B6: Government debt and Budget deficits

Question 1

DEFINE GOVERNMENT DEFICIT

Answer 1

The government runs a deficit if its spending exceeds its tax revenues.

Question 2

HOW DOES THE GOVERNMENT DEFICIT OCCUR?

Answer 2

It is from borrowing, either from the private sector or from foreign governments

Question 3

WHAT IS GILTS?

Answer 3

where the government sells bonds in the UK on financial markets.

Question 4

DEFINE DEBT

Answer 4

Debt (a stock) is the accumulation of past deficits ( a flow).

Question 5

HOW DOES

Question 6

WHAT DOES THE AUTOMATIC STABILISER IMPLY IN A BUSINESS CYCLE?

Answer 6

It implies that the budget balance will be procyclical

Question 7

WHAT DOES IT MEAN TO BE PROCYCLICAL?

Answer 7

Procyclical is when decline (weaken) during a recession and increase (strengthen) during a boom.

Question 8

WHAT IS THE SOLUTION TO ADJUSTING THE BUSINESS CYCLE? WHAT IS IT BASED ON?

Answer 8

calculate the cyclically adjusted budget deficit.

Based on estimates of what government spending and tax revenue would be if the economy were operating at its natural level of output; counterfactual

Question 9

THE CYCLICALLY ADJUSTED BUDGET BALANCE

Question 10

WHAT IS MEANT BY ‘WITH’ AND ‘WITHOUT’ IN CBO CALCALATIONS?

Answer 10

With: Observed (unadjusted data)

without: Cyclically adjusted deficit or structural deficit ( a counterfactual)

Question 11

WHAT IS THE TRADITIONAL VIEW OF GOVERNMENT DEBT?

Answer 11

Consumers would respond to their higher after-tax incomes by spending more.

• Deficit-finance tax cut

Question 12

DEFINE DEFICIT- FINANCED TAX CUT

Answer 12

If the budget is in balance and the government then cuts taxes and makes up the shortfall in revenue by borrowing

Question 13

WHAT IS THE KCF EQUATION (it is established in traditional view)

Answer 13

C=C+cY

C= Consumption
C= Constant
c= MPC
Y= Disposable income

Question 14

WHAT IS RICARDIAN VIEW OF GOVERNMENT DEBT?

Answer 14

His view is that consumers are forward-looking, their consumption decision is not only just on their current income but it is based on their expected future income.

Question 15

WHAT DOES THE RICARDIAN APPROACH LEADS TO?

Answer 15

It is where the Ricardian view applied forward-looking consumer behavior to fiscal policy.

• Forward-looking consumer would understand that a deficit-financed tax cut is not really a tax cut because higher government borrowing today means higher taxes at some point in the future.

Question 16

BARRO (1974)

Answer 16

Implies that if the government gifted a member a bond, this is not net wealth because the member would be a tax payer

Question 17

DOES DEFICIT- FINANCED TAX CUT REDUCE TAX BURDEN?

Answer 17

No, it does not. Just reschedule it.

Question 24

Does R.Eq. imply that fiscal policy can never influence consumption? Provide an example

Answer 24

No. However, present or future government spending must change to do so.

Example: Assume the government cut taxes today and plans to reduce government spending in the future. If consumers believe the government’s plan, they will increase consumption spending today.

Question 24

Borrowing constraints:

Answer 24

Ricardian consumer bases current consumption on lifetime income.

• Current income is more relevant than lifetime income for liquidity-constrained consumers.

Question 24

WHAT ARE THE THREE COUNTER-ARGUMENTS FOR RICARDIAN EQUIVALENCE?

Answer 24

1. Myopia
2. Borrowing constraints
3. Future generations

Question 24

WHAT IS THE GENERAL PRINCIPLE OF THE RICARDIAN VIEW?

Answer 24

Government debt is equivalent to future taxes and future taxes are equivalent to currrent taxes if consumer look sufficiently far into the future.

Question 24

WHAT ARE THE IMPLICATION OF RICARDIAN VIEW?

Question 24

Myopia:

Answer 24

Consumers are not as forward-looking as the R. Eq assumes.
In reality, they may not possess the knowledge and the foresight to be as calculating as this theory requires.

-Might be heuristics

Question 25

Future generations:

Answer 25

It implies that future tax bills might not fall upon those consumers alive today but upon their descendants.

• Deficit financed tax cuts can therefore involve intergenerational transfers. It is where current generation consumes at the expense of the next.

Question 26

Can the Ricardian equivalence result survive this criticism?

Answer 26

Yes, if current consumers care about future generations as much as they care about themselves.

It is where the current generation would save, not spend, a deficit-financed tax cut and leave their savings to the next generation so they can meet their future tax liability.

Question 27

WHAT IS THE GOVERNMENT BUDGET ACCOUNTING EQUATION?

Answer 27

Deficit = 𝐺 + 𝑖𝐵 − 𝑇

Question 28

WHAT ARE THE NOTATION FOR THE DEFICIT EQUATION?

Answer 28

G - Government consumption and investment, including transfer payments

𝑖𝐵 - Interest repayments due on debit accumulated in the past (nominal bonds)

Answer 29

𝑇 + Δ𝐵 = 𝐺 + 𝑖𝐵

Answer 30

𝑇 − 𝐺 = 𝑖𝐵

Answer 31

𝑡 + Δ𝐵/𝑌 = 𝑔 + 𝑖𝑏

Answer 32

∆𝐵 = 𝑌∆𝑏 + 𝑏∆𝑌

or

Δ𝐵/𝑌 = Δ𝑏 + 𝑏 (Δ𝑌/𝑌 )

Answer 33

Δ𝑏 = 𝑔 − 𝑡 + 𝑖 − 𝛾 𝑏

Answer 34

𝑏* = 𝑔 − 𝑡 / (𝛾 - 𝑟)

Question 35

WHAT IS THE INTERPRETATION FOR THIS EQUATION: 𝑏* = 𝑔 − 𝑡 / (𝛾 - 𝑟)? WHAT IS THE NOTATION FOR b*?

Answer 35

b* - can be positive (debtor) or negative (net assets)

All else equal, b*:

1. Rises with the primary deficit (g - t)
2. Falls with output growth (𝛾)
3. Rises with the real interest rate (r)

Answer 36

𝑇 + Δ𝐵 + Δ𝑀 = 𝐺 + 𝑖𝐵

Answer 37

𝑡 + (Δ𝐵/𝑃𝑌) + (Δ𝑀/𝑃𝑌) = 𝑔 + 𝑖𝑏

Answer 38

∆𝐵 = 𝑃𝑌∆𝑏 + 𝑏𝑌∆𝑃 + 𝑏𝑃∆𝑌

Answer 39

∆𝐵/𝑃𝑌 = ∆𝑏 + 𝑏 (𝜋 + 𝛾)

Answer 40

Δ𝑀/𝑃𝑌 = Δ𝑀/𝑀 (𝑀/𝑃𝑌) = 𝜇𝑚

Question 41

WHEN Δb=0, 𝑏∗ = 𝑔 − 𝑡 − 𝜇𝑚/ (𝛾 − 𝑟), WHAT IS THE INTERPRETATION FOR B*?

Answer 41

All else equal, b*:

1. Declines with 𝜇𝑚
2. All other terms are the same as before

Question 42

WHAT DOES THE GOVERNMENT DEBT USUALLY ISSUE? WHAT WOULD THEY DO THEN?

Answer 42

Government debt is typically issued in nominal terms. Therefore, they are tempted to generate higher inflation to reduce their real debt burden.

Question 43

WHAT…..? WHO ARE THE DEBTOR IN THIS CASE?

Answer 43

Unexpected inflation redistributes wealth from creditors to debtors.

• The debtor is the government, debtors can not print their way out of trouble.

Question 44

WHAT IS THE DRAWBACK OF THIS STRATEGY? WHY IS THAT?

Answer 44

There is little evidence that governments deploy this strategy in developed countries.

The reason why central bank independence + policymakers recognize that high inflation is an undesirable outcome.

Question 45

DEFINE SIGNIORAGE

Answer 45

It endows itself with purchasing power, i.e. a claim on the economy’s real resources.

It can be defined as 𝜇 (𝑀/𝑃 ) in our model.

Question 46

DEFINE INFLATION TAX

Answer 46

To the extent that money creation leads to inflation, the public loses some fraction of its income in real terms.

It can be defined as 𝜋 (𝑀/𝑃 ) in our model

Question 47

WHAT IS THE LIMIT OF HOE FAR THE GOVERNMENT CAN SOURCE ITS FINANCE?

Answer 47

There is a limit to how far the government can use these sources of finance because higher inflation eventually reduces money demand and so the inflation tax ‘base’ diminishes.

Question 48

WHAT ARE THE EMPIRICAL EVIDENCE FOR MONEY GROWTH AND INFLATION?