3. The deficit is the change in the debt in a year
4. The result will be payouts in excess of tax revenue (text Figure 15.7)
5. Fixing the social security system
a. Increase tax revenue by raising taxes, but this distorts labor supply decisions
1. People worry that their children will have to pay back the debt that past generations
have accumulated
2. To the extent that U.S. citizens own government bonds, future generations will just be paying
themselves; but now more than half of U.S. debt is owned by foreigners, so this argument is
3. However, there could be a burden, because if tax rates have to be raised in the future to pay
off the debt, the higher tax rates could be distortionary
4. Also, since bondholders are richer on average than nonbondholders, when the debt was
repaid there would be a large transfer from the poor to the rich
5. Finally, government deficits reduce national saving according to many economists
a. If so, with lower saving there will be lower investment
b. Lower investment means a smaller capital stock
c. A smaller capital stock means less output in the future
d. So the future standard of living will be lower
1. When will a government deficit reduce national saving?
a. It almost certainly does when government spending rises
2. Ricardian equivalence: an example
a. Suppose the government cuts taxes by $100 per person
b. Since S Y C G, (15.5)
national saving declines only if consumption rises (assuming Y is fixed at its
full-employment level)
3. Ricardian equivalence across generations
a. What if the higher future taxes are to be paid by future generations?
b. Then people might consume more today, because they wouldn’t have to pay the higher
future taxes
c. But as Barro pointed out, if people care about their children, they’ll increase their
1. The data show that Ricardian equivalence holds sometimes, but not always
a. It certainly didn’t hold in the United States in the 1980s, when high government deficits
2. What are the main reasons Ricardian equivalence may fail?
a. Borrowing constraints
(1) If people can’t borrow as much as they would like, a tax cut financed by higher future
taxes essentially lets them borrow from the government
b. Shortsightedness
1. The stimulus package of 2009 increased federal government spending by about $500 billion
and reduced taxes by almost $300 billion, leading economists to debate its impact
2. Temporary increases in government purchases lead to higher output in both Keynesian and
classical models
3. Research reviewed by Valerie Ramey suggests that the multiplier (the short-run change in
output from a one unit change in government purchases) is between 0.8 and 1.5
4. Alan Auerbach and Yuriy Gorodnichenko find that the multiplier is between 0 and 0.5 in
expansions but much higher, between 1 and 1.5, in recessions
5. Gauti Eggertsson’s research shows that the government purchases multiplier is even higher if
monetary policy is constrained by the zero lower bound, as has been the case in recent years
in the U.S.
Policy Application
1. Inflation results when aggregate demand rises more quickly than aggregate supply
2. Budget deficits could be related to inflation, but we usually think of expansionary fiscal
policy as leading to a one-time jump in the price level, not a sustained inflation
3. The only way for a sustained inflation to occur is for there to be sustained growth in
the money supply
4. Can government deficits lead to ongoing increases in the money supply?
a. Yes, if spending is financed by printing money
b. The revenue that a government raises by printing money is called seignorage
c. Usually, governments don’t just buy things directly with newly printed money, they do
so indirectly
5. Why would governments use money creation to finance deficits, knowing that it causes
inflation?
a. Developed countries rarely use seignorage, because it doesn’t raise much revenue
b. But war-torn or developed countries are unable to raise sufficient tax revenue to cover
government spending and may not be able to borrow from the public
1. The real revenue the government gets from seignorage is closely related to the inflation rate
2. Consider an all-currency economy with a fixed level of real output and a fixed real interest
rate, plus constant rates of money growth and inflation
a. The real quantity of money demanded is constant, so real money supply must be constant
b. Thus
3. Seignorage is called the inflation tax, because the government’s seignorage revenue equals
the inflation rate times real money balances
4. Will a rise in money growth increase seignorage revenue?
a. As the money growth rate rises, inflation rises, but people may hold less real balances
b. Whether seignorage rises or falls depends on whether inflation rises more or less than the
decline in real money holdings (Figure 15.1; like text Figure 15.8)
Figure 15.1
5. If governments raise money supply too rapidly, they may cause hyperinflation, but get less
seignorage revenue than they would get with less money growth
4. The result will be payouts in excess of tax revenue (text Figure 15.7)
5. Fixing the social security system
a. Increase tax revenue by raising taxes, but this distorts labor supply decisions
1. People worry that their children will have to pay back the debt that past generations
have accumulated
2. To the extent that U.S. citizens own government bonds, future generations will just be paying
themselves; but now more than half of U.S. debt is owned by foreigners, so this argument is
3. However, there could be a burden, because if tax rates have to be raised in the future to pay
off the debt, the higher tax rates could be distortionary
4. Also, since bondholders are richer on average than nonbondholders, when the debt was
repaid there would be a large transfer from the poor to the rich
5. Finally, government deficits reduce national saving according to many economists
a. If so, with lower saving there will be lower investment
b. Lower investment means a smaller capital stock
c. A smaller capital stock means less output in the future
d. So the future standard of living will be lower
1. When will a government deficit reduce national saving?
a. It almost certainly does when government spending rises
2. Ricardian equivalence: an example
a. Suppose the government cuts taxes by $100 per person
b. Since S Y C G, (15.5)
national saving declines only if consumption rises (assuming Y is fixed at its
full-employment level)
3. Ricardian equivalence across generations
a. What if the higher future taxes are to be paid by future generations?
b. Then people might consume more today, because they wouldn’t have to pay the higher
future taxes
c. But as Barro pointed out, if people care about their children, they’ll increase their
1. The data show that Ricardian equivalence holds sometimes, but not always
a. It certainly didn’t hold in the United States in the 1980s, when high government deficits
2. What are the main reasons Ricardian equivalence may fail?
a. Borrowing constraints
(1) If people can’t borrow as much as they would like, a tax cut financed by higher future
taxes essentially lets them borrow from the government
b. Shortsightedness
1. The stimulus package of 2009 increased federal government spending by about $500 billion
and reduced taxes by almost $300 billion, leading economists to debate its impact
2. Temporary increases in government purchases lead to higher output in both Keynesian and
classical models
3. Research reviewed by Valerie Ramey suggests that the multiplier (the short-run change in
output from a one unit change in government purchases) is between 0.8 and 1.5
4. Alan Auerbach and Yuriy Gorodnichenko find that the multiplier is between 0 and 0.5 in
expansions but much higher, between 1 and 1.5, in recessions
5. Gauti Eggertsson’s research shows that the government purchases multiplier is even higher if
monetary policy is constrained by the zero lower bound, as has been the case in recent years
in the U.S.
Policy Application
1. Inflation results when aggregate demand rises more quickly than aggregate supply
2. Budget deficits could be related to inflation, but we usually think of expansionary fiscal
policy as leading to a one-time jump in the price level, not a sustained inflation
3. The only way for a sustained inflation to occur is for there to be sustained growth in
the money supply
4. Can government deficits lead to ongoing increases in the money supply?
a. Yes, if spending is financed by printing money
b. The revenue that a government raises by printing money is called seignorage
c. Usually, governments don’t just buy things directly with newly printed money, they do
so indirectly
5. Why would governments use money creation to finance deficits, knowing that it causes
inflation?
a. Developed countries rarely use seignorage, because it doesn’t raise much revenue
b. But war-torn or developed countries are unable to raise sufficient tax revenue to cover
government spending and may not be able to borrow from the public
1. The real revenue the government gets from seignorage is closely related to the inflation rate
2. Consider an all-currency economy with a fixed level of real output and a fixed real interest
rate, plus constant rates of money growth and inflation
a. The real quantity of money demanded is constant, so real money supply must be constant
b. Thus
3. Seignorage is called the inflation tax, because the government’s seignorage revenue equals
the inflation rate times real money balances
4. Will a rise in money growth increase seignorage revenue?
a. As the money growth rate rises, inflation rises, but people may hold less real balances
b. Whether seignorage rises or falls depends on whether inflation rises more or less than the
decline in real money holdings (Figure 15.1; like text Figure 15.8)
Figure 15.1
5. If governments raise money supply too rapidly, they may cause hyperinflation, but get less
seignorage revenue than they would get with less money growth