[Purpose]Look into the dynamics of deficits and debt

[Questions]

Should reduce deficits rapidly to reassure markets that we'll pay the debt >< lower growth
Reduce deficits slowly

23-1 What We Have Learned:

23-2 The Government Budget Constraint: Deficits, Debt,
Spending, and Taxes:
Suppose that the government decrease taxes, creating a budget deficit, what will happen to
debt over time? Will the government need to increase taxes later?

The Arithmetic of Deficits & Debt

Definition of budget deficit

def icit t = r B t − 1 + G t + T t

All variables are in real terms

Bt − 1 government debt at the end of year t − 1 or at the beginning of year t
rB t − 1 real interest payments on government debt in year t
Gt government spending on goods and services
Tt taxes minus transfers during year t
In words: deficit equals spending, including interest payments on the debt, minus taxes
net of transfers.
Two characteristics of equation
Real interest payments - correct way
The correct measure of deficit is called the inflation-adjusted deficit
The government budget constraint states that the change in government debt during
year t is equal to the deficit during year t

B t − B t − 1 = def icit t

Bt − Bt − 1 = rB t − 1 + Gt − Tt

The government budget constraint links the change in debt to the initial level of debt and
current gov spending and taxes.
 B t = (1 + r)B t − 1 + (G t − T t )

In words: the debt at the end of year t equals (1+r) times the debt at the end of year
t − 1, plus the primary deficit.

Some implications

Current versus Future Taxes:

Firstly, Take a one-year decrease in taxes in year 1, debt at the end of year 1 B1 is equal to
1. What happens there after?

Full Repayment in Year 2:

B 2 = (1 + r)B 1 + G 2 − T 2

Debt fully repaid at year 2

0 = (1 + r)1 + G 2 − T 2

<=> T 2 − G 2 = (1+ r)

The government must make a surplus of 1 + r

We assume that the government does so through taxes

Year 0 1 2 3 4 5
Taxes 0 -1 (1+r)
End-of-year debt 0 1 0

Full Repayment in Year t:

t
T t − G t = (1 + r) − 1
Example: full repayment in year 5: (1 + r) 4

Conclusion:

If G is unchanged, a decrease in taxes must be eventually offset by an increase in taxes

t

in the future.
The longer the government waits to increase taxes, or the higher the real interest rate, the
higher the eventual increase in taxes must be

Year
Taxes 0 -1 0 0 0
End-of-year debt 0 1 (1+r)^2 (1+r)^3

Debt Stabilization

Suppose that we stabilize the debt from year 2

B 2 = (1 + r)B 1 + (G 2 − T 2 )

T 2 − G 2 = (1 + r) − 1 = r

Year 0 1 2 3 4 5
Taxes 0 -1 r r r
End-of-year-debt 0 1 1 1 1 1

The Evolution of the Debt-to-GDP Ratio

Bt Bt − 1 Bt − 1 Gt − Tt
− = (r − g) +
Yt Yt − 1 Yt − 1 Yt

In words:
The change in debt ration equals to
The difference between real interest rate and the initial debt ratio
The second term is the ration of primary deficit to GDP

23-3 Ricardian Equivalence, Cyclical Adjusted Deficits, and War

Finance
The three issues that budget constraint plays a central role

Ricardian Equivalence
The effects of deficits on output

One extreme view once the government budget constraint is taken into account, neither
deficit nor debt can have an effect
Ricardo-Barro proposition
Case: What will be the effect of the initial cut on consumption?
The tax cut is not much a gift Decrease taxes by 1 this year. However the present
value of next year's taxes goes up by (1 + r)/(1 + r), and the net effects of two
changes is 0. Consumers realize that their human wealth- the present value of after-
tax labor income is unaffected
Another way: looking at saving rather consumption. "*private saving increases one-
for-one with the deficit".
Government Deficit & Public Saving When the government increase their
deficits, they increase their spending thus decreasing their saving ( T-G). It
spends rather than collects taxes
Private Saving Response in response to deficits, consumers expect raised taxes
to repay the debt -> increase their private saving

Conclusion:

A long sequence of deficits and the associated increase in government debt are no
cause for worry
Total saving is unaffected, so is investment
Society would have the same capital stock today that it would have had if there had
been no increase in debt

Should we take this view?

Based on two things

Expectations matters
Consumption decisions depend on both current income and future income.
If a tax cut this year is going to be followed by an offsetting increase in taxes next year, the
effect on consumption would indeed probablu be small
This is supported by budget constraint

B 2 = (1 + r)B 1 + (G 2 − T 2 )

Contrasting:
People ignore because they do not think far into the future
Implication: budget deficit have an important effect on activity
 In the short run: larger deficits are likely to lead to higher demand and higher
output.
In the long run: higher government debt lower capital accumulation -> lower
output
Explanation:
Crowding Out: ( crowd out private investments Borrow more money ->
higher interest rate -> less incentivized to invest in capital ( factories,
machineries, infrastructure)
Capital Accumulation and Output:
Workers with less capital available, will work with lower productivity.

Deficits, Output Stabilization and the Cyclically Adjusted Deficit:

The fact that budget deficits have long-run adverse effects on capital accumulation and
output, does not imply that discal policy should not be used to reduce output fluctuations
It implies that deficits should be offsets by surpluses.
To assess whether fiscal policy is on track, economists have constructed deficit
measures to tell them what the deficit would be, if out put were at the natural level of
output.
Such measures are named full-employment deficit, mid-cycle deficit, standarized
employment deficit, structural deficit**
We use cyclically adjusted deficit
Why we measure at the natural level?
To distinguish between the cyclical deficit ( caused by current state of the
economy, eg recession) & structural deficit the deficit that remains when the
economy operates at its natural level of output, reflecting the effects of fiscal
policy.
Example: if the actual deficit is large but the cyclically adjusted deficit is
zero, then no systematic increase in debt over time
Implied: when output returns to its natural level, the deficit will disappear
and the debt will stabilize.
Why not zero cyclically adjusted deficit?
The gov may want to run a deficit large enough even when the CA deficit is
positive. ( in recession)
However, when CA deficit is positive, the return to the natural level of output
is insufficient to Stabilize debt -> they have to take specific measures.

The Construction of CA deficit

 Step 1: A reliable rule of thumb is that a 1% decrease in output leads automatically to an
increase in the deficit of 0.5% of GDP
Explanations: a decrease in output leads to
Lower GDP - lower income - lower tax
Automatic Stabilizer ( mostly welfare programs) -> more government spending
Step 2: assess the gap between actual and natural output
Challenges: misestimating the natural rate of unemployment

Wars & deficits:

Reasons for deficit finance:

Distributional
Help reduce tax distortions

Passing on the Burden of War

Key Insight
When government spending rises while output remains fixed, the adjustment comes through
reductions in consumption and/or investment.

Deficit financing shifts the burden mostly to investment.

Tax financing shifts the burden more to consumption.
The more the gov relies on deficits, the smaller the decrease in consumption + larger
decrease in investment -> reduced capital accumulation

Reducing Tax Distortions:

Tax smoothing** implies running large deficits when government spending is ex ceptionally
high, and small surpluses the rest of the time.

23-4 The Dangers of High Debt

(1) High debt can lead to vicious cycles and makes the conduct of fiscal policy extremely

difficult.
 (2) Investors's fears about the default risk have led to higher interest rates on government
bonds
Higher spreads make it harder for these countries to reduce their debt ratios.

Debt Default
Partial default = haircut
Comes in many name
Pros:
reduce fiscal consolidation
lower required tax
Potentially allowing for higher growth
Cons:
Held by pension funds -> retirees suffer
Held by banks -> bankrupt

Money Finance
If the fiscal situation is bad, ( deficits, debt are large and interest rate is high) -> gov wants
to finance through money finance
- FISCAL DOMINANCE : fiscal policy determines the behavior of money supply
- Mechanisms through
- Debt monetization: gov issues new bonds -> CB buys them -> finance moeneu
How large a deficit can a government finance through money creation
seignorage = △ H/ P
△H the changeof nominal money stock from one month to the net
Money creation divided by the price level

What rate of nominal money growth is required to generate a given amount of seinorage

We can think of it as the product of nominal money growth & real money stock
seinorage = △ H
H
H
P

relation of seignorage, the rate of nominal money growth & real money balances

seignorage △H H /P
=
Y H Y

Suppose the government is running a budget deficit equal to 10% of GDP and decides to
finance it through seinorage , so (deficit/Y) = (seignorage/Y) = 10%
 The average ratio of CB money to GDP = 1 , this implies that the nominal money growth
must satisfy

△H
× 1 = 10
H

High Money Growth Rate to alleviate deficit

Is it worth it?

Money growth increases, inflation increases -> reduced demand for Central bank money
As △H

H
increases, H /P is likely to increase
This leads to higher moeny growth
A vicious cycle --> HYPERINFLATION ( inflation in excess of 30%)

COSTS of Hyperinflation

The transaction system works less and less well

Price signals become less and less useful. Prices change so often, it is difficult for
consumers and producers to assess the relative prices of goods to make informed
decisions.
The higher the rate of inflation, the higher the variation in the relative prices of different
goods
Swings in the inflation rate become larger. if we borrow 1000$ for a year, we may end up
paying a real interest rate of 500%.
Borrowing and lending TYPICLALY come to a stop in the final months of hyperinflatio