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Chapter 14: Public Debt
Chapter Summary:
A look at the U.S. and U.K. debt ratios provides a historical perspective for
evaluating the government and deficits. Students should note that the debt to GDP
ratio tends to peak during wartime and recedes afterward. The government budget
constraint introduced in chapter 12 is augmented to include real interest payments
and the change in real debt. The concept of Ricardian Equivalence that government
saving and household saving are substitutes; students should recognize that
government bonds impose a future tax burden that is equal (in present value terms)
stable tax rates over time.
One of the conclusions of this chapter is that deficit financing is not
particularly important; however, the government spending which it finances is
important. Government spending imposes opportunity costs on society whether it is
financed by issuing debt, raising taxes, or even open market operations (see the
“Back to Reality section on page 359). The tendency in recent decades for
government spending to grow over time has given rise to the possibility of strategic
The standard view of a budget deficit, in which Ricardian equivalence fails, is
that increasing government debt leads to higher interest rates and lower levels of
investment. One possible reason for Ricardian equivalence to fail is that the lifetimes
of the current generation of taxpayers is finite, which implies they may be able to
impose the future taxes on to another generation of taxpayers. In this case, a tax cut
Chapter Outline:
I. The History of U.S. and U.K. Public Debt
II. Characteristics of Government Bonds
III. Budget Constraints and Budget Deficits
A. The Government’s Budget Constraint
B. The Budget Deficit
F. Ricardian Equivalence More Generally
IV. Economic Effects of a Budget Deficit
A. Lump-sum Taxes
A. Labor Income Taxes
V. Social Security
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Teaching Tips:
1. The students may or may not know that Barro is a columnist who writes for the
popular press. After encountering his entertaining and informative columns in
BusinessWeek, they may have a new appreciation for his writing ability. His
2. A two period intertemporal budget constraint is a useful visual tool for showing
Ricardian equivalence. For example, in the graph shown here, government spends
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3. The way in which imperfection of credit markets can be used to make a case in
favor of increasing government deficits can be vividly illustrated with the example of
the Great Depression. Because the period was a temporary reduction in income, the
Answers to review questions, pg. 368
1. Open market operations are purchases of government bonds by the central bank.
The creation of money used to purchase the bonds can be compared to two separate
2. A reduction in next years tax rate on labor income reduces the labor supplied in
the current period and increases the labor supplied next year.
3. The conventional view assumes that people fail to recognize the impact of current
tax policy on future tax liabilities. As a result, people will tend to misallocate
resources over time. In particular, an increase in government bonds will allow
Answers problems for discussion, pg. 368
4. a. The tax cut allows individuals to shift the tax liability onto future generations
should they wish to do so. In this case the income effect would increase current
consumption and reduce investment. On the other hand, if people care about the the
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5. The phased-in income tax cuts changed the after tax real wage rate and generated
intertemporal substitution effects on the labor supply. In particular, there would be
6. a. The capital stock will fall if people view the government program as an
increase in current taxes to be offset by a corresponding increase in future transfers.
The reduction in current after tax income will be offset by an increase in future after
tax income. If the present value of benefits is just equal to the present value of taxes,
b. In a pay as you go system, your savings do not determine your retirement
benefit. An increase in current benefits can be achieved by raising taxes on the
current generation of workers. Therefore, it is possible to generate the income effects