CHAPTERS IN ECONOMIC POLICY Part. II Unit 8 The dynamics of debt to GDP ratio

The Arithmetic of Deficits and Debt –The budget deficit in year t equals: is the interest payments on the debt In words: The budget deficit equals spending, including interest payments on the debt, minus taxes net of transfers. is government spending during year t. is taxes minus transfers during year t.

- Note that we measure interest payments as real interest payments rather than as actual interest payments. The correct measure of the deficit is sometimes called the inflation-adjusted deficit

The government budget constraint states that the change in government debt during year t is equal to the deficit during year t: It is often convenient to decompose the deficit into the sum of two terms:  Interest payments on the debt, rB t-1  The difference between spending and taxes, G t -T t. This term is called the primary deficit (equivalently, T t –G t is called the primary surplus). The Arithmetic of Deficits and Debt

change in the debtinterest paymentsPrimary deficit

The debt to GDP ratio - In an economy in which output grows over time, it makes sense to focus on the ratio of debt to output -The debt-to-GDP ratio, or debt ratio gives the evolution of the ratio of debt to GDP.

The Arithmetic of the Debt Ratio It is possible to demonstrate that the change in the debt ratio over time is equal to the sum of two terms. - The first term is the difference between the real interest rate and the growth rate times the initial debt ratio. - The second term is the ratio of the primary deficit to GDP.

The Evolution of the Debt Ratio in OECD Countries This equation implies that the increase in the ratio of debt to GDP will be larger: - the higher the real interest rate, - the lower the growth rate of output, - the higher the initial debt ratio, - the higher the ratio of the primary deficit to GDP

The Evolution of the Debt-to-GDP Ratio in OECD Countries - In the 1960s, GDP growth was strong. As a result, r  g was negative. Countries were able to decrease their debt ratios without having to run large primary surpluses. - In the 1970s, r  g was again negative due to very low (and even negative) real interest rates, leading to a further decrease in the debt ratio.

The Evolution of the Debt-to-GDP Ratio in OECD Countries - In the 1980s, real interest rates increased and growth rates decreased, thus, debt ratios increased rapidly. - Throughout the 1990s, interest rates remained high and growth rates low. However, most countries ran primary surpluses sufficient to imply a steady decline in their debt ratios. - So far, during the 2000s, real interest rates are low, but many countries are running primary deficits, and their debt ratios are again going up.

- High public debt and economic policy Let’s start from the equation: [(Bt /Yt)  (Bt-1 /Yt-1)] = (r  g)(Bt-1 /Yt-1)+(Gt  Tt)/Yt Let’s assume r = 3%; g = 2% Bt-1 /Yt-1 = 100%

-In order to have a constant debt/GDP ratio, a 1% primary surplus is sufficient Let’s assume now that, to counteract speculation in the currency market, the central bank is forced to increase domestic interest rate As a consequence, the real interest rate is likely to increase (e.g to 5%) and the GDP growth rate to decrease (e.g. to 1%) In order to have a constant debt/GDP ratio, a 4% primary surplus is now needed

This however implies a severely restrictive fiscal policy which could bring to a recession (g  0) In this context debt to GDP ratio is likely to increase, fuelling adverse expectations in the financial markets As a consequence: increase of interest rates to compensate the investors of the risk of default Likely outcame: default