Fiscal policy

Question 1

Define the government budget constraint (in terms of the Change in Debt-to-GDP ratio)

Answer 1

Change in debt-to-GDP ratio = deficit-to-GDP ratio + (real interest rate - GDP growth rate) * debt-to-GDP ratio

Δb_t = d_t + (r_t - g_t) * b_t

Change in debt-to-GDP is equal to this year’s deficit plus debt interest payments

Question 2

What happens to debt to GDP if the real interest rate is above the growth rate?

Answer 2

It rises, since interest payments on the existing debt are rising faster than GDP, making it harder to service the debt.

Question 3

If debt to GDP is rising, what can the government do?

Answer 3

Run a primary surplus (d<0) to stop debt rising, or an even bigger surplus to reduce the debt burden.

Instead, there is a tendency toward primary deficit bias, with debt to GDP rising over time.

Question 4

What are the causes of primary deficit bias? [4]

Answer 4

1. Impatience - politicians are only in office for 4 years so can increase spending now, leaving the cuts to their successor
2. Exploitation of future generations - the current generation votes, and no-one is going to vote for a tax increase today
3. ‘Common pool’ problem - the benefits of government spending are concentrated, but the costs are spread
4. Inadequate information - the public are less likely to object if spending increases

Question 5

Explain the problem of crowding out [5]

Answer 5

1. Government borrows to fund spending, which causes interest rates to rise
2. High rates perturb investment - firms stop borrowing, and output may fall
3. Ricardian equivalence: high debt now means tax increases in the future, so people increase their savings
4. Savings invested in company shares lessens the crowding out effect on firms
5. Savings invested in retirement funds (bonds) may make the problem worse

Question 6

Explain the generational issues associated with high government debt [3]

Answer 6

1. Future generations have to repay the debt, through higher taxes
2. If current generations are forward-looking and altruistic, then they should save to smooth these future consequences
3. The future government could cut future spending to reduce the deficit, meaning a lack of public good provision

Question 7

What are the issues around distortionary taxes? (A consquence of government debt) [3]

Answer 7

1. Leads to a lower level of output - e.g. discouraging people from working
2. If the tax is on emissions, the effect is positive
3. Also stops people working too much - ‘competitive consumption’

Question 8

What is seignorage?

Answer 8

The permanent funding of government debt through printing money - it leads to high inflation, which can deflate the debt, but isn’t attractive.

Question 9

Why might government debt be necessary? [4]

Answer 9

1. Automatic stabilisers - tax revenue falls in a recession, but spending may have to rise to pay benefits and cushion economy
2. Tax smoothing - better to let debt go up and down than change taxes all the time, especially distortionary ones
3. Actions today that benefit future generations - e.g. a war
4. If all government debt is owned domestically - e.g. Japan, people spend less but the tax revenue goes to those that own the debt - however, distributional effect

Question 10

What are the problems with using fiscal policy? [4]

Answer 10

1. Less easy to change than monetary policy - allocation, distortion effecs
2. Implementation lags
3. Some instruments have a small impact, especially due to RE
4. Distracts governments from controlling deficits

Thus use monetary first!

Question 11

When is it not possible to use monetary policy? [3]

Answer 11

1. At the ZLB
2. In a fixed exchange rate regime
3. If it becomes ineffective due to liquidity preference

Question 12

How does countercyclical policy work? [4]

Answer 12

1. Increase public spending in a recession to raise demand
2. If RE holds: the public spending increase will be greater than the reduction in consumer spending from smoothing
3. If RE doesn’t hold: people also increase spending now
4. Other tax changes (e.g. temporary VAT cut in 2008) may bring forward private sector spending

Question 13

(Poor) arguments for austerity:

1. The economy is growing
2. We don’t know how much spare capacity exists
3. Fiscal expansion will not work
4. Government attempts to manage the economy always fail
5. It was excessive debt that created the crisis
6. Debt levels are now so high that we can’t stimulate further without default premia
7. Is ‘austerity tomorrow’ credible?

Answer 13

Responses:

1. But austerity hits GDP
2. This is always the case
3. Contradicts all of the countercyclical policy theory
4. Monetary policy is also state intervention
5. Private debt, not public
6. Maybe in the Eurozone, but not here
7. No! Time inconsistency problem

Question 14

What happens if you increase government spending and the government intertemporal budget constraint is not satisfied?

Answer 14

Default: strategic or forced

Question 15

What is a strategic default?

Answer 15

When the cost of financing is greater than cost of being denied access to international capital markets, so the government decides not to pay.

Makes borrowing harder in the future, but that cost may be lower than the cost of getting money to pay now.

Question 16

What is a forced default?

Answer 16

When the government goes beyond the maximum of the Laffer curve and can’t raise enough taxes.

Can’t cut spending any more, no-one willing to lend, still can’t make interest payments / keep debt constant.

Might be self-fulfilling if bond yields go up due to increased risk, which makes interest payments / borrowing even harder!

Political constraints usually come in before the Laffer peak.

Question 17

When might debt get high enough for a self-fulfilling forced default to happen? [3]

Answer 17

1. Govt borrowing in own currency, with own central bank - no forced default, can always print the money (‘lender of last resort’)
2. Govt borrowing in own currency, but no central bank - e.g. Eurozone, where investors took money out of periphery, creating liquidity/solvency crises
3. Govt borrowing in foreign currency - worse, since the currency depreciates. Can’t print and convert due to depreciation, need more and more dollars…‘original sin’, can’t borrow abroad in your own currency

Consider: developing countries; state of the banking sector

Question 18

How is government debt monitored?

Answer 18

• SGP limits deficits to 3% (repeatedly broken)
• Gordon Brown wanted to keep debt-to-GDP <40% (didn’t happen)
• OBR forecasts and says if govt will meet target or not
• Fiscal councils - advisory bodies financed by the state