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GOVERNMENT DEBT (Continued…):Starting with too little capital,

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Macroeconomics ECO 403
VU
LESSON 36
GOVERNMENT DEBT (Continued...)
Traditional view of govt. debt.
How would a tax cut and budget deficit affect the economy and the economic well-being of the
country?
·  A tax cut stimulates consumer spending and reduces national saving. The reduction in
saving raises the interest rate, which crowds out investment.
·  The Solow growth model shows that lower investment leads to a lower steady-state
capital stock and lower output.
Solow Growth Model
Change in capital stock= investment ­ depreciation
Δk  = i ­ δk
Since i = sf (k), this becomes:
Δk = s f(k) ­ δk
Solow Growth Model
Investment and
Δk = sf (k) - δk
depreciation
δK
sf (k)
Δk
investment
depreciation
k1
k*
Capital per
worker, k
The economy will then have less capital than the Golden Rule steady-state which will
·
mean lower consumption and lower economic well-being.
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Macroeconomics ECO 403
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Starting with too little capital
If K* < K* gold, then increasing c* requires an increase in s.
Future generations enjoy higher consumption, but the current one experiences an initial drop
in consumption.
y
c
i
time
t0
Then we analyze the short-run impact of the policy change via the IS-LM model.
·
A Tax Cut
·
We Have C = C (Y -T)
At any value of r, ↓T⇒↑C ⇒ ↑E ⇒ ↑Y
...so the IS curve shifts to the right. The horizontal distance of the IS shift equals
ΔY = MPC/(1 ­ MPC) ΔT
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Macroeconomics ECO 403
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E =Y
E
E =C2+I (r1 )+G
E =C1 +I (r1 )+G
Y
Y1
Y2
r
r1
ΔY
IS2
IS1
Y
Y1
Y2
Next, we can see how international trade affects this policy change. When national
·
saving falls, people borrow from abroad, causing a trade deficit. It also causes the local
currency to appreciate.
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Macroeconomics ECO 403
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International Trade
S2 ­ I(r*)
ε
S1 ­ I(r*)
ε2
ε1
NX(ε )
NX
NX 1
NX 2
The Mundell-Fleming model shows that the appreciation and the resulting fall in net
·
exports reduce the short-run expansionary effect of the fiscal change.
Mundell-Fleming Model
Y = C (Y - T ) + I (r *) + G + NX (e )
M P = L (r *,Y )
At any given value of e, a fiscal expansion increases Y, shifting IS* to the right. Results: Δe >
0, ΔY = 0
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Macroeconomics ECO 403
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e
LM*1
e2
e1
IS*2
IS*1
Y
Y1
The Ricardian View of Government Debt
·
Forward-looking consumers perceive that lower taxes now mean higher taxes later, leaving
consumption unchanged. "Tax cuts are simply tax postponements."
·
When the government borrows to pay for its current spending (higher G), rational
consumers look ahead to the future taxes required to support this debt.
·
Another view
­  Govt. borrows Rs. 1,000 from a citizen to give him a Rs. 1,000 tax cut (similar to as
giving him a Rs. 1,000 govt. bond as a gift)
­  On one side the government owes him Rs. 1,000 plus interest. On the other side, he
owes Rs. 1,000 plus interest.
­  Overall no change in citizen's wealth because the value of the bond is offset by the
value of the future tax liability
·
General Principal (Ricardian equivalence)
­  Government Debt is equivalent to future taxes
­  If consumers are forward looking, future taxes are equivalent to current taxes
­  So
·
Financing govt. by debt is equivalent to financing it by taxes.
Consumers and Future Taxes
·  The essence of the Ricardian view is that when people choose their consumption, they
rationally look ahead to the future taxes implied by government debt. But, how forward-
looking are consumers?
·  Defenders of the traditional view of government debt believe that the prospect of future
taxes does not have as large an influence on current consumption as the Ricardian
view assumes.
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Macroeconomics ECO 403
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Myopia
·
Ricardian view assumes that people are rational when making decisions. When the govt.
borrows to pay for current spending, rational consumers look ahead to anticipate the future
taxes required to support this debt.
·
Traditional view is that people are myopic, meaning that they see a decrease in taxes in
such a way that their current consumption increases because of this new "wealth." They
don't see that when expansionary fiscal policy is financed through bonds, they will just have
to pay more taxes in the future since bonds are just a tax-postponements.
Borrowing Constraints
·  The Ricardian view assumes that consumers base their spending not only on current but
on their lifetime income, which includes both current and expected future income.
·  Advocates of the traditional view argue that current consumption is more important than
lifetime income for those consumers who face borrowing constraints, which are limits on
how much an individual can borrow from financial institutions.
·  A person who wants to consume more than his current income must borrow. If he can't
borrow to finance his current consumption, his current income determines what he can
consume, regardless of his future income. So, a debt-financed tax cut raises current
income and thus consumption, even though future income is lower.
·  In essence, when a government cuts current taxes and raises future taxes, it is giving tax
payers a loan.
Future Generations
·
According to traditional view of government debt, consumers expect the implied future taxes
to fall not of them but on future generations. This behavior raises the lifetime resources of
the current generation as well as their consumption.
·
In essence, the debt-financed tax cut stimulates the consumption because it gives the
current generation the opportunity to consume at the expense of the next generation
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Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand