Government budget Budget deficits and debt 1

 Recall, when we talked about national savings:  T – G is not a budget surplus  Because it is missing some items  From the beginning, we talked about government in Canada as all levels of government combined  Where does money come from and where does it go?  Government purchases of goods and services G  Debt-service payments i × D  Transfers  Tax revenues  Borrowing 2

 Government’s budget constraint:  G + i × D + Transfers = Tax revenues + Borrowing  G + i × D = (Tax revenues – Transfers) + Borrowing  G + i × D = T + Borrowing  Where T = net tax  G + i × D – T = Borrowing  This Borrowing = budget deficit  If Borrowing < 0, budget surplus  The sum of the budget deficits = government debt D  Means ΔD = budget deficit = (G + i × D) – T  Government debt is a stock  Budget deficit is a flow  Budget deficit > 0, means ΔD > 0, debt increases  Budget deficit < 0, i.e., surplus, means ΔD < 0, debt decreases 3

 There are two parts to the budget deficit  Debt cannot be changed by policies  G and T can be changed by policies  They are discretionary  G – T = primary budget deficit  Also called program spending  Shows the extent to which taxes cover the discretionary part of expenditure 4

 Characteristics of fiscal policy  Recall how we talked about fiscal policy with automatic stabilizers  Taxes decline if GDP declines  Transfers increase if GDP declines  Net taxes decline and increase with GDP  T = t × Y  G and i × D are not the functions of Y  But budget deficit = (G + i × D) – T  Thus the budget deficit function  Fiscal policy determines the position of the budget deficit function  Changes in GDP mean moving along a fixed budget deficit function 5

 Characteristics of fiscal policy  Changes in GDP mean moving along a fixed budget deficit function  Fiscal policy determines the position of the budget deficit function  More contractionary fiscal policy shifts the budget deficit function down  More expansionary fiscal policy shifts the budget deficit function up  We could look at the deficits and judge a policy  But there are changes in GDP  The CAD measures the deficit as if GDP = Y*  Also called structural deficit  Tells you about fiscal policy  Comparison of actual deficit and CAD tells you about business cycles 6

 Changes in debt-to-GDP ratio d  Canadian government tries to achieve a reduction in d  d = D/GDP  Then Δd = x + (r – g) × d  The debt-to-GDP ratio changes  If there is a primary budget deficit x  and/or if the debt accumulates faster than real GDP grows  To reduce the debt-to-GDP ratio  It is good to run primary budget surpluses  Spend on current programs less than collected in taxes  It helps if real interest rate r is low  It helps if the real economy grows at high rate g 7

 What do the deficits do to the economy?  Recall, increase in G => increase in GDP  AE = C + I + G + NX  Positive AD shock  But also, (T – G) = public savings  Then, increase in G => decrease in public savings  This leads to a decrease in national savings  Loanable funds theory of interest:  Decrease in national savings => increase in interest rate  This is crowding out private investments  In addition, increase in interest rate => decrease in NX  This is crowding out net export  This is referred to as long-term burden of government debt 8

 Is the long-term burden of government debt bad?  It depends:  Government invests (“better” than private sector) => we are better off  Government spends on current consumption => present generation benefits at expence of future generations  Is that bad?  Capital budgeting is a proposal to restrict borrowing to (“good”) investments only  Does Government Debt Hamper Economic Growth? Read --- not tested 9

 Formal fiscal rules  Annually balanced budget  Could not really achieve  Taxes and spending cannot be continuously adjusted  And likely a bad idea  Automatic stabilizers would be destroyed  Cyclically balanced budgets  What does it mean about the budget deficit function position?  Can you see the problem?  Formal fiscal rules are not generally followed but there is an understanding that the government strives to approach what they suggest 10