1

Fiscal Policy

The overall federal budget

14

16

18

20

22

24

26

60 65 70 75 80 85 90 95 00 05 10

Spending/GDP

Revenues/GDP

Deficit

2

• Actual budget is actual spending and receipts• Structural budget records spending, taxes, and

deficit that would occur if economy at potential output

• Important because taxes, spending programs respond to state of economy

Structural v Actual Budget

3

Structural and Actual Budget

-.10

-.08

-.06

-.04

-.02

.00

.02

.04

60 65 70 75 80 85 90 95 00 05 10

Govt surplus/ GDPCyclically adjusted govt surplus/ GDP

A substantial part of the deficit is cyclical.

4

Debt bathtub

Debt (beginning of year)

Spending

Revenues

Debt (end of year) = Debt (beginning) + deficit

5

Debt algebra

Basic identity:Change in Debt (end of t) = Deficit (t) + ε

Government budget constraint:Debt = PV(future taxes) – PV(future expenditures)

Unstable dynamics: Debt is explosive if when debt-GDP ratio (β) grows steadily, which occurs when the ratio grows rapidly:

interest rate minus

deficit GDP inverse ofgrowth rate ratio debt-GDPratio

G – T 10 << d / dt r g

Y

7CBO, September 2009

How Quickly the Budget Picture Can Change

-8

-6

-4

-2

0

2

4

6

8Projected 10-year deficit (trillions)

8From CBO reports, 1997 2009.

National saving is falling sharply …

-2%

0%

2%

4%

6%

8%

10%

12%

14%

1975 1980 1985 1990 1995 2000 2005

Net national saving and domestic invesment (% of NNP)

Net national savings rate

Net domestic investment rate

9Data from BEA.

Current projection of debt/GDP

10

Long-term projection of debt/GDP

11

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What is responsible for the fiscal problem?

What is responsible for the fiscal problem?

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Presidential (or near-so) views

“It’s a public debt… we owe it to ourselves… therefore, we never have to pay it back.” [F.D.Roosevelt]

“There are myths also about our public debt. Borrowing can lead to over-extension and collapse--but it can also lead to expansion and strength. There is no single, simple slogan in this field that we can trust.” [J.F.Kennedy, Yale Commencement Address, 1962]

"But most of all because I think this [deficit spending] can only be described as generational theft.“ [John McCain] 14

Preliminary Considerations

1. Deficits (and therefore higher debt) may be necessary to stabilize the business cycle (particularly in liquidity trap situations).

2. However, burden and impact of debt should be considered in long-run. Impacts on AD can be offset by fiscal and monetary policy.

3. One cost of debt is the efficiency losses (deadweight losses) from higher taxation (micro/public finance)

4. Ricardian debt theory holds that people offset it in saving (next slide)

5. Don’t blame it on the Chinese! (next week)6. The main macro cost is the “crowding out” of capital (today)

- Higher debt displaces capital from portfolios- This lowers growth of K and potential Q

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1. Do Deficits Matter? The Ricardian Theory of the Debt

1. Robert Barro (Chicago/Harvard) introduced a theory in which deficits do not affect national saving or output.

2. Chicago view of households: They are "clans" or "dynasties" in which parents have children’s welfare in utility function:Ui = ui (ci, Ui+1)

where Ui is utility of generation i and ci is consumption of generation i3. This implies by substitution:

Ui = ui (ci, ui+1(ci+1, Ui+2)) = vi(ci, ci+1, ci+2, ...)which is just like an infinitely lived person!4. Important result: Barro consumers are like a life-cycle model

with infinitely lived agents with perfect foresight:there will be no impact of anticipated taxes (or deficits) on

consumption or on aggregate demand.5. Controversial, but empirically questionable. Reasons are

myopia, singles, liquidity constraints, non-altruistic parents. 16

Mechanism of Crowding Out• Assume closed economy with full employment• Government borrows for consumption G

– wars, food stamps, ice cream, …• Wealth accounting: W = K + GD

– Wealth is owned in form of private assets (houses, bonds, stocks) and government debt; non-Ricardian consumers

• Demand for K by firms for production.– Demand for K is downward-sloping function of real interest

rate, r• Supply of capital and wealth:

– Households accumulate wealth in K and GD for life cycle and other purposes

– For simplicity, assume supply is interest-inelastic• Increased government debt then “crowds out” equities/capital

from portfolio– Higher GD with constant W reduced K

• Higher GD → lower K → lower potential output 17

Firm Balance Sheet

Assets Liabilities

Capital Stock 5000 Equities (stock) 5000

Net worth 0

Assets Liabilities

Government Balance Sheet

Assets 0 Debt (bonds) 1000

Net worth -1000

Household Balance Sheet Assets Liabilities

Govt bonds 1000

Equities 5000 Net worth 6000

Before increasein GD

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Firm Balance Sheet

Assets Liabilities

Capital Stock 5000 Equities (stock) 5000

Net worth 0

Assets Liabilities

Government Balance Sheet

Assets 0 Debt (bonds) 1000

Net worth -1000 -100

Household Balance Sheet Assets Liabilities

Govt bonds 1000

Equities 5000 Net worth 6000

+100

+100

-100

-100

-100

Net effect: +100 in GD → -100 of capital stock

After increasein GD

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r

Capital stock

r = f′(K)

K = W

r0

20K0

r

r = f′(K)

K = WK = W - GD

r0

r1

21K0K1

Capital stock

r

r = f′(K)

K = WK = W - GD

r0

r1

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Loss of NNP

= r ΔK

K0K1

Capital stock

time

ln K, ln GD

ln K

ln GD

ln GD’

ln K’

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time

ln Q, ln C

ln Q

ln (C+G)’

ln Q’

Note that govt spending firstraises (C+G), but then lowers (C+G)’

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ln (C+G)

A word on the open economy

• In open economy:W = K + GD + NFA (NFA = net foreign assets)

• Higher GD reduces (K+NFA)• Therefore, govt. debt displaces domestic K and/or foreign

capital

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The deficit dilemmaSuppose that we increase G by $1.Short run:- Increases Y by mult x 1 = 1.5- Taxes rise by t x 1.5 = 0.5- So deficit and debt rises by 0.5

Long-run:- National saving down by (say) 0.5, decreasing K by 0.5, for

annual loss of r x 0.5 = 0.05 x 0.5 = $0.025 per year- Taxes rise to service debt by (r – g) 0.5 = 0.03 x 0.5 = 0.015 per

year- Dead weight loss on taxes of (say) 50 % = $0.0075 per year

Total:Short run gain of 1.5Long run loss of (0.025 + 0.0075). At discount rate of 5%, = -$0.65Net gain = + $0.85 26

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Conclusions on Fiscal Policy and Economic Growth

• Fiscal policy affects economic growth through impact of government surplus through national savings rate

• Deficits and higher govt debt lowers national saving

• Decreases potential output through:– Lower capital stock for domestic investment– Lower income on foreign assets for foreign

investment in open economy• Consumption (C + G) increases at first and then

declines with the lower growth rate• Deficit dilemma of stimulus package

Readings

David Wessel, In Fed We TrustWilliam Cohen, House of CardsAlessandri and Haldane Banking on the

State (web page)

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