High Debt

Question 1

What is primary deficit?

Answer 1

Government Spending - Taxes (G-T)

Question 2

How is a primary deficit positive?

Answer 2

If G > T

Question 3

What is a cyclically adjusted deficit?

Answer 3

• Measures the deficit if output were at its natural level
• Adjusts deficit for the current point of the economy on the business cycle

Question 4

What is the inflation adjusted deficit?

Answer 4

The deficit measured in real terms

Question 5

Denote the budget deficit formula.

Answer 5

rBt-1 + Gt - Tt
Where:
- B is bonds and bills issued by gov. and held by priv sector
- r is real interest rate
- rBt-1 is real interest paid on gov. bonds in circulation
- Gt is government spending on goods and services
- Tt are taxes

Question 6

Assume only means of deficit financing is selling securities to private investors:

Answer 6

Bt - Bt-1 = Deficit t

Question 7

Denote the Government Budget Constraint formula.

Answer 7

Bt = (1+r)Bt-1 + (Gt - Tt)
where:
Bt - issued bonds and bills at time t
(1+r)Bt-1 - interest payments
Gt - Tt - primary deficit

Question 8

What happens to government deficit if they run a deficit/surplus?

Answer 8

Deficit - Government debt increases
Surplus - Government debt decreases

Question 9

Given B0 = 1 and B1 = 0, show how the budget constraint becomes T1 - G1 = (1+r) if government have to repay debt in 1 year

Answer 9

B1 = (1+r)B0 + (G1 - T1)
T1 - G1 = (1+r)B0
=> T1 - G1 = (1+r)

Question 10

How can government repay debt in 1 year

Answer 10

• Government must create a primary surplus in year 1 equal to (1+r) units of goods
• An increase in taxes of the initial cut in tax plus interest rate on debt

Question 11

What if the government must repay after t years?

Answer 11

Governments must create a primary surplus equal to (1+r)t units of goods - waiting to repay raises the required increase in taxes

Question 12

What is the government budget constraint in terms of GDP?

Answer 12

(Bt / Yt - Bt-1 / Yt-1) = (r-g) (Bt-1 / Yt-1 + (Gt - Tt) / Yt)

Question 13

What does the government budget constraint tell us.

Answer 13

The change in debt ratio is equal to the sum of
- the difference between the real interest rate and the rate of growth of GDP multiplied by the debt ratio at the end of the previous period
- The ratio of the primary deficit to GDP

Question 14

What are the dangers of a very high public debt?

Answer 14

• Increasing primary surplus means an increase in taxes which is unpopular
• Political uncertainty arises which increases both risk premium and interest rates
• Fiscal tightening induced by the first increase in rates generates an even deeper recession
• The increase in rates and lower growth result in higher r-g, making it more difficult to stabilise the debt ratio

Question 15

How can you reduce high debt?

Answer 15

• Generate sufficient primary surpluses
• Monetary financing by the central bank - purchase government bonds
• Repudiate the debt