Chapter 14

The Government Budget

2

Introduction

• Static Analysis :

Analysis of how the economy behaves at a given point in time.

• Dynamic Analysis :

The study of how the economy behaves at different points in time.

3

Introduction

• Although static analysis can go a long way toward answering questions that interest economists and policy maker, some issues in macroeconomics are explicitly dynamic.

• The Government Budget

• Neoclassical and Endogenous Growth Theory

• Unemployment, Inflation and Growth

• Rational Expectations

4

Introduction

• The General Theory

- Keynesian economists advocated a policy of stabilization.

if u < u* G↓ ; if u > u* G↑

• Following WWII, the pursuit of these policies made deficits grow as the government found it politically more expedient to increase spending than to raise taxes.

5

Introduction

• Difference equations enable us to know how these deficits accumulated and led to a crisis in the early 1990s that cause the government to raise taxes to balance the budget.

6

The Relationship of Debt and Deficits

• The primary deficit is equal to the value of government expenditures plus transfer payments minus the value of government revenues.

• The reported deficit is equal to the value of the primary deficit plus the value of interest payments on outstanding debt.

1 (1 )t t tB B i D Nominal value of

new government debt

Nominal value

of oustanding

government debt

One plus

the nominal

interest rate

Primary

government

budget deficit

7Table 14.1 ©2002 South-Western College Publishing

8

The Debt and the Deficit

The U.S. evidence-- the government’s budget was on average

approximately balanced from 1940 through 1970.

-- the national debt grew dramatically in the 1980s.

-- policymakers in the mid-1990s were concerned with the debt and the deficit.

9

©2002 South-Western College Publishing

Figure 14.1

The Debt and the Deficit

10

The Debt and the Deficit

• Figure 14.1 overstates how important this problem really was.

• Because the ultimate source of the government’s ability to repay is its ability to tax GDP, the appropriate measures of debt and the deficit of the U.S. are relative to GDP.

-- 1946, WWII

-- 1980, peace time

11©2002 South-Western College PublishingFigure 14.2

The Debt and the Deficit Measured Relative to GDP

12

Using the GDP as a Unit of Measurement

1

1

1 1

1

(1 )

(1 )

(1 )

t t t

t t tN N N

t t t

Nt t t

N N Nt t t

B D i B

B D Bi

Y Y Y

D B Yi

Y Y Y

1

1

1t t

ib d b

n

13

The debt-to-GDP ratio grows for two reasons:

1. The government must issue debt to cover a primary deficit. ( d )

2. The government must pay interest on existing debt.( (1+i)/(1+n) )

1

1

1t t

ib d b

n

Using the GDP as a Unit of Measurement

14

• Suppose that the primary deficit is equal to zero, ( d = 0 )

if i > n the debt-to-GDP ratio will grow.

if i < n the debt-to-GDP ratio will shrink.

1

1

1t t

ib d b

n

Using the GDP as a Unit of Measurement

15

Solving a Difference Equation

• A difference equation describes how a (state) variable that changes over time depends on its own past value and on a number of parameters.

1

1

1t t

ib d b

n

state var. parameters past value

16

Solving a Difference Equation

• The solution to a difference equation is a list of values for the state variable, one for each date in the future, given the initial value of the debt-to-GDP ratio.

• Then we can predict what policy changes are necessary.

• By Iterations.

1

1

1t t

ib d b

n

17

Steady State Solution

• A steady state solution is a value of the state variable that satisfies the government budget equation and that is independent of time.

• Condition :

1

1

1t t

ib d b

n

1t tb b

1 1.

1

i nb d b b d

n n i

18

©2002 South-Western College PublishingFigure 14.3

How To Solve a Difference Equation with a Graph

19

Stable and Unstable Steady State

• If the steady state is stable, the state variable moves closer toward the steady state over time, regardless of where it starts from.

• Conditions :

-- Stable :

-- Unstable :

(1 ) /(1 ) 1i n

(1 ) /(1 ) 1i n

20Figure 14.4A©2002 South-Western College Publishing

Stable and Unstable Steady States

21Figure 14.4B ©2002 South-Western College Publishing

Stable and Unstable Steady States

22©2002 South-Western College Publishing

Figure 14.5

The Nominal Interest Rate and the Nominal Growth Rate in the United States, 1940–2000 (%/Year)

23©2002 South-Western College Publishing

Table 14.2

24

The Sustainability of the Budget Deficit

• 1946-1979 Budget Equation

At the end of WW , debt was equal to Ⅱ120% of GDP.

For 30 years thereafter, the debt-to-GDP ratio fell steadily because i < n.

• d=-1.2%, n=7.5% > i=4.1%,

(1 )

( )0.38 1.2

nb d

n i

tb b

25©2002 South-Western College Publishing

Figure 14.6

The Dynamics of the Budget, 1946–1979

26

The Sustainability of the Budget Deficit

• The Budget Crisis of the 1980s

The Fed raised the interest rate to control inflation through 1993.(monetary policy tightens)

The debt-to-GDP ratio in 1979 was 30%.

• d=0.7%, n=6.8 < i=7.5%,

move farther away from .

tb b

(1 0.068)0.007

(0.068 0.01

75.068 .3

)0b

27©2002 South-Western College Publishing

Figure 14.7

The Dynamics of the Budget, 1979–1993

28

The Sustainability of the Budget Deficit

• The Budget Surplus Since 1993

In 1993, Congress passed the Omnibus Budget Reconciliation Act in an attempt to get deficit under control. (fiscal policy tightens)

The Fed also began to lower the interest rate.

• d=-1.9%, n=5.5% > i=4.9%.

tb b(1 0.055)

( 0.0019)(0.055 0.04

0.334 09)

b

29©2002 South-Western College Publishing

Figure 14.8

The Budget Surplus Since 1993

30

Different Perspectives on Debt and Deficits

• Ricardian Equivalence

- If government spending is financed by debt, household will choose to hold all of this increased debt without reducing the amount of saving that they devote to investments.

- The reason is that they anticipate that they will need extra wealth in the future to pay increased taxes.

31

Different Perspectives on Debt and Deficits

• The relationship between the Budget and the Rate of Interest

After 1979,

- the productivity growth slowed down. ( n↓ )

- the world capital markets are linked and a high deficit in the U.S. influenced the interest rate throughout the world economy. ( i↑ )

- n < i

32

Homework

Question 5, 7, 11, 12

END