ECON 2133 Lecture Notes - Lecture 4: Cash Flow, Ricardian Equivalence

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emeraldbeaver977

15 Mar 2017

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Growth rate of national debt (in a fiscal year) = deficit/debt + interest. * congress and the president control fiscal policy * (cid:498)crowding out story(cid:499): deficits mean government borrowing is going up; Counterarguments to the conventional wisdom: there are some benefits to the cost for younger generations, not every (cid:498)crowding out(cid:499) has high interest rates deficits have not led to interest rates rising in recent years. Historically, national debt has been large and it has lead to deficits, but: not all borrowing is bad. You must spend money to make money and/or achieve government and country goals. The national debt-to-gdp ratio: worthiness (what we owe relative to gdp). As long as this is good (falling over time/going horizontal), usa will never have to pay that debt back. The national debt-to-gdp ratio is the measure of our governments credit. If debt grows faster than rate of economic growth then the debt-to-gdp rises.

Related Questions

1. Why Niall Ferguson thought that the expansionary fiscal policy (or government deficit) could produce crowding-out effect? You can explain by using the IS-LM model or you can use the logic of loanable funds theory

Answer: Ferguson believes that an increase in the government deficit could produce a crowding-out-effect. First, I will touch base on fiscal policy. Well, what is it? Basically, it adjusts the nationâs spending amount which increases the economyâs deficit to close a recessionary gap, which therefore increases the the demand for loans, meaning people want to borrow money. An increase in demand for loans leads to an increase in interest rates. Higher interest rates lead to a decrease in investment and interest-sensitive consumer spending, so both C and I decrease. Thatâs what the crowding-out-effect is, the decrease in investment due to higher interest rates.

>in Deficit = >in Demand for Loans = >in interest rates =

The government speeds up the economy by deficit spending, they crowd out consumers and investors with high interest rates. So what this means is that the government is attempting to help the economy but it is actually hurting the economy. The reason why I think Ferguson believes this is because of what he says in his debate at the New York Review of Books, that âyou canât be both a monetarist and a Keynesian simultaneouslyâat least I canât see how you can, because if the aim of the monetarist policy is to keep interest rates down, to keep liquidity high, the effect of the Keynesian policy must be to drive interest rates up.â He continues on in the interview to say that the Fed has minted out a fresh $1.75 billion in bonds and that no one is going to buy them. Driving up bonds will increase interest rates which increases mortgage rates which is why he basically doesnât agree with the Keynesian theory.

2. Why Paul Krugman thinks that Niall Ferguson was wrong and thought that government deficit could not produce a crowding-out effect? In other words, please explain Krugman's Liquidity trap .

Answer: To start I think Krugman believes that the Fiscal policy is effective. It is effective when the Liquidity-Money (LM) curve is horizontal. It creates the crowding in effect. The supply of money is constant so it creates money demanded to be interest inelastic, meaning it doesnât change. So if the government wishes to stimulate the economy, it leaves interest rates at a constant rate, and an increase in investment and saving, therefore helping the economy close the gap on a recession. There is an indifference between money and bonds so this makes fiscal policy effective. So then we get into a monetary expansion, meaning we have an increase in the money supply. Well with the liquidity trap, we get the case that the investment-savings (IS) curve is horizontal. So when the government increases the money supply, investment responds to rapidly changing interest rates, which would decrease the money demanded, making monetary policy effective. But the liquidity trap becomes apparent because interest rates cannot fall below zero percent. This is when monetary policy would become ineffective because interest rates arenât declining meaning investment wouldnât continue. Krugman in his blog basically argues this. He states âMost spectacularly, IS-LM turns out to be very useful for thinking about extreme conditions like the present, in which private demand has fallen so far that the economy remains depressed even at a zero interest rate.â He sums up his argument for the liquidity trap and explains his logic behind the investment-savings, liquidity-money curve, and that is why he disagrees with Ferguson.

3. In the discussion, other discussants such as George Soros and Robin Wells pointed out some interesting issues. Please provide at least one thing that you agree and one thing that you disagree. Discuss in details why you think so.

Answer: One thing I found interesting was George Soroâs point in the debate in the New York review of books. He states âThe other feature is that the financial system collapsed of its own weight. That contradicted the prevailing view about financial markets, namely that they tend toward equilibrium, and that equilibrium is disturbed by extraneous forces, outside shocks. Those disturbances were supposed to occur in a random fashion. Markets were seen basically as self-correcting. That paradigm has proven to be false. So we are dealing not only with the collapse of a financial system, but also with the collapse of a worldview.â He continues to mention how Obama has 2 problems he has to face and how people who are viewing this crisis the same as the previous financial crisis, are making a huge mistake. To explain he states this: âBut when you have a collapse of credit thereâs only one source of credit that is still credible, and thatâs the state: the Federal Reserve and the Treasury. Then you have actually to inject a lot more leverage and money into the economy; you have to print money as fast as you can, expand the balance sheet of the Federal Reserve, increase the national debt. And that is, in fact, what has been done, which is the right thing to do. But then once this policy is successful, you have to rein in the money supply as fast as you can.â I think Soro is agreeing with Krugman and the monetary policy of pumping money into the economy. It will raise the money supply which eventually is left for us to capitalize on supply and let our GDP. Now I find this interesting because he is also agreeing with Krugmanâs IS-LM model, and later on, we come to find out that even Ferguson had come to an agreement with Krugmanâs points, with the exception being that the United States was a powerhouse, and therefore the European Union would eventually see its downfall.

Please make comments to the answer of discussion I provided above(at least 300 words total). And you can start with "I agree with you on some points... But I disagree with you on some points".

1.Ceteris paribus, if the U.S. federal government reduces its budget deficit which of the following will be observed?

Answer

	a.	The aggregate demand curve will shift to the right.
	b.	The economy will always approach potential GDP.
	c.	The marginal propensity to consume will increase.
	d.	The average price level will increase.
	e.	The aggregate demand curve will shift to the left.

2. If the government wants to close a GDP gap, it can:

Answer

	a.	lower government spending on social security.
	b.	adopt contractionary fiscal policies to control inflation.
	c.	increase its budget deficit.
	d.	repay its borrowings.
	e.	raise both direct and indirect tax rates.

3. Suppose the short-run equilibrium level of income exceeds the full employment level of income and there is high inflation. Hence, the government decides to implement a fiscal policy that will act to reduce national output and price level. This can be accomplished by:

Answer

	a.	lowering average tax rates such that aggregate supply is increased.
	b.	increasing government spending such that aggregate expenditures are increased.
	c.	increasing transfer payments such that aggregate expenditures decline.
	d.	raising taxes and government spending by the same amount such that aggregate supply is decreased and aggregate demand is increased.
	e.	decreasing government spending such that aggregate demand is reduced.

4. A drop in investment spending caused by increased government budget deficits is referred to as:

Answer

	a.	the multiplier effect.
	b.	crowding out.
	c.	an expansionary gap.
	d.	the paradox of thrift.
	e.	the Ricardian equivalence.

5. Discretionary fiscal policy is best defined as:

Answer

	a.	the deliberate manipulation of the money supply to expand the economy.
	b.	the deliberate change in tax laws and government spending to change equilibrium income.
	c.	the policy action taken by the Congress to reduce the federal budget deficit.
	d.	the arbitrary fluctuation in tax laws and budget requirements.
	e.	the automatic change in certain fiscal instruments when real GDP changes.

6. Which of the following can be considered as an automatic stabilizer in the economy?

Answer

	a.	Money supply
	b.	Disposable income
	c.	Real exchange rate
	d.	Real interest rate
	e.	Unemployment insurance

7. Which of the following is true about automatic stabilizers?

Answer

	a.	When income rises, automatic stabilizers increase/boost spending.
	b.	Automatic stabilizers are a part of discretionary fiscal policy.
	c.	An automatic stabilizer is any program that responds to fluctuations in the business cycle in a way that moderates the effects of those fluctuations.
	d.	Any kind of trade policy adopted by the government will be considered as an automatic stabilizer.
	e.	The interest rate is an example of an automatic stabilizer.

8. Increased budget deficits

Answer

	a.	can cause interest rates to increase and hence decrease net exports
	b.	have no effect on net exports
	c.	can cause interest rates to decrease and hence increase net exports
	d.	never impose additional interest costs on the government

9. The Ricadian Equivalence implies that when financing additional government expenditures

Answer

	a.	there is no difference between increasing current taxes or borrowing now and increasing taxes in the future because consumption will decrease either way.
	b.	there is no difference between increasing current taxes or borrowing now and increasing taxes in the future because consumption will increase either way.
	c.	increasing borrowing is the best option
	d.	increasing current taxes is the best option

10. Assuming no effects on aggregate supply, if the government increases government spending and decreases taxes in an attempt to prevent a possible recession, aggregate demand will shift to the ____, the price level will either remain constant or ____, and the level of real GDP will ____.

Answer

	a.	right; decrease; increase
	b.	right; decrease; decrease
	c.	left; decrease; decrease
	d.	left; increase; increase
	e.	right; increase; increase

11. For a hypothetical economy, the MPS is 0.08 and the MPI is 0.17. If government spending increases by $35 and taxes increase by $35, what will be the net effect on equilibrium income?

Answer

	a.	A decrease of $35
	b.	An increase of $105
	c.	An increase of $35
	d.	A decrease of $105
	e.	A decrease of $15

12.12. The term fiscal policy refers to

Answer

	a.	the adjustment of the GDP for inflation.
	b.	the purchase and sale of U.S. government securities to regulate the money supply.
	c.	the use of government spending and taxation to influence the level of economic growth and inflation.
	d.	the use of fines to penalize unfair business practices.
	e.	a policy action by Congress to overrule unpopular budget cuts by the president.

13. If aggregate demand intersects aggregate supply in the vertical range of the aggregate supply curve, then, other things equal, an increase in government spending will

Answer

	a.	raise the price level and leave real GDP unchanged.
	b.	raise real GDP by the amount indicated by the government spending multiplier and leave the price level unchanged.
	c.	raise both real GDP and the price level by a multiple of the initial spending increase.
	d.	have no effect on real GDP or on the price level, because all private investment will be crowded out.
	e.	lower real GDP by an amount equal to the spending increase and reduce inflation.

14. Which of the following is not a means to finance government spending?

Answer

	a.	Government subsidies
	b.	Government debt
	c.	Capital gains taxes
	d.	Personal income taxes
	e.	Money creation

15. An automatic stabilizer is

Answer

	a.	a change in government spending aimed at achieving a policy goal.
	b.	an element of fiscal policy that automatically changes in value as real GDP changes.
	c.	an element of monetary policy that automatically changes in value as real GDP changes.
	d.	a decrease in tax rates as the economy moves into a recession.
	e.	a deliberate change in taxation aimed at increasing real GDP.

16. Budget deficits tend to grow during recessions because

Answer

	a.	real GDP growth is zero, which causes neither tax receipts nor government expenditures to grow.
	b.	real GDP growth is positive, which reduces both tax receipts and transfer payments.
	c.	real GDP growth is negative, which reduces transfer payments in relation to tax receipts.
	d.	real GDP growth is negative, which reduces tax receipts in relation to government expenditures.
	e.	real GDP growth is positive, which increases tax receipts in relation to government expenditures.

Big banks urge Ottawa to spend $20-billion in rapid stimulus

"Two of Canada's big banks want the federal government to pump $20-billion into an economic stimulus for a fast jolt to the flagging economy. Bank of Nova Scotia urged Ottawa to spend that much by mid-2017. Such a measure, the bank said, would equal 1 percent of gross domestic product and would play into its new economic forecast for GDP growth of 1.3 percent this year and 2.5 percent next. Canadian Imperial Bank of Commerce called for $20-billion in the government's first year, saying the pledges on the table just aren't enough. The Liberal government of Prime Minister Justin Trudeau has indeed promised to spend billions in infrastructure stimulus. But, beyond the recent campaign pledges, there have been no details on the final amount, the targets, and the timeline. And remember, the fiscal outlook has changed rapidly, with the Liberals now forecasting a deficit of $18-billion even without their promised spending. Canadians will get the details when Finance Minister Bill Morneau unveils his budget on March 22. While Scotiabank and CIBC are the first to have specific calls, other bank economists have said the further stimulus would be welcome, and that the government certainly has the fiscal room to accommodate it. Scotiabank painted a weak economic picture for 2016, particularly for the oil-shocked province of Alberta, and a national unemployment rate that will top 7 per cent this year and next. It projected the economy of Alberta, which had been the country's economic engine until the oil route, will contract by a further 1.9 percent this year, with a jobless rate of 7.5 percent. Our Canadian forecast incorporates our recommendation for the federal fiscal stimulus of $20-billion, equivalent to 1 per cent of GDP, implemented during the second of 2016 and the first half of 2017, said Aron Gampel, Scotiabank's deputy chief economist. "This stimulus would be over and above the deficit resulting from weaker economic conditions, estimated for fiscal 2016-17 at $18-billion by the federal government," he added. "The stimulus should be designed to: deliver a rapid economic impact; raise Canada's economic capacity and thus our longer-term growth prospects; and, facilitate adjustments in the provinces most affected by weak commodity prices. Once the Canadian economy no longer requires policy support, targeting a declining ratio of net debt-to-GDP should resume." CIBC also weighed in on the stimulus debate today, calling for $20-billion in stimulus over two years. The Liberal pledges had been for $5-billion infrastructure and a further $5-billion in other measures in their first two years in power. But CIBC World Markets doesn't think that's enough given the country's economic troubles. "Federal stimulus under that scenario would be barely more than 0.5 percent of GDP, arguably too little to do the job, particularly with some provinces applying fiscal brakes," said CIBC's Royce Mendes and Avery Shenfeld. "We see a $20-billion stimulus program with a $40-billion deficit as being more appropriate, but given the political sensitivities, the government might show something closer to $35-billion for 2016-17, while perhaps taking on some further stimulus charged to the outgoing year." Some academics believe that in this low-interest-rate environment, what we need is a strong blast of fiscal stimulus to drive employment and growth. They argue that we should reject fiscal austerity and embrace public investment. Indeed, that has been the primary economic platform for the Liberal party, and for some, the reason for them winning a majority in the last election."

(a) The IMF "It is Mostly Fiscal" appears to be what Trudeau and his economic team have bought into. Explain why further fiscal austerity could be particularly painful for the Canadian economy, and how deficit spending may lower the government debt to GDP ratio. Be sure to illustrate using the IS-LM and the AD-AS frameworks.

(b) Discuss why Canadian banks are particularly concerned that the government fiscal stimulus plan may not be enough.

(c) Discuss what are some of the problems with using expansionary monetary policy in an environment of low interest rates. That is, describe the problem of a "liquidity trap."

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ECON 2133 Lecture Notes - Lecture 4: Cash Flow, Ricardian Equivalence

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