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Fiscal Policy
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The overall federal budget
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Deficit
24
Spending/GDP
22
20
18
Revenues/GDP
16
14
60
65
70
75
80
85
90
95
00
05
10
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Structural v Actual Budget
• 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
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Structural and Actual Budget
.04
.02
.00
-.02
-.04
A substantial
part of the deficit
is cyclical.
-.06
Govt surplus/GDP
Cyclically adjusted govt surplus/GDP
-.08
-.10
60
65
70
75
80
85
90
95
00
05
10
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Debt bathtub
Spending
Debt (end of year) = Debt (beginning) + deficit
Debt (beginning of year)
Revenues
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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:
0 << d /dt 
r  g 
interest rate minus
growth rate
 G – T  
 


Y

1

deficit GDP inverse of
ratio
debt-GDP
ratio
CBO, September 2009
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How Quickly the Budget Picture Can Change
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Projected 10-year deficit (trillions)
6
4
2
0
-2
-4
-6
-8
From CBO reports, 1997 2009.
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National saving is falling sharply …
Net national saving and domestic invesment (% of NNP)
14%
Net national savings rate
Net domestic investment rate
12%
10%
8%
6%
4%
2%
0%
1975
1980
1985
1990
1995
2000
2005
-2%
Data from BEA.
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Current projection of debt/GDP
10
Long-term projection of debt/GDP
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What is responsible for the fiscal problem?
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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]
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Preliminary Considerations
1.
2.
3.
4.
5.
6.
Deficits (and therefore higher debt) may be necessary to stabilize the
business cycle (particularly in liquidity trap situations).
However, burden and impact of debt should be considered in longrun. Impacts on AD can be offset by fiscal and monetary policy.
One cost of debt is the efficiency losses (deadweight losses) from
higher taxation (micro/public finance)
Ricardian debt theory holds that people offset it in saving (next slide)
Don’t blame it on the Chinese! (next week)
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 i
3. 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.
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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
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Before
increase
in GD
Firm Balance
Sheet
Assets
Capital Stock
5000
Liabilities
Equities (stock)
5000
Net worth
Government
Balance Sheet
Assets
Assets
Liabilities
0
Debt (bonds)
Net worth
Household
Balance Sheet
Assets
Equities
0
1000
-1000
Liabilities
5000
Govt bonds 1000
Net worth
6000
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After
increase
in GD
Firm Balance
Sheet
Assets
Capital Stock
5000
Liabilities
-100
Equities (stock)
5000 -100
Net worth
Government
Balance Sheet
Assets
Assets
Liabilities
0
Debt (bonds)
Net worth
Household
Balance Sheet
1000
+100
-1000 -100
Liabilities
Assets
5000
-100
Govt bonds 1000
+100
Equities
0
Net effect: +100 in GD → -100 of capital stock
Net worth
6000
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r
K=W
r0
r = f′(K)
K0
Capital stock
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r
K = W - GD
K=W
r1
r0
r = f′(K)
K1
K0
Capital stock
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r
K = W - GD
K=W
r1
r0
r = f′(K)
Loss of
NNP
= r ΔK
K1
K0
Capital stock
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ln K, ln GD
ln K
ln K’
ln GD’
ln GD
time
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ln Q, ln C
ln Q
ln Q’
ln (C+G)
ln (C+G)’
Note that govt spending first
raises (C+G), but then lowers (C+G)’
time
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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 dilemma
Suppose 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 1.5
Long run loss of (0.025 + 0.0075). At discount rate of 5%, = -$0.65
Net gain = + $0.85
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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
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Readings
David Wessel, In Fed We Trust
William Cohen, House of Cards
Alessandri and Haldane Banking on the State (web
page)
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