1. Debt, Deficits, and Economic Dynamics Chapter 12

2. 2 ©1999 South-Western College Publishing Figure 12.1 ’55’60’65’70’75’80’85’901940’50’45 Debt ($billions) 1000 2000 3000 4000 5000 Deficit ($billions) ’95 The Budget and the Deficit Debt (left scale) Primary deficit (right scale) Reported deficit (right scale) -100 100 200 300

3. 3 ©1999 South-Western College Publishing Figure 12.2 Debt/GDP Deficit/GDP The Budget and the Deficit Measured Relative to GDP Primary deficit Debt Reported deficit -0.1 0.1 0.2 0.3 0.2 0.4 0.6 0.8 1.0 1.2 1.4 ’55’60’65’70’75’80’85’901940’50’45’95

4. 4 ©1999 South-Western College Publishing Figure 12.3 How to solve a Difference Equation with a Graph b btbt b2b2 b1b1 b1b1 b0b0 b2b2 b t-1 This is the steady state of the difference equation. This path represents the solution to the difference equation when b begins at b 0. b t = b t - 1 b t = d + (1 + i) b t - 1 (1 + n) 45°

5. 5 ©1999 South-Western College Publishing Figure 12.4A Steady state Stable Steady State Panel A b t = d + (1 + i ) b t - 1 (1 + n) 45° b0b0 b1b1 b b t - 1 d btbt b t = b t - 1

6. 6 ©1999 South-Western College Publishing Figure 12.4B Unstable Steady State Panel B b t = d + (1 + i ) b t - 1 (1 + n) 45° b0b0 b1b1 b b t - 1 d btbt b t = b t - 1 Steady state

7. 7 ©1999 South-Western College Publishing Figure 12.5 ’55’60’65’70’75’80’85’901940’50’45’95 Percentage per year The Nominal Interest Rate and the Nominal Growth Rate in the United States from 1940 Through 1995 (% per year) -5 0 5 10 15 20 25 The interest rate on three-month Treasury bills The growth rate of nominal GDP

8. 8 ©1999 South-Western College Publishing Table 12.2 U.S. Data Before and After 1979 Average Value 1950–1979 Average Value 1980–1995 d-0.6%+0.5% n7.5%6.5% i3.8%7.4% (1 + i)/(1 + n)0.9651.008

9. 9 ©1999 South-Western College Publishing Figure 12.6 The Dynamics of the Budget Before 1979 The deficit-to- GDP ratio is the intercept of the difference equation with the vertical axis. The graph shows what would happen if this were maintained at 0.005. The slope of the difference equation is (1 + i)/(1 + n). In the pre-1979 case, this equals 0.965. btbt b = 0.14 45° b t = b t - 1 b t - 1 b t = 0.005 + 0.965b t - 1 b 1946 = 1.2 0.005

10. 10 ©1999 South-Western College Publishing Figure 12.7 The Dynamics of the Budget After 1979 b t = 0.005 + 1.008b t - 1 The slope of the difference equation is (1 + i)/(1 + n). In the post-1979 case, this equals 1.01. b t = b t - 1 45° b 1979 = 0.3 b t - 1 b = -0.53 btbt In the post-1979 case, the deficit-to- GDP ratio is 0.005.

11. 11 ©1999 South-Western College Publishing Figure 12.8 The Dynamics of Balancing the Budget d = -0.006 btbt To maintain the current debt-to-GDP ratio of 67%, the government would need to run a primary surplus of 0.7% GDP. b 1995 = 0.67 b t-1 b t = -0.006 + 1.008b t - 1 b t = b t - 1

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