978-0133780581 Chapter 22 Lecture Note

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Chapter 22. Fiscal Policy: A SUMMING UP

I. MOTIVATING QUESTION

What do macroeconomists know about fiscal policy?

Fiscal policy affects output in the short run—through its effect on aggregate demand—and in the long run—

through its effect on investment. Fiscal policy is limited by the government budget constraint, which links the

deficit to the increase in debt. Given the budget constraint, prudence suggests that governments should run fiscal

surpluses during booms to balance deficits during recessions. Such a policy allows the government to stimulate

the economy during recession, but avoids the dangers inherent in accumulating a large debt.

II. WHY THE ANSWER MATTERS

The major long-term policy issue facing U.S. economic policymakers is how to finance expenditures associated

with the retirement of the baby boomers and the continued aging of the population. This chapter alerts students to

what lies ahead.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS

1. Tools and Concepts

i. The inflation-adjusted deficit is the deficit measured in real terms. It equals real interest payments plus

the (real) primary deficit, defined below.

ii. The primary deficit is government spending minus taxes.

iii. The cyclically-adjusted deficit measures what the deficit would be if output were at its natural level.

iv. Ricardian equivalence is the proposition that neither deficits nor debts have any effect on economic

activity.

v. Debt restructuring, or debt rescheduling occurs when interest payments are deferred rather than

cancelled.

vi . Debt monetization occurs when the central bank then pays the government with money it creates, and

the government uses that money to finance its deficit.

vii. Hyperinflation is a very high level of inflation.

IV. SUMMARY OF THE MATERIAL

1. What We Have Learned

This section offers a brief review of fiscal policy as covered throughout the text. The authors highlight the role of

fiscal policy during short run, medium run, and long run time periods.

In the short run, an increase in the deficit increases aggregate demand and real output, with the strength of

the initial impact depending on expectations. In the medium run, output returns to its natural level, but

with a higher real interest rate and a lower rate of investment. In the long run, output may be lower (than

it would be otherwise) because a higher deficit leads to less investment and therefore less capital

accumulation.

Also the authors highlight the important role of fiscal policy during a case when the interest rate is equal to

zero and the economy is in a liquidity trap (see Chapter 6).

2. The Government Budget Constraint: Deficits, Debt, Spending, and Taxes

The inflation-adjusted deficit is defined as

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Deficit = rBt-1 + Gt – Tt (22.1)

where all variables are expressed in real terms, B is real debt, and r is the real interest rate. The text notes that

official deficit measures typically substitute nominal interest payments (iBt-1) for real interest payments (rBt-1) in

equation (26.1). The deficit is linked to the increase in debt by the government budget constraint:

Bt–Bt-1 = rBt-1 + Gt – Tt (22.2)

Defining the primary deficit as (Gt – Tt), government debt can be expressed as

Bt = (1 + r)Bt-1 + Primary Deficit. (22.3)

This relationship implies that, starting from zero debt and a zero primary deficit, a one-unit increase in the

primary deficit for one period will generate a debt of Bt = (1 + r)t after t periods. To repay this debt after t periods,

the government must run a primary surplus of (1 + r)t. If spending is unchanged, this means that a reduction in

taxes today implies an increase in future taxes of equal present value. If the government seeks to stabilize the

debt instead of repaying it, then the government must run a primary surplus equal to the real interest payment on

the debt in every future period. In other words, the government must eliminate the inflation-adjusted deficit,

defined as the primary deficit plus real interest payments on the debt (or equivalently, as the official deficit minus

inflation times real debt.)

To examine the evolution of the debt-to-GDP ratio, rewrite the government budget constraint as

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

which can be approximated as

(Bt/Yt) – (Bt-1/Yt-1) = (r – g)(Bt-1/Yt-1) + (Gt – Tt)/Yt, (22.5)

where g is the growth rate of output. Given some initial debt, equation (22.5) implies that the debt-to-GDP ratio

will grow when there is a primary deficit and when the real interest rate exceeds the growth rate of output. To

understand the latter effect, suppose the primary deficit is zero. Then, debt (the numerator) will grow at rate r and

output (the denominator) will grow at rate g. The difference in growth rates is approximately the change in the

debt-to-GDP ratio.

3. Ricardian Equivalence, Cyclical Adjusted Deficits, and War Finance

i. Ricardian equivalence. Ricardian equivalence is the proposition that neither deficits nor debt affect

economic activity. For example, given unchanged government spending, a tax cut today implies a tax increase of

equal present value in the future. Therefore, consumer wealth is unchanged, and private consumption is

unaffected. An increase in today’s government deficit will be matched with an equal increase in private saving.

In practice, however, tax increases that are distant and uncertain are likely to be ignored by consumers, because

they may not live to see them or because they do not think that far into the future. As a result, although

expectations certainly affect economic behavior, it is unlikely that Ricardian equivalence holds in strict form.

ii. Deficits, output stabilization, and the cyclically-adjusted deficit. The fact that deficits reduce

investment does not mean that they should be avoided at all times, but rather that deficits during recessions should

be offset by surpluses during booms. In this way, fiscal policy will not lead to a steady increase in debt. The

cyclically-adjusted deficit removes the effect of the business cycle from the deficit. Thus, it can be used to assess

whether fiscal policy is consistent with no systematic increase in debt over time. Estimating the

cyclically-adjusted deficit requires knowledge of two facts: the reduction in the deficit that would occur if output

were to increase by 1% and the difference between current output and its natural level. The first fact is relatively

easy to determine. As a rule of thumb, a 1 percent decrease in output increases the deficit by 0.5% of GDP. The

deficit increases because most taxes are proportional to output, but most spending does not depend on output.

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The second fact is more difficult to ascertain, because the natural level of output depends on the natural rate of

unemployment, which changes over time.

iii. Wars and deficits. There are two good reasons to run deficits during wars. First, deficits shift part of the

burden of paying for a war to future generations (because they inherit a smaller capital stock). Second, by using

debt instead of tax financing, the government avoids imposing very large and distortionary tax rates. Borrowing

permits tax increases to be smoothed over time.

4. The Dangers of High Debt

High debt ultimately requires higher taxes in the future but it can also lead to vicious cycles. The text explains

how the presence of a large debt leaves governments in a vulnerable position. For example, a government may

increase debt to the point where investors begin to worry about the government’s ability to repay the debt. These

initial groundless fears about the government’s ability to repay its debt can lead to an increase in the risk premium,

which will start the process in motion. This process can turn into a vicious cycle which can become

self-fulfilling.

Figure 22-2 plots the spreads between the two-year interest rate on Italian and Spanish two-year government

bonds over the interest rate of two-year German bonds. The figure shows that over the time period spanning from

March 2012 to December 2012, the spread for these countries fluctuated between 150 and 660 basis points. The

increase in the spread and volatility makes it harder for these countries to stabilize their debt ratios

If a government does not succeed in stabilizing the debt, historically, one of two things happens: 1.) Either

the government explicitly defaults on its debt; or (2.) the government relies increasingly on money

finance (i.e. debt monetization), which typically leads to very high inflation.

1. Debt Default: Default is often partial, and creditors take what is known as a haircut: A haircut of

30%, for example, means that creditors receive only 70% of what they were owed.

2. Money Finance: Entails the central bank finding itself in the fiscal dominance case where the

central bank must do what the government tells it to do. The government issues new bonds and tells

the central bank to buy them. The central bank then pays the government with money it creates, and

the government uses that money to finance its deficit. This process is called debt monetization.

a. The revenue from money creation is called seignorage. Equation 22.6 gives us the

nominal money and real money balances relative to monthly GDP. Therefore, if a

country needed to finance a deficit of 10% of GDP through seignorage, given a ratio of

central bank money to monthly GDP of 1, the monthly growth rate of nominal money

must be equal to 10%. Inflation is likely to follow. And very high inflation is likely to

lead people to want to reduce their demand for money, and in turn the demand for central

money.

b. Chapter 22 concludes with the economic costs of hyperinflation, which are: the decline

transaction system; price signals become less and less useful; and swings in inflation

become larger and larger and harder to predict.

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V. PEDAGOGY

1. Points of Clarification

It is worthwhile to emphasize that Ricardian equivalence implies that the size of the deficit has no effect on

economic activity, not that fiscal policy has no effect on economic activity. For example, starting from a position

of budget balance, the balanced budget multiplier implies that an increase in government spending fully financed

by taxes would increase aggregate demand and thus output. Ricardian equivalence implies that the effect will be

the same regardless of whether the increase in government spending is financed by tax increases or debt.

2. Alternative Sequencing

It is easy for instructors to pick and choose from this chapter. Any of the theoretical topics—for example,

Ricardian equivalence—can be examined independently. Alternatively, instructors could limit attention to the

U.S. budget deficit and ignore the theoretical sections. The 6th edition also offers a section that explains the risk

countries facing when running a high debt.

VI. EXTENSIONS

1. The Global Crisis

Clearly, the fiscal picture is an ongoing issue. Instructors may wish to supplement the material with current

articles from the Wall Street Journal and The Economist, which highlight fiscal deficit, debt and spending issues

within the U.S. and Europe. And of course, incorporating the most recent budget projections is advisable.

2. Points of Clarification

The concept of the inflation-adjusted deficit provides instructors an opportunity to review the Fisher effect. For a

given nominal interest rate, the inflation-adjusted deficit will be less than the official deficit when inflation is

positive. Thus, it seems that the government can reduce its real deficit and its real debt burden through inflation.

In fact, historically inflation has been an important means for governments to reduce their real debt burdens.

Although governments can use inflation in this way for some period of time, they cannot do so indefinitely. In the

long run, the Fisher effect implies that the nominal interest rate will increase one-for-one with the inflation rate.

Thus, in the long run, an increase in inflation will simply increase the nominal deficit and have no effect on the

inflation-adjusted deficit.

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