1. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 32 Government Debt and Deficits

2. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-2 In this chapter you will learn to 4. Explain why a high stock of debt may hamper the conduct of monetary and fiscal policies. 5. Explain why legislation requiring balanced budgets may be undesirable. 1. Describe the relationship between the government’s annual budget deficit (or surplus) and its stock of debt. 2. Define the cyclically adjusted deficit and how it can be used to measure the stance of fiscal policy. 3. Explain how budget deficits may crowd out investment and net exports.

3. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-3 The Government’s Budget Constraint Government expenditure must be financed by either tax revenue or by borrowing: Government expenditure = Tax revenue + Borrowing Facts and Definitions

4. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-4 purchases of goods and services = G debt-service payments = i  D transfers Since T is the government’s net tax revenues, the budget constraint becomes: G + i  D = T + Borrowing (G + i  D) – T = Borrowing Government expenditures are composed of: Facts and Definitions

5. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-5 The government’s annual budget deficit is: - the government’s borrowing - the change in the stock of debt The budget deficit can therefore be written as: Budget Deficit =  D = (G + i  D) - T If there is a: - budget deficit  the debt rises - budget surplus  the debt falls Facts and Definitions

6. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-6 The primary budget deficit: - the deficit on the non-interest part of the budget: Primary budget deficit = Total budget deficit - Debt-service payments = (G + i  D – T) – i  D = G – T 2005-06 fiscal year: debt-service payments = $227 billion - total budget deficit = $248 billion - primary budget deficit = $21 billion Facts and Definitions

7. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-7 Deficits and Debt in the United States Between 1980 and 1993, the average budget deficit was about 4% of GDP. By 1998, the federal government had its first budget surplus in almost 30 years. Four years of budget surplus were followed by a return to a deficit in 2002.

8. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-8 Figure 32.1 Federal Government Expenditures, Revenues, and Deficit, 1962–2005

9. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-9 Figure 32.2 Federal Government Net Debt as a Percentage of GDP, 1940–2006

10. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-10 Two Analytical Issues The Stance of Fiscal Policy Fiscal policy is the use of the government’s tax and spending policies in an effort to influence the level of GDP. For a given set of tax and spending policies, the budget deficit is negatively related to real GDP.  the budget deficit function shows this negative relationship between the deficit and Y

11. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-11 Figure 32.3 The Budget Deficit Function

12. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-12 The cyclically adjusted deficit (CAD) is the budget deficit that would exist with the current policies if Y were equal to Y*. Since changes in Y will lead to changes in the budget deficit, we cannot infer anything about policy from changes in the deficit. Changes in the stance of fiscal policy are shown by changes in the cyclically adjusted deficit. Two Analytical Issues

13. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-13 Figure 32.4 The Cyclically Adjusted Deficit and Changes in Fiscal Policy

14. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-14 Figure 32.5 The Actual and Cyclically Adjusted Deficit, Federal Government, 1962–2006

15. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-15 Changes in the Debt-to-GDP Ratio Simple but crucial equation:  d = x + (r – g)  d Where: d is the debt-to-GDP ratio x is the government’s primary budget deficit as a percentage of GDP r is the real interest rate g is the growth rate of real GDP  d is the change in the debt-to-GDP ratio

16. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-16 1. If r > g, then d will rise unless there is a sufficient primary surplus. 2. If r = g, then all that is required to keep d constant is a primary budget balance. EXTENSIONS IN THEORY 32.1 Derivation of the Debt-to-GDP Ratio Equation Two Implications: Changes in the Debt-to-GDP Ratio

17. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-17 The Effects of Government Debt and Deficits We assume in what follows that changes in the government’s flow of saving are not offset by changes in private saving:  changes in the budget deficit lead to changes in national saving

18. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-18 Do Deficits Crowd Out Private Activity? Crowding out is the reduction in private expenditure caused by an expansionary fiscal policy: - higher interest rates (investment) - appreciated currency (net exports) The fiscal expansion can be either: - an increase in G - a reduction in T

19. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-19 Figure 32.6 The Crowding Out of Investment Consider a closed economy at Y*. A fiscal expansion increases the deficit and reduces national saving. Interest rates rise and investment falls.

20. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-20 In an open economy, as interest rates increase there is an inflow of foreign financial capital. This capital inflow leads to an appreciation of the currency and a crowding out of net exports. How About in an Open Economy?

21. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-21 Do Deficits Harm Future Generations? Government debt generates a redistribution of resources away from future generations toward the current generations. Whether there is a burden on future generations depends on the nature of the government spending being financed by the deficit. Debt incurred to finance public investment may result in no burden for future generations.

22. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-22 Does Government Debt Hamper Economic Policy? Government debt can impose costs in the very distant future  we tend to ignore their importance Government debt can also cause problems that are more immediately apparent:  the conduct of monetary and fiscal policy become more difficult

23. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-23 Monetary Policy To see how government debt can hamper the conduct of monetary policy: - consider a very high debt-to-GDP ratio - creditors may come to expect monetization of debt  an increase in inflation expectations  makes monetary policy more difficult

24. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-24 Fiscal Policy - governments often try to implement counter-cyclical fiscal policy - deficits in recessions and surpluses in booms - but a high debt-to-GDP ratio may restrict the government severely  may be unable to have stabilizing fiscal policy Fiscal Policy

25. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-25 Current Budget Surpluses Since 1998, the federal government has had a budget surplus. What does our model predict if these are sustained? -higher national saving -lower interest rates -higher investment -currency depreciation and greater net exports - enhanced ability for counter-cyclical fiscal policy should the need arise

26. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-26 Formal Fiscal Rules? The potential problem with large public debt leads some people to consider formal fiscal rules to prevent the excessive build-up of debt. What are some possibilities? APPLYING ECONOMIC CONCEPTS 32.1 Is Foreign-Held Debt a Problem?

27. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-27 A balanced budget every year is difficult because: - a large part of G and T is beyond the control of the government - it may be destabilizing on real GDP Annually Balanced Budgets? For example: In a recession, tax revenues naturally decline:  a balanced budget requires a reduction in G or an increase in T  real GDP declines further

28. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-28 Desirable in principle, but very difficult to define and implement. Cyclically Balanced Budgets? An alternative is to require that the government’s budget be balanced over the course of a full economic cycle.

29. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 32-29 Some economists view a stable (or falling) debt-to-GDP ratio as the appropriate indicator of fiscal prudence. This view permits a deficit as long as the stock of debt grows no faster than GDP. Allowing for Growth Another problem with any formal fiscal rule is the emphasis on the overall budget deficit: - but the debt-to-GDP ratio is probably more important