Government Debt – Chapter 19 8 th and 9 th Chapter 16 7th

THIS CHAPTER COVERS  about the size of the U.S. government’s debt and how it compares to that of other countries  problems measuring the budget deficit [SKIP]  the traditional and Ricardian views of the government debt  other perspectives on the debt [SKIP] 1

Indebtedness of the world’s governments Country Gov Debt (% of GDP) Country Gov Debt (% of GDP) Japan142.9France70.9 Greece125.3U.K.64.2 Italy120.4Germany42.4 Portugal99.8Netherlands42.3 Belgium91.6Canada40.9 United States 85.5Switzerland6.5 Spain73.3Australia3.5 US debt is large in absolute terms. Moderate compared to other countries. df df

Ratio of U.S. govt debt to GDP Revolutionary War Civil War WW1 WW2 Financial Crisis Great Depression

The U.S. experience in recent years Early 1980s through early 1990s  debt–GDP ratio: 25.5% in 1980, 48.9% in 1993  due to Reagan tax cuts, increases in defense spending & entitlements Early 1990s through 2000  $290b deficit in 1992, $236b surplus in 2000  debt–GDP ratio fell to 32.5% in 2000  due to rapid growth, stock market boom, tax hikes

The U.S. experience in recent years Early 2000s  the return of huge deficits due to Bush tax cuts, 2001 recession, Iraq war The recession and its aftermath  fall in tax revenues  huge spending increases (bailouts of financial institutions and auto industry, stimulus package)  a weak recovery did not stop the debt–GDP ratio from rising further

The troubling long-term fiscal outlook  The U.S. population is aging.  Health care costs are rising.  Spending on entitlements like Social Security and Medicare is growing.  Deficits and the debt are projected to significantly increase…

U.S. population age 65+, as percent of population age 20–64 Percent of pop. age actual projected

U.S. government spending on Medicare and Social Security, 1948–2014 Percent of GDP

Is the govt debt really a problem? Consider a tax cut with corresponding increase in the government debt. Two viewpoints: 1. Traditional view 2. Ricardian view

The traditional view of Debt  Say cut T and hold G constant:  Short run:  Y,  u  Long run:  Y and u back at their natural rates  C ,  r,  I  Very long run:  slower growth because I  => K is lower than otherwise => Y p is lower than otherwise.

Ricardian equivalence  due to David Ricardo (1820), more recently advanced by Robert Barro  According to Ricardian equivalence, a debt-financed tax cut, holding G constant, has no effect on consumption, national saving, the real interest rate, investment, or real GDP, even in the short run.  This section 19.3 and 19.4 in 8 th edition and 16.3 and 16.4 in the 7 th edition. Government Debt and Budget Deficits.

The logic of Ricardian Equivalence  Consumers are forward-looking and base spending on current and expected future income - permanent Income/ Life Cycle Hypothesis  Implication - Consumers know that a debt-financed tax cut today (holding G constant) implies an increase in future taxes that is equal in present value terms to the tax cut.  The tax cut today (coupled with a tax hike in the future) is merely transitory income. Consumption does not change, Y does not change as stated on previous slide.

 Consumers 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, r unchanged, I unchanged, Y unchanged.  A tax cut financed by government debt does not reduce the tax burden, it just reschedules the tax.  Deficit financed by debt is equivalent to deficit financed by taxes. The logic of Ricardian Equivalence

Question:  Suppose consumers understand that the tax cut today is to be followed by a decrease in government spending in the future. Would consumption increase?

Arguments against Ricardian Equivalence  Myopia: Not all consumers think so far ahead, some see the tax cut as a windfall or an increase in life time income.  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.

Bush 1992 withholding  Lower withholding, but pay up in the following April.  RE predicts no change in consumption because life time resource(permanent income) was not changed – lower withholding was transitory income.  Survey – 57% said would save and 43% spend.  Most studies show MPC out of temporary tax change < MPC out of permanent tax change.

Other examples  Johnson 1968 tax surcharge. Temporary, people just reduced savings  Ford 1974 tax rebate. People just increased saving

The IS-LM-PC Model Not in the Book but Easy to Understand

Fed Targets Interest Rate  In the LM model we assumed Fed targets M  At odds with policy today - Fed targets r  Let r* be the Fed target interest rate in real terms r Y LM r*

Equilibrium  Add IS-curve –  How to we show fiscal and monetary policy? LM IS r Y r*

Use Phillips Curve (PC) as the AS-curve 0 Y PC Yn

IS-LM-PC Model: Dynamics for LR Equilibrium at Y n Point A represents SR. At r, Y >Yn, the economy is in a “boom” and the rate of inflation is increasing. If nothing is done, inflation continues to increase. Eventually the Fed will increase r.

The Fed increases r to r n The Fed increases r to r n and the economy equilibrates at Y n and interest rate r n We call r n the natural rate of interest to reflect the fact that it is the interest rate consistent with the natural rate of unemployment and the natural rate of output. All of this is easier said than done. It assumes the Fed knows Y n and also knows the r n that gets you to Y n Also, there are long lags. It takes 12 to 24 months for inflation to respond to change in r.

But … at A’, while Δ  =0, the level of inflation is higher. That is, inflation has been stabilized but at a higher rate. What must the Fed do to reduce the rate of inflation?

Contractionary Fiscal Policy Say at full employment and administration wants to reduce the deficit and increases T. In the IS-LM-PC model IS shifts to the left and Y falls (nothing new), in a recession. If r is held at r n, Y falls to Y’. C also falls. In the bottom diagram, the rate of inflation falls. The Fed reacts by reducing the target rates. LM shifts down to LM’ and the economy moves to full employment at Y’’. At Y’’, C is lower and I is higher. Question: Can the deficit be reduced without a recession?