Macroeconomics Final Study Guide
Lecture 18 – Deficits, Debt, Debt Ratio, Debt Trap
Deficit – the excess of expenditures over taxation in any period
Public Debt – the accumulated total of past deficits minus surpluses, or the total debt outstanding
Debt ratio – the ratio of debt to GDP
*If GDP is growing, the debt ratio will fall.
- If the denominator grows faster than the numerator, the ratio will fall.
- % ∆ R = % ∆ D - % ∆ GDP
Over the past 6 years in the US, the debt ratio has more than doubled. If large debts persist, we could get
stuck in the debt trap.
Debt Trap – when investors doubt the ability of a nation to repay its debt and see securities as risky.
They’ll only buy securities if offered higher interest rates, but these higher interest rate only increase the
- Deficit = D = iD + PBD = iD + p(GDP)
Usually, the real interest rate on government debt for industrialized nations is lower than the real growth
rate of GDP, which means if the nation can balance their budget excluding the interest then the debt ratio
In a recession, the deficit would most likely rise due to lower revenues and fiscal measures taken to put
people back to work.
If a nation has a high debt ratio and a large primary deficit, they will fall into the debt trap.
They then have 4 options:
1. They can default and say sorry we can’t pay
2. It can adopt a program of severe fiscal austerity, meaning spending cuts and tax increases, which
could cause a recession or deepen the one they’re in
3. They could appeal to other nations or to the IMF for a bailout, but these outside entities would
most likely require austerity in order to bail them out.
4. The nation could print the money they need to pay and lean on the Fed to buy the bonds, but this
would result in very high inflation.
Most nations fall into the debt trap because they don’t realize that the good times don’t last forever. - If in a boom, the government increasing spending to meet the higher tax revenue, then their debt
grows, but so does GDP so the debt ratio doesn’t rise.
- But then, if they enter a recession, their tax revenues will fall and they will have a huge primary
o The primary deficit grows from loss of tax revenue, the interest rate required by lenders
rises, and the growth rate falls (or goes negative)
Anation faced with the threat of the debt trap should enact a combo of spending cuts and tax increases to
start to balance the structural budget.
- Keynesian model: pursue short-term stimulus with temp. spending programs or tax cuts that they
eliminate as the economy gets back to full employment
Lecture 19: Debt Trap
Lately, our unemployment rate has been dropping but it is deceiving. It’s just dropping because more
people are becoming discouraged workers and have given up looking, so our labor force is getting
smaller. This then brings the unemployment rate down, but doesn’t account for discouragement.
Anation caught in the debt trap MUST balance their structural budget by spending programs and taxes.
- They should also pursue rapid growth in the short run. This may require large-scale deficit
Temporary spending programs could include rebuilding infrastructure, which would also provide jobs and
would end once the job is done. They could also subsidize private investment.
They also must do whatever they can to make their economies more competitive.
*We don’t know what the tipping point is for getting stuck in the debt trap, so we must be cautious
-Also, we don’t know when another war or crisis could happen, which would require spending,
so we don’t want to have a large PBD
Also, a high debt ratio makes it harder to use fiscal policy during a recession, so we would lose that
Neo-classical Production Function (Robert Solow) – output depends on resources and technology and Q*
is any point on the frontier.
- Q = A L4 K 4 whereAis technology, L is labor, and K is capital
∆ ∆ ∆ ∆
- % Q = % A= 3/4 % L + ¼ % K
Output rises with gains in technology, growth of the labor force, or accumulation of capital.
Lecture 20: International Trade, Finance, and Exchange Rates Exchange rates can be determined by either supply and demand or it can be fixed by governments.
If 2 nations are on a gold standard, but then the US goes into a boom and prices start rising relative to
those in the other country, then our goods become less competitive and we will have a deficit on our
balance of payments.
If we become less competitive, we will spend more money on imports than we export to other countries,
so we will have a trade deficit.
- Under a gold standard, more dollars accumulating abroad would be exchanged for gold, so the
US would lose gold and…
Hume’s Gold-FlowAdjustment Mechanism – British philosopher David Hume argued that if all nations
had a gold standard, then trade deficits would be eliminated by way of market forces.
- With a trade deficit, we have a net reduction in bank reserves and deposits. Banks will stop
lending as much, the system will slow, and prices at home will fall.
- Imports will then go down as exports go up
- This continues until the imports and exports are in balance again.
1944 Bretton Woods Conference – the world’s superpowers meet and create the International Monetary
Fund (IMF). This established a fixed rate system with currencies tied to gold. The IMF was allowed to
adjust it if a currency became over or under valued.
Nations must adhere to the “rules of the game” – an understanding that a nation with a chronic trade
deficit would pursue a contractionary policy (cut spending, increase taxes, pursue tight money)
- It could temporarily borrow from the Fed if they were short of reserves, but this came with
conditions of austerity.
After WWII, Europe’s economy was destroyed. We sent them goods to rebuild and money through the
Marshall Plan through purchasing European securities. For a while the US had a huge trade surplus. In the
late 1960s, we had a huge boom and inflation made our goods less competitive. The foreign short-term
claims had grown so large that they exceeded our gold reserves. Nixon suspended convertibility to gold
and set price and wage controls so we could bring inflation down and before foreigners could rush our
- BUT, we didn’t slow our economy at the same time. Since the next year was an election year we
did nothing to slow our economy. We could not resume convertibility, and now have a system of
floating exchange rates.
Managed float – managed but flexible rates determined by supply and demand (central banks sometimes
intervene by buying/selling securities)
Fixed rates – some nations peg their currency to the dollar or to a mix of currencies
Lecture 21: International Finance and Currency Crises Southeast Asia 1997-1998: these nations were prosperous for 10 to 20 years and were called theAsian
Tigers. They had moderate inflation, but it was higher than Japan, Europe, and the US. Their interest rates
were also higher. We slowed our exports to Japan because the US dollar was becoming less competitive,
and since theAsian currencies were tied to the dollar, their