CHAPTER 32 – GOVERNMENT DEBT AND DEFICITS
- How the government’s actual budget deficit (or surplus) is related to its stock of debt
- Cyclically adjusted deficit and how it can be used to measure the stance of fiscal policy
- How budget deficits may crowd out investment and net exports
- Why a high stock of debt may hamper the conduct of monetary and fiscal policies
- Why legislation requiring balanced budgets may be undesirable
32.1 FACTS AND DEFINITIONS
The Government’s Budget Constraint
Expenditures must be financed either by income or by borrowing. Income – taxes.
Thus all expenditure must be financed by tax revenues or borrowing.
Budget constraint: government expenditure = tax revenue + borrowing
- Purchases of goods and services, G
- Interest payments on debt, debt-service payments: payments that represent the interest owed
on a current stock of debt. i x D (i = interest, D = stock of debt)
- Transfers to individuals and firms – included in T
G + i x D = T + borrowing
(G + i x D) – T = borrowing
Budget deficit: shortfall of government revenue below current expenditure. Equals amount borrowed
Government debt: the outstanding stock of financial liabilities for the government, equal to the
accumulation of past budget deficits
The government’s annual budget deficit is the excess of expenditure over tax revenues in a given year. It
s also equal to the change in the stock of government debt during the year.
1. Change in size of deficit requires change in level of expenditures relative to tax revenues
2. Stock of government debt will rise whenever the budget deficit is positive
Budget surplus: any excess of current revenue over current expenditure
A budget deficit increases the stock of debt; a budget surplus reduces it.
The Primary Budget Deficit
Debt-service component is beyond control of government. G and T are discretionary.
Primary budget deficit: the difference between the government’s overall budget deficit and its debt-
Primary budget deficit = G – T
Shows extent to which tax revenues finance discretionary part of total expenditure. Also known as
Big differences overall budget deficit and primary budget deficit.
The primary budget surplus or deficit shows the extent to which tax revenues can cover the government’s
program spending; it is equal to the overall deficit minus debt-service payments.
Deficits and Debt in Canada
Federal Government Economists look at government debt and deficits in relation to the overall size of the economy.
Deficit implies that the stock of government debt is rising.
Budget deficit – large in 70s/80s – first budget surplus in 1998. Returned to deficit in 2009.
Debt-to-GDP ratio fell dramatically after WW2 and kept falling until 1975. Then increased until late
When examining the size and effects of budget deficits or surpluses, it is important to consider all levels
of government – federal, provincial, territorial, and municipal.
32.2 TWO ANALYTICAL ISSUES
The Stance of Fiscal Policy
Only some of the changes in the budget deficit are due to discretionary changes in the government’s
expenditure or taxation policies.
Others due to changes in level of economic activity outside the influence of government policy.
The Budget Deficit Function
Budget deficit = (G + i x D) – T
Net tax revenues depends on national income
Net taxes increase with national income.
Government purchases/debt-service payments more or less independent of national income.
Thus, with no changes, budget deficit will tend to increase in recessions and fall in booms.
Negative relationship national income and government’s budget deficit.
For a given set of expenditure and taxation policies, the budget deficit rises as real GDP falls and falls as
real GDP rises.
Budget deficit function: a relationship that plots, for a given fiscal policy, the government’s budget
deficit as a function of real GDP
Expenditure and taxation policies determine position of the budget deficit function.
Expansionary fiscal – shift budget deficit function up.
Contractionary fiscal – shift budget deficit function down
Change in level of real GDP is movement along budget deficit function.
Fiscal policy determines the position of the budget deficit function. Changes in real GDP lead to
movements along a given budget deficit function.
The Cyclically Adjusted Deficit
Holding rGDP constant, an increase in deficit would show fiscal expansion and decrease fiscal
Cyclically adjusted deficit (CAD): an estimate of what the government budget would be if real GDP were
equal to Y*; sometimes called a structure deficit
Changes in CAD reveal changes in stance of fiscal policy.
An expansionary change in fiscal policy increases the cyclically adjusted deficit; a contractionary change
in fiscal policy reduces the cyclically adjusted deficit
CAD can only be estimated – depends on Y* (estimated)
Actual deficit larger than cyclically adjusted deficit in recessions.
Changes in expansionary or contractionary stance of fiscal policy are shown by changes in CAD.
Changes in the Debt-To-GDP Ratio
d = x + (r-g) x d X – primary budget deficit as percentage of GDP
R – interest rate on government bonds
G – growth rate real GDP
- If interest rate exceeds growth rate of GDP (r > g), the debt-to-GDP ratio will rise because debt
accumulates at faster rate than GDP grows
- If government has primary budget deficit (x is positive), debt-to-GDP ratio will rise because it is
incurring new debt
To reduce debt-to-GDP ratio
- Continuing primary budget surpluses
- Real interest rate less than growth rate of real GDP is helpful
If the real interest rate on government debt is approximately equal to the growth rate of real GDP,
reductions in the debt-to-GDP ratio require the government to run primary budget surpluses.
32.3 THE EFFECTS OF GOVERNMENT DEBT AND DEFICITS
Deficits may crowd out private-sector activity and harm future generations by reducing the economy’s
Surpluses may crowd in private-sector activity and be beneficial to future generations
When government increases budget deficit, it necessarily increases borrowing. Is a reduction in
government’s saving. Has only small amount of saving by private sector – national saving falls.
Increase in government’s budget deficit leads to reduction in national saving.
In our model, we assume that an increase in the government’s budget deficit leads to a decrease in
national saving. Alternatively, a reduction in the budget deficit leads to an increase in national saving.
Do Deficits Crowd Out Private Activity?
Investment in closed economies
In closed economy, saving must equal investment.
Increase in budget deficit – reduction in government saving – reduction national saving – excess demand
loanable funds and increase in the interest rate – investment will fall
Crowding out: the offsetting reduction in private expenditure caused by the rise in interest rates that
follows an expansionary fiscal policy
If a government budget deficit leads to a reduction in national saving, real interest rates will rise and
private investment will be crowded out.
Net Exports in Open Economies
Increase in budget deficit.
As real interest rates rise, foreigners are attracted to higher-yield Canadian assets and foreign capital
flows into Canada. Need Canadian dollars, so this leads to increased demand and leads to appreciation.
Makes Canadian goods relatively more expensive, induc