

e.g. : govt sells an office building and uses the money to pay back the debt.

under current system, deficit would fall
under capital budgeting, deficit unchanged, because fall in debt is offset by a fall in assets

Problem with capital budgeting: determining which government expenditures count as capital expenditures.

Question 3

What are the problems with measuring the deficit? (PT 2)

Answer 3

3. Uncounted Liabilities:
   - Current measure of the deficit omits important liabilities of govt:
4. future pension payments owed to current govt workers
5. future Social Security payments
6. contingent liabilities, such as covering federally insured deposits when banks fail
7. Business Cycle
   The deficit varies over the business cycle due to automatic stabilizers (the income tax system).

These are not measurement errors but do make it harder to judge fiscal policy stance.

Example: Is an observed increase in the deficit due to a downturn or an expansionary shift in fiscal policy?

Question 4

What is the solution to measuring the deficit?

Answer 4

cyclically adjusted budget deficit (full-employment deficit)

-Based on estimates of what government spending and revenues would be if the economy were at the natural rates of output and unemployment.

Question 5

What is the traditional view to ‘is the govt debt really a problem?’

Answer 5

Short run: Increase C, Increase spending, Increase Y, Decrease u

LR:
Y and U back at natural rates
- Closed Economy - Increase r, Decrease I
- Open Economy - Increase in ε and decrease in NX

Very LR:
slower growth until the economy reaches a new steady state with lower income per capita

Question 6

What is the Ricardian view to ‘is the govt debt really a problem?’

Answer 6

According to Ricardian equivalence,
a debt-financed tax cut has no effect on consumption, national saving, the real interest rate, investment, net exports, or real GDP, even in the short run.

Question 7

What is Ricardian Equivalence/ the logic of it?

Answer 7

Theory that states:
- Consumers are forward-looking, know that a debt-financed tax cut today implies an increase in future taxes,
that is equal—in present value—to the tax cut.

The tax cut does not make consumers better off, so they do not increase consumption spending.

Instead, they save the full tax cut in order to repay the future tax liability.

Result: Private saving rises by the amount public saving falls, leaving national saving unchanged.

Question 8

What are the problems with Ricardian Equivalence?

Answer 8

Myopia: Not all consumers think so far ahead; some see the tax cut as a windfall.

Borrowing constraints: Some consumers cannot borrow enough to achieve their optimal consumption, so they spend a tax cut.

Future generations: If consumers expect that the burden of repaying a tax cut will fall on future generations, then a tax cut now makes them feel better off, so they increase spending.

Question 9

What are some other perspectives on govt debt? (Balanced budget V optimal fiscal policy)

Answer 9

Some politicians have proposed amending the U.S. Constitution to require a balanced federal government budget every year.

Many economists reject this proposal, arguing that the deficit should be used to:

1. stabilize output and employment
2. smooth taxes in the face of fluctuating income
3. redistribute income across generations, when appropriate