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Chapter 32

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ECON 110
Ian James Cromb

Chapter 32: Government Debt and Deficits Facts and Definitions The Government’s Budget Constraint  Gov’t Expenditure (constraint) = Tax Revenue + Borrowing  Gov’t Expenditure is divided into two categories: purchases of goods and services and interest payments on the outstanding stock of debt (or debt-service payments – i D) o i is the interest rate and D is the stock of gov’t debt  A third category of gov’t spending is transfers to individuals and firms – like before it is included as part of T, the gov’ts net tax revenue  Government constraint can now be written as: (G+ i D) – T = Borrowing  A budget deficit is any shortfall of current revenue below current expenditure o Budget deficit = = (G+ i D) – T  Gov’t debt is the outstanding stock of financial liabilities for the gov’t, equal to the accumulation of past budget deficits  Budget surplus is any excess of current revenue over current expenditure  pay off debt The Primary Budget Deficit  It’s the difference between the gov’t overall budget deficit & its debt-service payments o Primary Budget Deficit = G – T  The primary budget surplus/deficit shows the extent to which tax revenues the gov’ts spending program Two Analytical Issues The Stance of Fiscal Policy  We know that when the gov’t changes their expenditure or taxation it normally leads to a change in the gov’t budget deficit or surplus  However, a the budget deficit can rise/fall even when there is no change in fiscal policy The Budget Deficit Function  This is a relationships that plots, for a given fiscal policy, the gov’t budget deficit as a function of the level of real GDP  For a given set of expenditure and taxation policies, the budget deficit rises as real GDP falls and falls as real GDP rises  people have higher incomes = more tax revenue  An expansionary fiscal policy shifts the function up; contractionary policy shifts it down o Changes in GDP lead to movements along the function The Cyclically Adjusted Deficit (CAD)  This is an estimate of what the gov’t budget deficit would be if real GDP = Y* o An expansionary change in fiscal policy increases the cyclically adjusted deficit o A contractionary change in fiscal policy reduces the cyclically adjusted deficit  During a recession, the CAD will be lower than the actual one because Y < Y* Changes in the Debt-to-GDP Ratio  In order to gauge the importance of gov’t deficits and debt, they should be considered relative to the size of the economy  so we use the Debt-to-GDP Ratio  The equation of finding the change is the debt-to-GDP ratio is: ( ) o d is the debt-to-GDP ratio; x is the gov’ts primary deficit as a percentage of GDP; r is the real interest rate on gov’t bonds; g is the growth rate of real GDP  If r > g, the debt-to-GDP ratio will rise, if opposite, the ratio will fall  If the gov’t has a primary budget deficit (if x is positive), the debt-to-GDP ratio will rise because the gov’t is incurring new debt to finance its program spending The Effects of Government Debt and Deficits  In our model, we assume that an increase in the gov’ts budget deficit leads to a decrease in national saving  reduction in deficit leads to an increase in national saving Do Deficits Crowd out Private Activity? Investment in Closed Economies  Recall from ch. 26: Savings = investment in a closed economy o The only way an economy can save is to accumulate physical capital  Crowding out is the offsetting reduction in private expenditure caused by the rise in interest rates that follows an expansionary fiscal policy o If a gov’t 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  If Canadian gov’t increases its budget deficit, the resulting higher interest rates will attract foreigners to Canada’s now higher yielding assets o Need Canadian dollars to buy assets, Canadian dollar appreciates making Canadian goods more expensive relative to those of other countries o Imports increase, and exports drop  rise is deficit = crowding out of net
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