Views of American leaders on the national debt “A national debt, if it is not excessive, will be to us a national blessing.” [Alexander Hamilton, 1781] “It’s a public debt… we owe it to ourselves… therefore, we never have to pay it back.” [F. D. Roosevelt] “There are myths also about our public debt. Borrowing can lead to over-extension and collapse – but it can also lead to expansion and strength. There is no single, simple slogan in this field that we can trust.” [John F. Kennedy, Yale Commencement Address, 1962] 1

The Endgame These FAQs will be posted and updated as new information comes in. This is as of 12/2/2013. This is all subject to revision. Here are some reminder FAQs on the paper: Q. When is it due? A. The paper is due by noon on Monday, December 9. Q. Where and how do I hand it in? A. it to me and your TF by noon on Monday Dec 9. Drop a hard copy off in the box outside my office, 2 nd floor, 28 Hillhouse Avenue by Monday 3 pm. When and where are the review sessions for the final exam? There will be review sessions. Details to follow The TAs will have regular sections the week of 12/2; special sessions next week. All review sessions are optional. The format is student Q and prof A. 2

Here are some FAQs on the final exam: Q0. When and where is the final examination? A0. ECON 122, Intermediate Macroeconomics, group 34, Friday, 12/13/2012, at 2 p.m. Places TBD Q1. What is the exam format? A1. The exam will be 3 hours plus ½ hour for proofreading and looking over your answer. There will be short answer questions, medium-length problems, and essay- type questions. Q2. What kind of problems will be on the exam? A2. Problems will be similar to the ones on your problem sets. We may well take one of the problem set questions for the final exam. Q3. Are there length limitations on the answers? A3. Yes. You will be constrained on the length of your answers. The idea is that your answers should be carefully crafted and succinct rather than “write everything you know and hope that something hits the target.” You may find it helpful to draft an answer and copy that into a bluebook. Sloppy answers and writing will get penalized. 3

Q4. Are electronics allowed? A4. Nothing but pen and pencil. No electronics at all. Q5. What will be covered on the exam? A5. The entire course will be covered. There will be slightly more emphasis on the material since the midterm. The core material is the textbook, the lectures, and the lecture notes. Q6. Will you post a sample exam? A6. Yes, with an answer key if we can find one. Q7. Will it be a fun exam? A7. Definitely, it will be a hoot! 4

Questions to think about in debt analysis 1.What is the impact on growth of potential output? –Higher deficit and debt leads to lower saving and capital stock –Leads to lower potential output 2.What is the impact on unemployment and the business cycle? –Lowers unemployment in short run through IS-MP or Mundell-Fleming –But may lower growth through #1 in long run. 3.What are the impacts in an open economy? –Open economy has lower wealth and operates like #1 4.What happens if debt is unsustainable? –Can have spiral of hyperinflation or default 5

Debt bathtub Debt (beginning of year) Spending Revenues Debt (end of year) = Debt (beginning) + deficit 6

The overall federal budget 7 Deficit

Current projections of debt/GDP Congressional Budget Office, Long-term Budget Outlook, September

Long-term spending 9

Debt algebra Basic identity: Debt (end of t) = Debt (beginning of t) + Deficit (t) Sustainable debt when debt-GDP ratio is constant or declining. Define debt-GDP ratio = β Primary surplus = PS = taxes – noninterest spending. Given U.S. parameters, stable β when PS = 0. 10

Primary surplus ratio Clinton-era surpluses Recession and stimulus package CBO Forecast 11

How to think about the government debt 1.In a classical, full-employment economy: -Basically use the neoclassical growth model 2.In a Keynesian recession -Basically use the IS-MP or Mundell-Fleming model -May have a tradeoff between recovery today and higher debt in the future. 3.In a financial crisis or with unsustainable debt growth -A country with a debt in its own currency? Problems mainly of inflation -A country with its debt in another currency? Financial crisis like the Romer model 12

Case 1. Closed classical economy Fundamental difference between spending on I and spending on C: -Borrowing for spending on productive I does not lower long-run C -Growth lowered from borrowing for government or private C Two problems from domestic debt (or closed economy debt) -Internal debt requires taxation to service and leads to inefficiency -Debt crowds out capital and reduces the growth/level of potential output 13

Debt in neoclassical growth model National investment = national saving = private saving + government saving NS = PS + GS If PS unchanged, then higher deficit leads to lower saving and investment. Then follow through standard Solow neoclassical growth model, with lower s. 14

15 k y = f(k) (n+δ)k y** (I/Y)* k** Impact of Deficits on Economy k* y* i = s 1 f(k) i = s 2 f(k)

time ln K, ln GD ln K ln GD ln GD’ ln K’ 16

time ln Y, ln C ln Y ln (C+G)’ ln Y’ Note that govt spending first raises (C+G), but then lowers (C+G)’ 17 ln (C+G)

18 Case 2. Impact of government debt in an open economy (assuming borrowing in own currency) In open economy: K + NFA = Wealth = Private wealth – Government Debt W/L = v = (K + NFA)/L = k +nfa, where nfa=NFA/L For small open economy, the marginal investment is abroad! –With r = r w, no change in domestic capital stock! –Therefore, no effect on GDP, but has effect on income from abroad –Will show up in national income (NNP) not in GDP! (Most macro models get this wrong.) Large open economy like US: –Somewhere in between small open and closed. –I.e., some decrease in domestic I and some in decrease net foreign assets But results of changes in saving on changes in W and C are same in open as closed economy.

19 k, v y = f(k*)+f’(k*)(v-k) = f(k*)+r w (v-k) nv v* Solow model for open economy with net foreign borrowing k* i = sy Foreign debt = -nfa* y=NNP/L; v = per capita wealth; v= k + nfa; Show how: ↓s → ↓v → ↓nfa but no change k → ↓y

Case 2. Deficit spending in recession: IS-MP or MF Standard Keynesian analysis Open economy largely the same as closed economy here (with some wrinkles on exchange rate and liquidity trap). 20

Fiscal expansion i Y = real output (GDP) IS(G) MP IS(G’)

r = real interest rate Y = real output (GDP) IS rere IS’ MP Fiscal expansion in liquidity trap

Case 2. Deficit spending in recession: IS-MP or MF Standard Keynesian analysis Long-run impact concerns whether higher debt at end of recession leads to lower s and lower long-run potential. Does austerity improve or hurt long-run output? –Conventional pre-recession wisdom that it helped. –But it may hurt output and investment so much that reduces long-run output. –Unsolved question in macro! 23