Download ch08

CHAPTER 14
The Budget Balance, the National
Debt, and Investment
14-1
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• From the standpoint of analyzing
stabilization policy, what is the best
measure of the government’s budget
balance?
• From the standpoint of analyzing the
effect of changes in the national debt
on long-run growth, what is the best
measure of the government’s budget
balance?
14-2
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• What is the typical pattern America’s
debt follows over time?
• How has recent experience in the
past generation deviated from this
traditional pattern of debt behavior?
• What are the reasons that we should
worry about a rising national debt?
• What are the reasons that we
shouldn’t worry too much about a
rising national debt?
14-3
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Debt & Deficits
• The national debt (D) is the amount
of money that the government owes
those from whom it has borrowed
– when government spending < tax
revenues, the difference is the
government surplus (-d)
• the national debt falls by d
– when government spending > tax
collections, the difference is the
government deficit (d)
• the national debt rises by d
14-4
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Debt & Deficits
• Economists are interested in the debt
and the deficit for two reasons
– the deficit is an index of how government
spending and tax plans affect the IS
curve
– the debt and deficit are closely connected
with national savings and investment
• a rising debt tends to depress capital
formation
• a high national debt means that future taxes
will have to be higher to pay interest charges
14-5
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Deficit & the IS Curve
• An increase in government purchases
or a decrease in taxes increases
aggregate demand
– the IS curve shifts out
• The appropriate measure of fiscal
policy is the full-employment
deficit (or surplus)
– it measures what the government’s
budget balance would be if the economy
was at full employment
14-6
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 14.1 - An Increase in the FullEmployment Deficit Shifts
the IS Curve Outward
14-7
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Measuring the Budget Balance
• The government budget balance
reported in the news is generally the
unified cash balance
– the difference between the money the
government actually spends in a year and
the money it takes in
– unifies all of the government’s accounts
and trust funds
– doesn’t take account of changes in the
value of government-owned assets or
future liabilities
14-8
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Measuring the Budget Balance
• The full-employment budget balance
is a better index than the unified cash
balance
– the cash budget balance can change even
when there is no change in government
policy to shift the IS curve
• tighter monetary policy raises interest rates
and lowers real GDP and tax collections
– we must adjust the cash balance deficit
(surplus) for the automatic fiscal
stabilizers
14-9
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 14.2 - A Fall in Real GDP
14-10
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 14.3 - The Full-Employment and the
Cash Budget Deficit
14-11
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Inflation
• A good measure of the deficit should
be a measure of whether the
government is spending more in the
way of resources than it is taking in
– we should correct the officially-reported
cash budget balance for inflation
– the real deficit (dr) is related to the cash
deficit (dc) by
r
c
d  d - D
14-12
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 14.4 - The Cash Balance and the
Inflation-Adjusted Budget Balance
14-13
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Public Investment
• Private spending on long-lived assets
is called investment
– standard accounting treatment of longlived assets is to spread out their costs
over their useful lives (amortization)
• The government spends money on
long-lived assets
– shouldn’t the government amortize these
assets?
• which government expenditures are capital
expenditures?
14-14
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Liabilities & Generational
Accounting
• The correct way to count the
government’s debt is to look at all of
its promises to pay money out in the
future
– this system is called generational
accounting
• it would examine the lifetime impact of taxes
and spending programs on individuals born in
specific years and would come up with a
balance that could be used for long-term
planning
14-15
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Steady-State Debt-toGDP Ratio
• Fiscal policy is sustainable if the debtto-GDP ratio (D/Y) is heading for a
steady state
– D and Y must be growing at the same
proportional rate
• Y grows at a proportional rate equal to the
sum of the annual rate of growth of the labor
force (n) and the annual rate of growth of
labor efficiency (g)
growth rate of Y  n  g
14-16
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Steady-State Debt-toGDP Ratio
• The debt next year will be equal to
Dt 1  (1 - )Dt  d
• Since tax revenues and spending grow
with real GDP, it makes sense to focus
on the deficit as a share of GDP
(=d/Y)
14-17
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Steady-State Debt-toGDP Ratio
• The proportional growth rate of the
debt is
 Yt 
Dt 1 - Dt
 -     
Dt
 Dt 
14-18
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Steady-State Debt-toGDP Ratio
• The debt-to-GDP ratio will be stable
when this proportional growth rates of
the debt and GDP are equal
n  g  -    (Y/D)
D


Y ng 
14-19
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Steady-State Debt-toGDP Ratio
• Example
– growth rate of labor force (n) = 2%
– growth rate of output/worker (g) = 1%
– inflation rate () = 5%
D

4%
1



Y n  g   2%  1%  5% 2
– if the current debt-to-GDP ratio<1/2, the
debt-to-GDP ratio will rise
– if the current debt-to-GDP ratio>1/2, the
debt-to-GDP ratio will fall
14-20
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Sustainability
• The higher the debt-to-GDP ratio, the
more risky an investment do
financiers judge the debt of a country
– if the government changes hands, the
new government must decide whether to
honor the debt issued by previous
governments
– the government can lower the real value
of its debt by increasing the rate of
inflation
14-21
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Sustainability
• A deficit is sustainable only if the
associated steady-state debt-to-GDP
ratio is low enough that investors
judge the debt safe enough to be
willing to hold it
• If a government’s has too much debt
to be considered safe, the interest
rates it must pay will rise dramatically
– the government will then be faced with a
larger deficit (because of interest costs)
14-22
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Debt-to-GDP Ratio in
the U.S.
• The typical pattern the U.S. has
followed is one of sharp spikes in the
debt-to-GDP ratio during wartime,
followed by the paying-off of the debt
during peacetime
– the greatest peaks in the debt-to-GDP
ratio occurred after the Civil War, World
War I, and World War II
– the debt-to-GDP ratio also rose during
the Great Depression and the Reagan and
Bush presidencies
14-23
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 14.5 - U.S. Debt-to-GDP Ratio Since
the Revolutionary War
14-24
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 14.6 - Federal Revenues and
Expenditures as Shares of National Product
since the Civil War
14-25
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Effects of Deficits
• A deficit can have three significant
effects on the economy
– it may affect the political equilibrium that
determines the government’s tax and
spending levels
– it may affect the level of real GDP in the
short run (if the central bank allows it)
– it will affect the level of real GDP in the
long run
14-26
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Political Consequences
• The possibility of financing
government spending through
borrowing makes the government less
effective at advancing public welfare
– the benefits from higher government
spending today are clear and visible to
voters
– the costs of higher taxes in the future are
distant and excessively discounted
14-27
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Political Consequences
• Since the 1980s, some have argued
for deficits created by tax cuts
– in this view, the political system delivers
steadily-rising government spending
unless it is placed under pressure to
reduce the deficit
– thus, the only way to avoid an evergrowing inefficient government share of
GDP is to run a constant deficit that
politicians feel the need to try to reduce
14-28
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Short-Run Consequences
• A deficit produced by either a cut in
taxes or an increase in government
spending raises aggregate demand
and shifts the IS curve to the right
– if monetary policy is unchanged, output
and employment will rise
– if the Federal Reserve does not want
inflation to rise, it will respond by raising
interest rates, neutralizing the
expansionary effect of the deficit
14-29
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Open-Economy Effects
• An increase in the government’s
budget deficit also leads to an
increase in the trade deficit
– the outward shift of the IS curve pushes
interest rates up
– higher interest rates mean an
appreciated dollar
– imports rise and exports fall
14-30
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Long-Run Effects
• Higher full-employment deficits lead
to low investment
– a deficit shifts the IS curve out, leading
to lower national savings, higher real
interest rates, and lower investment
• Low investment reduces capital
accumulation and productivity growth
– puts the economy on a lower steadystate growth path
14-31
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 14.7 - Higher Full-Employment
Deficits Reduce Investment
14-32
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Long-Run Effects
• If the deficits continue for long, they
will affect the economy’s capital
intensity
• A lower steady-state capital-output
ratio implies a lower level of output
per worker for any given level of the
efficiency of labor
14-33
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 14.8 - Long-Run Effects of Persistent
Deficits on Economic Growth
14-34
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Long-Run Effects
• A higher deficit also implies a higher
debt, which means that the
government owes more in the way of
interest payments to bondholders
– over time, the increase in interest
payments will require tax increases
– these tax increases will discourage
entrepreneurship and economic activity
14-35
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The U.S. is usually a moderate-debt
country
– the level of national debt with which
politicians and voters are comfortable is
not large relative to the debts of other
countries
– only immediately after total wars does
the U.S. national debt reach a high value
relative to real GDP
14-36
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The 1980s and 1990s, however, saw
steep rises in the national debt-unprecedented rises in peacetime
– the era of deficits is now at an end
– The United States’ national debt is
significantly below the level at which
economists begin serious worrying about
the consequences of the debt for the
health of the economy
14-37
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• From the standpoint of analyzing
stabilization policy, the best measure
of the government’s stance is the fullemployment deficit
– the full-employment deficit is not a bad
measure of the net effect of government
policy on the location of the IS curve
14-38
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• From the standpoint of analyzing the
effect of changes in the national debt
on long-run growth, the debt and
deficit need to be adjusted for
inflation and government investment
– a third adjustment--for outstanding
government liabilities--has been
proposed and has some very attractive
features, but is not usually used
14-39
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Persistent deficits--a rising national
debt--threaten to diminish national
savings, reduce the level of output per
worker along the economy’s steadystate growth path, and retard
economic growth
14-40
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Past deficits--a high current debt-toGDP ratio-- threaten to reduce
national prosperity because the higher
taxes required to service the national
debt act as a drag on economic
activity
14-41
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.