1. Issues on fiscal policy

2. Ricardian Equivalence and Ponzi Game - Ricardian equivalence (Barro 1974) (Romer (2012) sec.12.1to 12.3) The Intertemporal government budget constraint: Introduction: The two traditional views regarding budget deficits: Keynesian versus neo-classical. Barro (1974) contradicts both. Starting point:

3. The GBC does not imply that public debt B is constant or zero. As show in Barro in its reply to Feldstein, it can even be growing. Let’s define: Where g is the growth rate of public debt. For g > 0, part of interest payments are financed by borrowing. For g < 0, the debt is gradually reimbursed. At time t, taxes required for the financing of the debt are:

4. The present value of these taxes are:

5. In Barro (1974), intergenerational links (inheritance, bequest) Same problem as with the PIH - liquidity constraint - distortion costs for taxation Barro 1979

6. Discussion: g > r Ponzi Game g MAX is the growth rate of the economy, B/Y constant g > r, dynamic inefficiency Ricardian equivalence, foresighted agents (Ramsey model) Government and agents satisfy their Intertemporal budget constraint: For a given sequence of G(t), the division of the financing of G(t) between taxes and debt is irrelevant. Famous result. Public debt is not net wealth since it is future taxes. The sequence T(t) is irrelevant. What matter is the sequence G(t). Consequently, ↓T(0) (for a given G(t)) →↑S(0) corresponding Permanent income hypothesis with infinite horizon.

7. Tax-Smoothing (Barro 1979) Romer (2012) section 12.4 Distortion costs from raising T t : The government chooses the path that minimizes this distortion:

8. Costs are minimized when: This result is very interesting under uncertainty:

9. Discussion: T/Y follows a random walk (no predictable changes in T/Y. 1)Important role for debt financing: War 2)Recessions

10. Model of debt crisis, Romer 4 th edition section 12.10 One period model D debt has to be rolled over (issue D of new debt to pay off the debt coming due) T tax revenues the following period, Government want investors to hold the debt for one period T is random with cumulative function F() R is the interest factor (1+r) and R-1 is the interest rate r If T is less than RD full default Default is all-or-nothing Investors are risk neutral The riskless interest factor RMIN is independent of R and D. π is the expected probability of default

11. Arbitrage between risky and riskless assets implies (1-π)R = RMIN Or π = (R-RMIN)/R (12.42) Example European debt crisis 12.42 is plotted in the following graph

12. π RRMIN 1 Condition for investors to be willing to hold government debt From 12.42

13. Second equilibrium condition: government defaults if T < RD T distribution function is F() π = F(RD) (12.43) The maximum value of T is TMAX The minimum value of T is TMIN Density function is bell-shaped The cumulative distribution function is S- shaped

14. π RTMIN/D 1 TMAX/D The probability of default as a function of the interest factor

15. π RTMIN/D 1 TMAX/D The determination of the interest factor and the probability of default RMIN A B B is unstable (p. 636) Two stable equilibria, A And π=1 πAπA

16. Analysis So there are two equilibria, one when the interest factor and the probability of default are low, one where no investor want to hold the debt For a sufficiently large riskless rate RMIN (Figure 12.6 next) the red curve is on the right of the blue curve and the only equilibrium is π=1. You don’t need large change in fundamental to have π moving from a low πA to π=1 For RMIN below this point, and increase in RMIN increase the low πA Read page 637-638 (the conclusion on expectation, beliefs about beliefs about fundamentals is Keynesian).