Someone recently bought our

students are currently browsing our notes.


Debt And Fiscal Policy Notes

Economics Notes > Macroeconomics Notes

This is an extract of our Debt And Fiscal Policy document, which we sell as part of our Macroeconomics Notes collection written by the top tier of University Of Oxford, Balliol College students.

The following is a more accessble plain text extract of the PDF sample above, taken from our Macroeconomics Notes. Due to the challenges of extracting text from PDFs, it will have odd formatting:

Debt and Fiscal Policy
- Theories of public debt with critiques of Ricardian equivalence and how it actually works in practice
- Theory of tax smoothing
- Theories of public debt with budget deficits, debt accumulation and delated stabilization
- Costs of deficits
- Fiscal councils-What is fiscal policy:
o Decisions the government makes about taxation and redistributing that money

Why does fiscal policy play a role: needs to be used to meet certain government requirements eg.
Income distribution, resource allocation, provision of public goods

Discretionary policy for stabilisation: still widely used as a stabilisation tool eg. Coordinated fiscal stimulus programmes widely used during the GFC. Could be particularly important when MP limited eg. At ZLB
o Automatic stabilisers: in times of strife, automatically a fiscal spending increase because social spending will go up and tax burdens reduced. Also means budget deficit automatically enlarges when there's a recession

Debt: affects burden of debt = big downside of discretionary fiscal policy. Advanced countries tend to have ageing populations + rising health costs = increasing debt ratio.
Ricardian equivalence:
o Links to PIH - how will effects of fiscal policy change if households are rational and fully forward looking

Assume households RE and fully forward looking = they internalise the gov's intertemporal budget constraint

Model economy over infinite time horizon - households indifferent between taxes now and in future

Depends on assumptions:
 No credit constraints
 Households and gov face same rates
 Households have children and incorporate them into utility (last forever)
 If gov borrowing cheaper than household, or households more myopic = place more weight on their own utility, they will prefer gov to finance through borrowing rather than higher current taxation
Effects of discretionary fiscal policy

 Relationship between change in gov spending and change in output - short-run Keynesian multiplier is greater than 1
 The larger the multiplier, the greater the argument for continuing with stimuli during recessions rather than austerity
 Eg. Deep recession: CB can't use MP due to ZLB, gov can use fiscal stimulus package to shift up IS curve, so then can gradually reduce it to move economy back to inflation and output at target = new medium-run equilibrium where gov spending up and private sector spending down = benefit of stabilising private sector expectations
 But outcome could be different: effect of G depends on context, model and behaviour of CB.
In economy with spare capacity, gov can boost output and AD = welfare enhancing.
However, if economy at equilibrium and CB keeps r unchanged, economy will end up at new
MRE with inflationary bias and debt

Effects of fully tax-financed expenditure:
 Depends on relative marginal propensities to consume between groups it would redistribute funds between eg. Redistributing spending power from taxpayers to those who provide goods and services. If same marginal propensity to consume, then multiplier of 1 between amount of gov spending and change to output, as aggregate consumption remains unchanged. If MPCs different, 'balanced budget multiplier', could raise AD
 With RE: if people consumption smooth, will still lead to permanent income, just a lower one due to the taxation
 Ramer (2011): size of multiplier depends on the country. Larger in developed than developing (more waste in developing, less efficient). Larger in closed economies (leaks of -AD in open). Large with fixed excnage rates but zero in flexible (MP offsets effect of fiscal stimulus). Neg multiplier in high debt countries due to anticipated macro effects
Automatic stabilisers:
o Cyclically adjusted budget deficit - shows what deficit would be if economy at equilibrium. So if current deficit above/below, this indicated where we are in business cycle

Larger gov spending = larger automatic stabilisers = less discretionary fiscal policy necessary

Stock of gov bonds that have been sold to private sector in the past

Budget deficit = money spent on interest on debt

Primary deficit = difference between gov spending and tax revenue

Financial crisis undermined certainty govs would repay their debts and keep paying the interest,
there's now sovereignty default risk

Does high debt matter?
 Unless RE holds, gov debt crowds out productive capital in the long-run, implies higher interest rates and therefore lower output. It would crowd out if higher debt didn't lead to an equal rise in private savings, which it would if there was RE and so private sector anticipated that increased spending now = higher taxes later so saved to pay for these
 Gov may choose to default if political costs associated with raising taxes or cutting spending are too high - gov may also be forced to default if it is unable to refinance existing debt or
'roll over', as market will no longer lend to it. CB can act as lender of last resort in this situation, problem in Eurozone as ECB refused to do this

Why is there a deficit bias:
 Tendency for deficits to rise during recessions, but not fall in a sufficiently offsetting way during booms = gov prefers to finance through borrowing rather than taxation

Normative theories of public debt:
- Ricardian Equivalence: given a stream of government spending, rational intertemporal people know tax cut today = tax increase in future, so unless stream of public spending changes, consumption won't change.
Financing by taxes or debt should make no difference

Budget constraints:
 Basic idea is that consumption smoothing means that consumption will drop by less than output drops, so savings drops to account for consumption not dropping as much
(investment drops)
 Consumers/households: d(B+E)/dt = r (B+E) +Y - T - C with initial bond holdings B(0) and initial equity holdings E(0) given (B + E is bonds + equity = financial assets)
 Government: dB = r B + G - T with initial debt B(0) given
 Integrate these from future back to the present with no-Ponzi-games condition = the corresponding present-value budget constraints
 Consumers present-value budget constraint is: PVt[C] £ financial assets + human wealth
= At + PVt(Y - T) with At = Et + Bt and PVt Y)= òt¥ exp(-r(s-t))Y(s)ds
 Government's present-value budget constraint is:
PVt[T] ³ net liabilities = Bt + PVt[G]
 Consumer present-value budget constraint thus becomes:
PVt[C)] £ Et + PVt[Y - G]
 With logarithmic utility, consumption grows at rate equal to rate of interest r minus rate of time impatience r > 0, so PVt[C] = Integralt ®¥[exp(-rt) Ct exp((r-r)t)] = Ct/r
 Given this, optimal aggregate consumption becomes: Ct = p(Et + PVt[Y-G])
Any increase in public spending, G, must lead to some crowding out of private spending, C
 Therefore, timing of taxes does not affect the household budget constraint and does not affected consumption - irrelevant whether public spending is financed by current taxes or by debt (= future taxes). If public sector, G, is minimised in future, so tax cut comes from a real reform program to public spending, then the private sector will react and increase consumption
 Rational households would anticipate that a tax cut will be followed in the future by a tax hike - however, if they anticipate that it is followed by a reduction in the size of the public sector, consumption will be cut an equivalent amount Does it hold:
 Households may not exist in the future to benefit from future tax cuts or deal with the burden of future tax hikes (if they are not dynastic, no operational bequest motive) -
Blanchard 1985. Birth of new generations may help to shoulder the burden of future taxes,
so if birth rate is rising, temporary tax cuts may boost consumption, depends on population of old versus young
 If financial markets are underdeveloped the RE less valid eg. If individuals are credit constrained then they can't borrow now even if future income is expected to be higher. Tax hike implies households must borrow against the anticipation of lower rates in the future,
but may not be able to do this or can only do it at an interest rate premium
 Path of public spending affected by costs and benefits - a temporary tax cut financed by bond issue implies higher taxes in the future, meaning future primary spending, G, may need to be lower
 Distorting taxes: tax rate might affect labour supply, so tax cut decreases labour supply which reduces the share of taxes gov gets
 Imperfect information: households unaware that a current tax cut for the given time path of
G will lead to a future tax hike
 Imperfect insurance markets - bird-in-hand problem
 If interest rate, r, and economic growth, y, are not exogenous
 Public spending hikes are crowd funded - from a present value perspective any hike in public spending leads to a corresponding fall in private consumption. Due to intertemporal consumption smoothing private consumption will fall by the permanent increase in public spending
Debt Dynamics: Thatcher tried to use lump-sum taxes, same tax rate for all, which did not work.
o Each period: government finances expenditure plans and pays interest on the government debt

To finance expenditure: government can tax, sell new bonds or print money

Government's Budget Identity:
oo o

Exclude the possibility that the government can borrow from the central bank, so the change in H=0
Government deficits and debt:


Gamma term makes sense - if GDP grows faster than growth rate then it won't rise as much.
If you have outstanding government debt, you need primary surplus because D will be negative, so you need sufficient surplus to finance interest on borrowing, otherwise debt would rise indefinitely
Government deficits and debt as a % of GDP: o

Real interest rate > growth rate = unstable


Greece Example:
 Greece prior to 2007: Growth rate > real interest rate

High GDP growth rate (5.5% in 2006), had access to borrowing at low interest rates (barely above German bunds). So b = 107% GDP
Greece in 2007-2009:

Government reacted to the financial crisis and recessions with fiscal expansion - primary deficit increases from -2% to -10.4%, b increases to 129% of GDP
Greek crisis: 2009-2010

Greek Doubt about Greek statistics on public debt, government budget deficit and GDP
growth rate, so a change in market sentiment leads to higher borrowing costs.
Remedy: Largest fiscal consolidation in the developed world over such a short period, 10.4%
GDP over 3 years

Buy the full version of these notes or essay plans and more in our Macroeconomics Notes.