16.3 The Effects of Government Debt and Deficits

Question 1

What do we assume in our macro model concerning the relationship between budget deficits and national savings?

Answer 1

In our macro model, we assume that an increase in the government’s budget deficit leads to a decrease in national saving.

We make this assumption because it is consistent with the bulk of empirical evidence on this issue.

Question 2

A Fiscal Expansion Crowds Out Private Investment (Graph)

Answer 2

Question 3

What are the long-run effects of an icnrease in the budget deficit in a closed economy?

Answer 3

For a closed economy, the long-run effects of an increase in the budget deficit will be a higher real interest rate and a reduction in private investment.

Question 4

What is the effect of an increase in the budget deficit on the amount of investment in the economy?

Answer 4

As we said earlier, an increase in the budget deficit is assumed to cause a reduction in the supply of national saving.

As we saw in Chapter 10, a reduction in the supply of national saving will shift the NS curve to the left, increase the equilibrium real interest rate, and reduce the amount of investment in the economy.

Question 5

What is Crowding out?

Answer 5

Crowding out

The offsetting reduction in private expenditure caused by the rise in interest rates that follows an expansionary fiscal policy.

Question 6

What is useful to examine in order to better understand the crowding out of investment?

Answer 6

To better understand the crowding out of investment, it is useful to examine the short-run effects in the AD/AS diagram, and also the economy’s adjustment process as Y moves back to Potential

Question 7

What is the effect of a higer interest rate in the new long-run equlibrium that follows it?

Answer 7

The higher interest rate causes a reduction in desired investment. In the new long-run equilibrium, the amount of investment is less than it was prior to the increase in the budget deficit. The end result of the fiscal expansion is therefore a crowding out of private investment.

Question 8

What is the long-run effect of a fiscal expansion?

Answer 8

The long-run effect of a fiscal expansion is to reduce national saving, increase the real interest rate, and crowd out private investment.

Question 9

In an open economy, what is the effect of a rise in the rea interest rate on Canadian net exports.

Answer 9

In an open economy, the government budget deficit attracts foreign financial capital and appreciates the domestic currency. The long-run result is a crowding out of net exports.

As real interest rates rise in Canada, foreigners are attracted to the higher-yield Canadian assets and thus foreign financial capital flows into Canada.

But since Canadian dollars are required in order to buy Canadian interest-earning assets, this capital inflow increases the demand for Canadian dollars in the foreign-exchange market and leads to an appreciation of the Canadian dollar.

If the currency appreciation is sustained over several months or longer, it will cause a reduction in Canada’s exports and an increase in Canada’s imports; Canadian net exports, NX, will fall.

Question 10

Recall an equation of national income accounting

Answer 10

Question 11

What is the effect on private expenditure after a fiscal expansion policy (Increase spending in G) AFTER Y has returned to Y*

Answer 11

In the long run, however, after Y has returned to , the higher-than-initial value of government purchases implies that the sum of the three private expenditure components must be lower than it was at the initial long-run equilibrium.

We cannot say precisely how the reduction in private spending is distributed across the three components, but in the long run in our model total private expenditure (C+I+NX) has been crowded out by the full amount of the fiscal expansion.

Note, however, that full crowding out does not occur if the level of potential output, , increases as a result of the fiscal expansion.

Question 12

Relationship between an icnrease in potential output caused by fiscal expansion and riveate expenditure.

Answer 12

The larger is the increase in potential output caused by a fiscal expansion, the less private expenditure will be crowded out.

Question 13

What is The Long-term burden of government debt?

Answer 13

We have now seen that in a closed economy, a rise in the government’s budget deficit pushes up interest rates and crowds out domestic investment.

In an open economy, a rise in the deficit also appreciates the currency and crowds out net exports.

In both cases, there may be a cost to future generations. Economists call this cost the long-term burden of government debt.

Question 14

When will a long-term burden of government debt be present?

Answer 14

Such a burden will be present if the private expenditure that is crowded out would have added more to the economy’s productive capacity than what is added by the government’s expenditure financed by the budget deficit.

Whether government budget deficits harm future generations depends on the nature of the government goods and services being financed by the deficit (and also on the nature of the private expenditure that gets crowded out).

Question 15

What are the two extreems of when government borrowing may help or hinder future generations?

Answer 15

At one extreme, the government borrowing may finance a project that generates a substantial return to future generations, and thus the future generations may be made better off by today’s budget deficit.

At the other extreme, the government deficit may finance some government program that mainly benefits the current generation. An example might be the government’s financing of temporary cultural or sporting events that benefit the current generation but produce little or no benefits for future generations.

Question 16

What does the government budget deficit represent and when does it harm future generations?

Answer 16

Government budget deficits represent taxes that must be paid by future generations. Whether these future generations are harmed by the current budget deficit depends to a large extent on the nature of the government spending financed by the deficit.

Question 17

What is capital budgeting?

Answer 17

The concern that budget deficits may be inappropriately placing a burden on future generations has led some economists to advocate the idea of capital budgeting by the government.

Under this scheme, the government would essentially classify each of its expenditure items as either consumption or investment; the former would be spending that mostly benefits the current generation while the latter would be spending that mostly benefits future generations.

With capital budgeting, undesirable redistributions of income between generations could be minimized, while still permitting some budget deficits.

Question 18

What is a potentially mroe immeadiate effect of government debt?

Answer 18

he costs imposed on future generations by government debt are real, though they are often ignored because they occur in the very distant future.

But other problems associated with the presence of government debt are more immediately apparent.

In particular, high levels of government debt may make the conduct of monetary and fiscal policy more difficult.

Question 19

To see how a large stock of government debt can hamper the conduct of monetary policy, consider a country that has a high debt-to-GDP ratio and that has a real interest rate above the growth rate of GDP….

Answer 19

As we saw previously, the debt-to-GDP ratio will continue to grow in this situation unless the government starts running significant primary budget surpluses.

But such primary surpluses require either increases in taxation or reductions in program spending, both of which tend to be politically unpopular.

If such primary surpluses look unlikely to be achieved in the near future, both foreign and domestic bondholders may come to expect the government to put pressure on the central bank to purchase—or monetize—an increasing portion of its deficit.

Such monetization means that the money supply is increasing and will eventually cause inflation.

Any ensuing inflation would erode the real value of the bonds held by creditors.

Question 20

What will fears of debt monetization likely lead towards?

Answer 20

Fears of future debt monetization will likely lead to expectations of future inflation and put upward pressure on longer-term nominal interest rates.

Thus, even in the absence of any current actions by the central bank to increase the rate of growth of the money supply, a large government debt may lead to the expectation of future inflation, thus hampering the task of the central bank in keeping inflation and inflationary expectations low.

Question 21

What are examples of counter-cyclical fiscal policy?

Answer 21

Having fiscal expansions during recessions and fiscal contractions during booms is one way of implementing counter-cyclical fiscal policy.

Question 22

How does the presence of government debt affect the government’s ability to conduct such counter-cyclical fiscal policy?

Answer 22

Question 23

Consider the problem faced during a recession by a government considering an expansionary fiscal policy.

Answer 23

Such a policy would increase the primary budget deficit and therefore increase x.

On the one hand, there would be short-run benefits from the higher level of real GDP;

On the other hand, the government may be wary of taking actions that lead to large increases in the debt-to-GDP ratio.

Question 24

What determines the flexibility the government has in conducting counter-cuclical fiscal policy?

Answer 24

If d is relatively small, the government has a great deal of flexibility in conducting counter-cyclical fiscal policy.

The small value of d implies that d will be rising only slowly in the absence of a primary deficit.

Thus, the government may be able to increase the primary deficit—either by increasing program spending or by reducing tax rates—without generating a large increase in the debt-to-GDP ratio.

Question 25

When does the government have less flexability in conducting counter-cyclical fiscal policy?

Answer 25

But the government has significantly less flexibility if d is already very high.

In this case, and with our assumption that r is greater than g, the high value of d means that even in the absence of a primary budget deficit, d will be increasing quickly.

Thus, any increase in the primary deficit associated with the counter-cyclical fiscal policy runs the danger of generating increases in the debt-to-GDP ratio that may be viewed by creditors as unsustainable.

Such perceptions of unsustainability may lead to an increase in the real interest rate on government debt, which exacerbates the problem by driving d up even faster.

Question 26

Who is Douglas Purvis and what did he argue?

Answer 26

The idea that a large and rising stock of government debt could “tie the hands” of the government in times when it would otherwise want to conduct counter-cyclical fiscal policy was brought to the fore of Canadian economic policy by the late Douglas Purvis of Queen’s University (and a co-author of this textbook for many years).

Purvis argued in the mid-1980s that Canadian government deficits must be brought under control quickly so that the debt would not accumulate to the point where the government would have no room left for fiscal stabilization policy.