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CHAPTER 16Government Debt and Budget Deficits

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To Accompany

MACROECONOMICS, 7th. EditionN. Gregory Mankiw

Tutorial written by:

Mannig J. SimidianB.A. in Economics with Distinction, Duke University

M.P.A., Harvard University Kennedy School of GovernmentM.B.A., Massachusetts Institute of Technology (MIT) Sloan School of

Management

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What is the government debt and the annual budget deficit?

Annual Deficit (2007)Annual Deficit (2006)

Annual Deficit (2005)Annual Deficit (2004)

Annual Deficit (2003)Annual Deficit (2002)

The government debtis an accumulationof all past annual

deficits. In 2005, the debt of the U.S. federal government was $4.7

trillion.

When a government spends more than it collects in taxes, it has a budge deficit, which it finances by borrowing from the private sector.

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When Ronald Reagan because president in 1980, he wanted toreduce taxes and increase military expenditures. These policies, coupled with a deep recession attributable to tight monetary policy,began a long period of subsequent higher budget deficits.

The increase in government debt during the 1980s caused concernamong policymakers. In response, over the next few years, therewere tax increases, spending restraints, and rapid economicgrowth due to the technology boom, which ultimately, caused thebudget deficits to shrink and eventually turn into surpluses.

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• Modifies the real value of outstanding public debt to reflect current inflation.

• Subtracts government assets from government debt.

• Includes hidden liabilities that currently escape detection in the accounting system.

• Calculates a cyclically-adjusted budget deficit (based on estimates of what government spending and tax revenue would be if the economy were operating at its natural rate of output and employment).

The government budget deficit equals governmentspending minus government revenue, which inturn equals the amount of new debt the government needs to issue to finance its operations. A meaningful deficit…

Problems in Measurement

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How would a tax cut and budget deficit affect the economy and the economic well-being of the country?From Chapter 3, we know that a tax cut stimulates consumer spending and reduces national saving. The reduction in saving raises the interest rate, which crowds out investment. From Chapter 7, the Solow growth model shows that lower investment leads to a lower steady-state capital stock and lower output. From Chapter 8, we know that the economy will then have less capital than the Golden Rule steady-state, which will mean lower consumption and lower economic well-being. Using Chapter 10-11,we can analyze the short-run impact of the policy change via the IS-LM model. Using Chapters 5 and 12, we can see how international trade affects this policy change. When national saving falls, people borrow from abroad, causing a trade deficit. It also causes the dollar to appreciate. The Mundell-Fleming model shows that the appreciation and the resulting fall in net exports reduce the short-run expansionary effect

of the fiscal change.

The Traditional View of Government Debt

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The Ricardian View of Government Debt

Forward-looking consumers perceive that lower taxes now mean higher taxes later, leaving consumption unchanged. “Tax cuts are simply tax postponements.”

When the government borrows to pay for its current spending (higher G), rational consumers look ahead to the future taxes required to support this debt.

-T + G+Tlater

+Tlater

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Consumers and Future Taxes

The essence of the Ricardian view is that when people choose theirconsumption, they rationally look ahead to the future taxes implied bygovernment debt. But, how forward-looking are consumers?

Defenders of the traditional view of government debt believe that the prospect of future taxes does not have as large an influence on current consumption as the Ricardian view assumes.

Some of their arguments follow.

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Myopic (short-sighted) Consumers

• Proponents of the Ricardian view assume that people are rational when making decisions such as choosing how much of their income to consume and how much to save. When the government borrows to pay for current spending, rational consumers look ahead to anticipate the future taxes required to support this debt.

• One argument for the traditional view is that people are myopic: they see a decrease in taxes in such a way that their current consumption increases because of this new “wealth.” They don’t see that when expansionary fiscal policy is financed through bonds, they will have to pay more taxes in the future since bonds are just a tax-postponements.

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Borrowing ConstraintsThe Ricardian view of government debt assumes that consumers basetheir spending not only on current but on their lifetime income, which includes both current and expected future income. Advocates of the traditional view of government debt argue that current consumption is more important than lifetime income for those consumers who faceborrowing constraints, which are limits on how much an individualcan borrow from banks or other financial institutions.

People who want to consume more than their current income must borrow. If they can’t borrow to finance their current consumption, their current income determines what they can consume, regardless of their future income. In this case, a debt-financed tax cut raises current incomeand thus consumption, even though future income is lower. In essence, when a government cuts current taxes and raises future taxes, it is giving taxpayers a loan.

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Balanced Budgets Versus Optimal Fiscal Policy

Most economists oppose a strict rule requiring the government to balancethe budget. There are three reasons why optimal fiscal policy may at times call for a budget deficit or surplus:

1) Stabilization

2) Tax smoothing

3) Intergenerational redistribution

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Stabilization

A budget deficit or surplus can help stabilize the economy. A balancedbudget rule would revoke the automatic stabilizing powers of thesystem of taxes and transfers. When the economy goes into a recession,tax receipts fall, and transfers automatically rise. Although theseautomatic responses help stabilize the economy, they push the budgetinto deficit. A strict balanced-budget rule would require that the government raise taxes or reduce spending in a recession, but theseactions would further depress aggregate demand.

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Tax Smoothing

A budget deficit or surplus can be used to reduce the distortion of incentives caused by the tax system. High tax rates impose a cost on society by discouraging economic activity. Because this disincentiveis so costly at particularly high tax rates, the total social cost of taxesis minimized by keeping tax rates relatively stable rather than makingthem high in some years and low in others. This policy is calledtax smoothing. To keep tax rates smooth, a deficit is necessary in yearsof unusually low income or unusually high expenditure.

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Intergenerational Redistribution

A budget deficit can be used to shift a tax burden from current to future generations. For example, some economists argue that if thecurrent generation fights a war to preserve freedom, future generations benefit as well and should therefore bear some of the burden. To pass on the war’s costs, the current generation can finance the war with a budget deficit. The government can later retire that debt by raising taxes on the next generation.

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Fiscal Effects on Monetary Policy

One way for a government to finance a budget deficit is to print money—a policy that leads to higher inflation. When countriesexperience hyperinflation, the typical reason is that fiscal policymakersare relying on the inflation tax to pay for some of their spending. Theends of hyperinflations almost always coincide with fiscal reforms that include large cuts in government spending and therefore a reduced needfor seigniorage.

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Capital BudgetingCyclically adjusted budget deficitRicardian equivalence

Capital BudgetingCyclically adjusted budget deficitRicardian equivalence