1. Government Debt – Chapter 19, 8th and 9th
This chapter covers very topical issues, it is not particularly difficult, and students enjoy the material a lot. This chapter also leads nicely into the next chapter, new to this edition, on financial crises.
The PowerPoint presentation for this chapter includes a lot of data that complements the material in the chapter.

2. 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

3. Indebtedness of the world’s governments
Country
Gov Debt (% of GDP)
Japan
142.9
France
70.9
Greece
125.3
U.K.
64.2
Italy
120.4
Germany
42.4
Portugal
99.8
Netherlands
42.3
Belgium
91.6
Canada
40.9
United States
85.5
Switzerland
6.5
Spain
73.3
Australia
3.5
Table 19-1 on p.557
Source: OECD Economic Outlook, no. 96 (November 2014)
Despite all the alarms sounded by politicians and some economists, the U.S. debt-to-GDP ratio is moderate when compared to other countries.
(Of course, the U.S. has the largest GDP, so in absolute terms U.S. debt is a whopper when compared to other countries’ government debts.)
US debt is large in absolute terms. Moderate compared to other countries.

4. Ratio of U.S. govt debt to GDP
Revolutionary War
Civil War
WW1
WW2
Financial Crisis
Great Depression
Figure 19-1, p.558.
The historical pattern: the debt–GDP ratio rises during wars and falls during peacetime. The exception is the substantial rise that occurred beginning in the early 1980s.
Source: See textbook.

5. U.S. government spending on Medicare and Social Security, 1948–2014
Percent of GDP
Source:
Table 14.5, Total Government Expenditures By Major Category of Expenditure
Historical Tables, Office of Management and Budget
Retrieved 6 May 2015

6. 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

7. The traditional view of Debt
Cut T and hold G constant:
In the Short run: Y, u
Long run (AD-AS model):
Y and u back at their natural rates
C , r, I
Very long run:
slower growth. Yp is lower than otherwise because I => K is lower than otherwise.
The traditional view is just the viewpoint embodied in the models that students learned in Chapters 3 through 14 of this textbook. This viewpoint is accepted by most mainstream economists.

8. 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 is in section 19.3 and 19.4.

9. The logic of Ricardian Equivalence
Consumers are forward-looking, 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.

10. The logic of Ricardian Equivalence
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.

11. 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?

12. 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.

13. 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.

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