What are the two options for the government?
Borrow and acquire interest on borrowed amount (not all tax revenue is spent)
Lend and get a return
- Ricardian equivalance - Government present discount value must be balanced therefore a deficit now means a surplus in the future. Budget deficit acquires interest must be balanced by surplus in the future, so the presetn discounted value is balanced
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What do recent forecasts show?
Fiscal policies are unsisutainable
- Shocks (E.g. Financial crisis, COVID, Russian invasion of Ukraine)
- Demographic change
- Healthcare (Tendency for an ageing population, who are a strain on healthcare)
- Pension system (Pay pension to more people for longer)
Flow version of governmetn budget constraint
Source of funds must be equal to uses of funds
- Debt has different maturity, but in the equation, we aggregate it
- Transfer payments: Unemployment benefits, subsidieies given to firms and households
- Issue new debt if taxes do not cover government purchases
- Monetary aggreaget is minimal in developed countries and is essentially printing more money.
Primary deficit
Total deficit
Growth in deficit because it acquires interest
Primary deficit does not include spending on interest payments
What is the budget balance?
Difference between tax reveneues and spending
What is a budget surplus?
Tax revenue > Spending
Budget deficit
Tax reveneue < Spending
- The government must borrow by selling bonds
Balanced budget
Tax revenue = spending
- No need to issue additional debt
WW2
US: War spending and recenues were an approximately stable fraction of GDP. Deficits emerged in 1970s
Europe: Welfare building increased deficits
Debt to GDP ratio
Primary balance: pbt
- Interest rate = Growth rate: debt remains the same forever
- Interest rate> growth rate: debt will grow because accumuilation is higher than growth, as interest payments increase the accumulation of debt
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Budget constraint for period 1
B2=(1+i)B1+G1-T1
Budget constraint for period 2
B3=(1+i)B2+G2-T2=0
Only 2 peiods therefore there must be a balanced budget
Intertemporal budget constraint
The government’s budget must balance—not period by period, but rather in a present discounted value sense.
Debt to GDP ratio
Pay interest on outstanding debt
Changing because of primary balance pbt
What happens when GDP is growing faster than interest rate?
Debt to GDP ratio will tend to decrease
What happens when GDP is greater than the growth rate?
Economy is accumulating debt
What is the impact of a negative primary deficit?
Falling debt to GDP ratio, as government is paying back the debt
Calculating changes
How much can a government borrow?
Economic growth being low means debt to GDP ratio will rise if interest rates are high
Intergenerational equity is the fairness of future generations (Do we want the future society to pay back more taxes for the debts of the current society?)
Crowding out investment: Higher deficit reserve resources from the private sector and reduces investment
What limits the amount the government can borrow?
- Amount it can credibly be expected to pay back
- How large the economy is
- Stable economic growth and debt-gdp ratio, as well as good credibility is the key assumption that the stock of debt will stabilise and go down
What happens to the stock of debt when the GDP is growing even faster?
Debt-GDP ratio will fall if this happens
What happens when debt-GDP ratio becomes too high?
Lenders worry about the ability of the governmetn to repay = investors demand higher interest rate, as they want compensation for the risker loan
What is the impact of printing money as a reuslt of the increasing interest?
Inflation
What happens when a governmetn defaults?
Government declares it will not repay certain debts
Or it will them at less face value
Government therefore has limited access to investors and in many cases has to seek international organisations
