Week 7 Twin Deficits Flashcards
How does government impact the current account model?
CA = S - I
but savings can be impacted by the government.
What is the equation for savings?
S = Spr + Spub
What is government savings the same as?
Same as fiscal surplus.
What is the twin deficits hypothesis?
Is this correct?
Decrease in sg
causes decreases in CA
Fiscal Deficit causes CA deficit.
Flawed as private savings will not stay constant when gov changes fiscal policy.
What does the data say about twin deficits hyoptehsis?
What is the overall?
Reagan era is aligned with TDH
After WW2 is not aligned
Clinton area is not aligned as fiscal surplus but CA was still negative.
The great contraction
-Overall it is not causal in the data.
In the model that includes the government what is different from a household persepctive?
Now taxes are part of the budget constraint.
What is the set up for the model with the government in two periods
G1 and G2 is government consumption
T1 and T2 is government taxes
Bgi is government asset holdings in period 0,1,2,
Use of funds
G
and payment on debt r0(Bg0)
Source of funds
Taxes
issuance of new debt btg-btg-1
What are the single two period budget constraints for the government
G1 + r0(Bg0) = T1 - (Bg1- Bg0)
G2 + r1(Bg1) = T2 - (Bg2-Bg1)
What is a primary fiscal deficit?
= G1 - T1
What is Secondary fiscal deficit?
T1 - G1 - r0(bg0) = -s1g
How do you get the intertemporal government budget constraint
Make Bg2 = 0 and then eliminate Bg1 from both equations
G1 + G2 / 1+ r1 = T1 + T2 / 1+r1 + r0(1+r0)
-What is the household budget constraint of the government model in two periods
-What is the intertemporal budget constraint for household with government
C1 + B1p - B0p = Q1 - T1 + (1+r0)B0p
C2 + B2p-B1p = Q2 - T2 + (1+r1)B1p
B2p = 0
Then eliminate for B1p
C1 + C2 / 1+r1 = Q1 + Q2 / 1+r1 + (1+r0)(Bp0) - T1 - T2/ 1+r1
Does the presence of taxes impact the optimality condition for households?
No as they are lump sum so not impacted by consumption so are not in the optimality condition.
2.How do you get an OVERALL budget constraint for whole economy in the government model?
What does it say?
- You eliminate T1 - T2/ 1+r1 out of it
to get
C1 + C2/1+r1 + G1 + G2/ 1+r1 = Q1 + Q2/1+r1 + (1+r0)(Bp0+Bg0)
- It says the presented discounted value of public and private consumption = the presented discounted value of endowment + initial wealth.
Why are taxes not important in the optimality problem?
The taxes individually and the timing are not important. All that is important is the present value of taxes
What is the implication of the optimality problem with both the pro
Means that tax cuts have no impact on the optimal allocation, do not give rise to twin deficit.
What is the impact on the tax cut on the various intertemporal budget constraints?
In order to satisfy the gov IBC a decrease in T1 leads to a neccessary increase in T2 next period.
This feed through to consumers as they are forward looking and if taxes decrease in P1 they will increase in P2.
Therefore, consumption doesnt change as individual tax values do not matter but the whole present discounted value does matter.
TIMING OF TAXES DOES NOT MATTER FOR HOUSEHOLDS.
It saves the amount exactly the same to the differential in taxes.
This increases savings in period 1 to finance taxes in period 2 and not erode consumption.
What is riccardian equivalence
If a fiscal deficit is only led by a tax cut with gov spending unchanged will leave consumption allocation as:
decrease in tax will have to be financed next period so households know this and save so the endowment is not eroded next period.
Therefore current account does not change.
REASON: households are forward looking and timing of taxes does not impact optimal behaviour.
saves exact amount = to the differential of taxes
Mathematically how does riccardian equivalence worK?
CA = S - I
S = Sp + Sg
change in Sg = T
change in Sp = -T
so the they cancel each other out and no change to CA.
What is the implication of riccardian equivalence?
Twin deficiits hypothesis does not hold.
What is the impact of an increase in gov spending in period 1?
On trade balance?
What is this the same as?
What is the relationship between the increase in gov spending and consumption.
G1 increases
-This shifts BC left
-This erodes amount that Private sector has to spend on consumption in period 1
-As they want to consumption smooth
-But they decrease consumption diaganolly not horizontally as they borrow from next period to smooth consumption.
So will run negative trade balance?
The same as a negative endowment shock.
-Change in consumption decreases less than increase in gov spending.
How does the twin deficit hypothesisi through government spending fit the data?
Why else may this be?
It fits that it causes a CA deficit but the magnitudes to not square with the reagan area.
Riccardian equivalence can fail.
What are the three reasons why riccardian equivalence may fail?
-Borrowing constraints
-Intergenerational effects
-Distortionary taxes
What is an important pre-requisite for riccardian equivalence to hold?
GOV EXPENDITURE MUST BE UNCHANGED.
Why would borrowing constraints cause riccardian to fail
How do we know who is impacted?// how do we know the magniutude.
-If the borrowing constraint is binding and households cannot consume at optimal.
-Therefore, they consume tax cut to get closer to the optimal.
-they will eat the tax cut.
-Therefore it will cause a current account deficit as it causes national savings to fall.
-Those under the borrowing constraint must be impacted by the tax cut
Mathematically how does borrowing constraint cause riccardian equivalence to fail?
Change S1 = sp + sg
Change in tax1 cuases Sg to fall so national savings fall
CA = S- I
deteriorates and we observe a twin deficit.
Why do intergenerational effects cause riccardian equivalence fail?
Generation benefitting from the tax cut has no care of the generation having to pay it back.
Therefore, period 1 consumption increases 1 to 1 with tax cut.
How do distortionary taxes make riccardian equivalence fail?
- if there is a proportional tax on consumption
-More you consume the more tax you pay
-You then write the budget constraints with proportional taxes on consumption
-You then write the IBC with proportional taxes
-If taxes are greater in one period than the other then consumption becomes cheaper in one of the periods rather than the other.
