LECTURE 19: GOVERNMENT & THE MACROECONOMYOLGA DENISLAMOVA

INTRODUCTION

¡ In this lecture, we learn about

¡ government spending, taxation, budget deficits, and the debt-GDP ratio.

¡ the government’s intertemporal budget constraint.

¡ the economic consequences of budget deficits.

¡ the fiscal problem of the twenty-first century: how to finance rising health expenditures.

GOVERNMENT SPENDING AND REVENUE

¡ The budget balance

¡ The difference between tax revenues and spending

¡ A budget surplus

¡ Tax revenues > Spending

¡ A budget deficit

¡ Tax revenues < Spending

¡ The government must borrow by selling bonds.

¡ A balanced budget

¡ Tax revenues = Spending

THE U.S. FEDERAL GOVERNMENT BUDGET, 2018

U.S. FEDERAL GOVERNMENT REVENUE AND SPENDING

THE DEBT-GDP RATIO

¡ Government debt¡ The outstanding stock of bonds that have been issued in the past

¡ In 2005¡ The debt-GDP ratio was just over 35 percent.

¡ In 2018¡ The debt-GDP ratio rose to nearly 80 percent.

¡ Half of the debt is owed to foreigners.

¡ The net debt:¡ Government debt that is held outside of the government

¡ In 2018, including debt held by the government, total debt-GDP was more than 100 percent.

FEDERAL DEBT AND DEFICITS IN THE UNITED STATES

INTERNATIONAL EVIDENCE ON SPENDING AND DEBT

¡ Among the richer OECD countries, the United States has a lower than average

¡ government spending-to-GDP ratio (38 percent).

¡ debt-GDP ratio.

¡ Norway

¡ Negative debt-GDP ratio

¡ Saves its surpluses

THE GOVERNMENT BUDGET CONSTRAINT

¡ The flow version of the government budget constraint holds in each period.

¡ The sources of funds to the government must equal the uses of funds.

Government purchases

Transfer payments

Interest payments on debts

Taxes New borrowingChange in the money stock

THE GOVERNMENT BUDGET CONSTRAINT

¡ Assume for this chapter¡ The change in the stock of money is zero.

¡ Transfer payments are zero.

¡ Therefore:

¡ The primary deficit:¡ It excludes spending on interest.

¡ The total deficit:

THE INTERTEMPORAL BUDGET CONSTRAINT—1

¡ Suppose an economy exists for only two periods.

¡ The budget constraint for period 1 is:

¡ The budget constraint for period 2 must equal zero:

¡ Why?

THE INTERTEMPORAL BUDGET CONSTRAINT

¡ Substitute the budget constraint for period 2 into period 1:

¡ Uses must equal sources, in PDV

THE INTERTEMPORAL BUDGET CONSTRAINT

¡ Collect the tax and spending terms on the same side of the equation:

¡ The government’s budget must balance.

¡ It balances not period by period, but in PDV.

¡ The government must have surpluses in the future to pay off deficits today.

INFINITELY-LIVED GOVERNMENTS AND PERMANENT DEFICITS

¡ In 2-period world, deficit today means surplus tomorrow

¡ 2-period simplification makes sense in context of finitely lived agents (e.g. in neoclassical consumption model)

¡ Governments, however, are infinitely-lived (barring revolutions, etc.)

¡ Suppose B3 (and B4…) can be nonzero. Can an infinitely- lived government run a permanent deficit?

INFINITELY-LIVED GOVERNMENTS AND PERMANENT DEFICITS

¡ Suppose that, instead of assuming B3=B4=…=0, we impose a weaker restriction:

¡ government debt as a fraction of GDP must not grow or:

¡ Suppose this constraint is binding, i.e., holds with equality:

¡ Assume for simplicity that GDP grows at a constant rate g, (Solow- Romer steady state growth rate, for example)

INFINITELY LIVED GOVERNMENTS AND PERMANENT DEFICITS

¡ Divide all terms by Yt

¡ Multiply and divide left-hand side by Yt+1

¡ Rearrange LHS:

INFINITELY-LIVED GOVERNMENTS AND PERMANENT DEFICITS

¡ Use out assumption of “government borrowing constraint:”

¡ Re-arrange:

INFINITELY-LIVED GOVERNMENTS AND PERMANENT DEFICITS

¡ Is a permanent deficit possible?

¡ If GDP growth rate is greater than nominal interest rate, we can run primary deficit (G>T) forever, and still keep debt/GDP constant!

¡ Note that debt is still growing, just at same rate as GDP

¡ But if GDP growth rate is lower than interest rate, must run primary surplus