TOPIC 2 Flashcards
(29 cards)
What is the public sector + its functions
The public sector is a group of administrative bodies through which the state performs the following
functions:
* Safeguarding free competition (e.g., fighting monopolies)
- Correcting market failures (externalities, public goods)
- Redistributing wealth: This is implemented by taxing higher incomes more and ensuring good social
coverage for the poorest sectors of society. - Fighting economic recessions through:
Demand-side policies (expansionary or contractionary)
Supply-side policies
Public Balance
Records all public sector revenues and expenditures.
Revenues: two main types:
- Direct: Derived from direct taxes (T), applied directly to income.
- Indirect: Derived from indirect taxes, applied to consumption and transactions.
Expenditures: two main categories:
- Government Spending (G): Purchases of goods and services by the state (public
investment). - Transfers (TR): Payments from the public to the private sector, including
unemployment benefits, business subsidies, and aid to low-income families.
Public Deficit
A public deficit occurs when the public sector balance (SPP) is negative, meaning expenditures exceed
revenues. A primary deficit excludes interest payments on debt from the calculation.
Monetization (Finance of Public Deficit)
This consists of printing money (increasing the money supply). The state asks the central bank for more money, leading to more cash in circulation.
Issuance of public debt (Finance of Public Deficit)
The state issues public debt securities, which third parties buy in exchange for future repayment with
interest.
In other words, a buyer lends money to the state, expecting repayment with interest at a future date.
Buying public debt becomes a way to allocate money safely.
States rarely default, as doing so causes stigma, uncertainty, bad reputation, and severe economic
consequences.
Issuing public debt is the orthodox and most common way to finance a deficit in developed economies.
Problem with monetization
Highly inflationary.
Some cases of hyperinflation have resulted from deficits financed through monetization.
Monetization is explicitly prohibited in the EU, the USA, and many other developed and developing
countries, although emergency mechanisms exist.
Problems with debt issuance:
- Increases public deficit: The state must pay interest, creating a new expenditure item each
year. As more bonds are issued, the deficit tends to grow. - Currency risk: If debt is external, currency depreciation raises the domestic currency value of
the debt. - Debt sustainability: Sooner or later, public surpluses are needed to repay debt. Debt levels cannot grow indefinitely.
- Crowding-Out Effect: Public borrowing reduces private investment, limiting potential economic growth.
Crowding out effect
The crowding-out effect occurs when public sector borrowing limits the availability of funds for private
investment.
When the state issues debt at attractive interest rates, private investments become less profitable,
leading to reduced private sector investment.
In essence, private investment is “pushed out” by public sector borrowing, disturbing financial
conditions and limiting growth.
Risk Premium
The risk premium is the extra return investors demand to buy debt from a country considered riskier
than a “risk-free” country.
If investors perceive a risk of public debt default, they will demand a higher interest rate as
compensation.
Numerically, it is the difference between the interest rate paid by a risky government and that paid by
a risk-free government (typically Germany or the USA).
Risk Premium Formula
Interest Rate of Risky Country – Interest Rate of Risk-Free Country
Fiscal policy
Fiscal policies are all measures affecting the public budget (reflected in the national budget).
The emergence of Keynesian macroeconomic theory highlighted that fiscal policy decisions
significantly influence short-term production, employment, and price levels.
Expansionary fiscal policy
Its objective is to increase economic activity and to reduce unemployment.
Instruments:
− Increase in G and/or TR
− Decrease in T
Objective: to fight agains economic recessions, how?
− Increasing economic activity (GDP, C…)
− Reducing unemployment
Problems:
- Creates public deficit
− Generates public debt
− Can generate inflation
− Generates crowding out effect
Contractionary fiscal policy
Its objective is to reduce the public deficit and fight inflation.
Instruments:
− Decrease of G and/or TR
− Increase in taxes
Objective:
− Decreasing public deficit
− Reducing inflation
Problems with contractionary fiscal policy
- It slows down economic activity
− Increases unemployment
What is the Income-Expenditure Model?
A simplified model of the economy. It is a Keynesian model
focused on Aggregate Demand (AD), which it considers the main driver of economic activity.
It originates from Keynesian theories that seek to explain the workings of economic cycles as crises
of insufficient Aggregate Demand.
Main message: When private consumption and investment slow down, the government should increase public spending. (Short-term perspective.)
Comments on the model
It is a model without prices or money: inflation is assumed to be nonexistent, so prices are constant
and have no influence on the model.
It operates with real variables: Aggregate Demand (AD) and Aggregate Supply (AS) are measured in
units of a generic, unspecified good.
Aggregate Demand drives the economy: whenever AD increases (or decreases), AS adjusts in the
same amount to maintain balance.
The economy is considered to be in equilibrium when AD = AS.
Assumption 1 of the Model
There is only one product in the economy.
This simplification means that certain elements are excluded from the model:
- Indirect taxes
- Subsidies
- Capital depreciation
- Capital transfers between countries
- Exports
- Imports
Thus, it is assumed that: GDP = GNP = National Income (Y).
Assumption 2 of the Model
There is a Public Sector that performs two main functions:
- Collects revenue through direct income taxes (T).
- Spends through Government Spending (G) or Transfers (TR).
Thus, we can define the Public Budget Balance:
- If revenues exceed expenditures →budget surplus.
- If expenditures exceed revenues →budget deficit.
Assumption 3 of the Model
Different Agents have different behavioural functions:
- Domestic households: Consume (C)
C = c (fija) + c (marginal prepensity to consume) * Yd (renta disponible)
Yd = Y (lo q he cobrado) - t * y + TR
So we can conclude that C:
C = c (fija) + c * (Y - tY + tr)
- Companies: Investment (I)
- Public Sector: Public Expenditure (G)
Aggregate Supply in the model
AS = National Income
AS = GDP = Y
Aggregate Demand in the model
It is the base of the model, calculated by adding the different agent’s demand functions:
AD = C + I + G
If we substitute the initial assumptions:
AD (GDP) = C (fija) + c * (Y - ty + TR) + I + G
