ECOS3997
Interdisciplinary Impact in Economics
Stream 4: Implications of Macroeconomic Policies
Lecture 8: Implications and Current Issues
of Fiscal policy
Semester 2, 2023
1
This lecture
• Fiscal policy: Summing up
• Dynamics of government debt
– Dynamics of deficits and debt
– Problems with high public debt
• Applications
– Ricardian equivalence
• Reading:
• Blanchard chapter 22
• Mankiw chapter 17
2
Fiscal policy: Summing Up
3
Fiscal policy: Summing Up
• In most advanced economies, the crisis has led to large
budget deficits and a large increase in debt-to-GDP ratios.
• This calls for governments to reduce deficits, stabilize the
debt, and reassure investors.
• The purpose of this lecture is
– to review what we have learned about fiscal policy so far
– to explore in more depth the dynamics of deficits and debt
– to shed light on the problems associated with high public debt
4
Fiscal policy in the short-run
• Economy in the short-run:
– output primarily driven by movements in aggregate demand
– unemployment is negatively related to output
– many prices are sticky (not fully flexible)
• Types of fiscal policy:
– Fiscal contraction, decrease in G and/or increase in T
– Fiscal expansion, increase in G and/or decrease in T
• Fiscal policy affects the position of IS curve, still affects
financial markets through money demand
5
Fiscal policy in the short-run
• Fiscal policy, output, and unemployment
– fiscal expansion increases output, decreases unemployment
– fiscal contraction decreases output, increases unemployment
• Fiscal policy, output, and interest rate
– fiscal contraction leads to lower disposable income
– households decrease consumption
– decrease in demand leads to a decrease in output and income
through a multiplier
– decrease in the policy rate by the central bank can potentially
offset the adverse effects of the fiscal contraction
6
Fiscal policy in the short-run
• Increase in taxes (contractionary fiscal policy) shifts IS curve to the left,
making output ↓, unemployment ↑
7
Fiscal policy in the medium-run
• When the economy is in a liquidity trap,
– a reduction in the interest rate can no longer be used to
increase output
– fiscal policy (i.e., large increases in spending and tax cuts) has
an important role to play
• In the medium-run (that is, taking the capital stock as given),
– a fiscal consolidation has no effect on output
– but is reflected in a different composition of spending
8
Fiscal policy in the medium-run
• Medium run equilibrium: inflation stable, (πt = πt−1), and
shocks at their mean values (εt = vt = 0)
• Because of adaptive expectations, this implies inflation
expectations also stable
Et(πt+1) = πt = πt−1 = Et−1(πt)
• Phillips curve implies output at natural level: Yt = Y¯
• Demand for goods implies real rate at natural rate: rt = ρ
• Fisher equation then implies: it = ρ+ πt
• Monetary policy rule then implies: πt = π∗
9
Fiscal policy in the long-run
• Economy in the long-run:
– trend growth dominates (cf. fluctuations dominate in the
short and medium-run)
– long-run growth is driven by supply-side considerations
– prices are flexible
• Saving (both private and public) affects the level of capital
accumulation and the level of output in the long run
• Once capital accumulation is taken into account, a larger
budget deficit leads to a lower level of output in the long run
– lower national saving rate decreases capital accumulation
10
Fiscal policy and expectations
• Returning to the short-run effects of fiscal policy
• Considering not only fiscal policy’s direct effects through
taxes and government spending, but also its effects on
expectations
• Effects of fiscal policy depend on
– expectations of future fiscal policy
– deficit reduction leads to
• people’s expectations of higher future disposable income
• an increase in output even in the short-run
11
Fiscal policy and open economy
• Fiscal policy affects both output and the trade balance
– fiscal expansion at home reduces national saving, net capital
outflow, and the supply of domestic currency in the exchange
market ⇒ ϵ ↑, NX ↓ (i.e., trade deficit)
• The effects of fiscal policy depend on the exchange rate
– fiscal policy has a stronger effect on output under fixed
exchange rates than under flexible exchange rates
– e.g., fiscal expansion at home
• would raise the exchange rate (if under flexible exchange rate)
• To fix the exchange rate, the central bank increases Ms
• resulting in a higher level of output in the equilibrium
12
Fiscal policy under fixed exchange rates
• Exchange rate fixed at e1 (i.e., ∆ϵ = 0)
• output increases from Y1 to Y2 (i.e., ∆Y > 0)
13
Fiscal policy under floating exchange rates
• Exchange rate increases from e1 to e2 (i.e., ∆ϵ > 0)
• output fixed at Y1 (i.e., ∆Y = 0)
14
Dynamics of government debt
15
Government spending in Australia
• Source: Australian government, Budget strategy and outlook
• Social security and welfare is the largest functional expenditure
16
Trends in expenditure
• Source: Australian government, Budget strategy and outlook
• Prior to 2019-2020, average around 25%. During pandemic, expenditure
grew up to 34.4%
17
Government revenue in Australia
• Source: Australian government, Budget strategy and outlook
• Personal income tax is the major components of government revenue
18
Trends in revenue
• Source: Australian government, Budget strategy and outlook
• Significantly lower revenue during economic crises
19
Government budget constraint
• The budget deficit (inflation-adjusted deficit)
Deficitt = rBt−1︸ ︷︷ ︸
real interest payments
+ Gt − Tt︸ ︷︷ ︸
taxes net of transfers
(1)
– where
r: real interest rate, Bt−1: government debt at the end of year
t− 1, Gt: government spending, Tt: taxes
– Government budget deficit equals to spending, including
interest payments on the debt, minus taxes net of transfers
20
Government budget constraint
• Government budget constraint
Bt −Bt−1︸ ︷︷ ︸
change in debt
= rBt−1︸ ︷︷ ︸
interest payments
+ Gt − Tt︸ ︷︷ ︸
primary deficit
(2)
– The change in government debt during year t equals
the deficit (i.e., RHS) during year t
– or equivalently, Tt −Gt: primary surplus
– If the government runs
• a deficit, government debt ↑ as the govt borrows to fund the
part of spending in excess of revenues
• a surplus, government debt ↓ as the government uses the
budget surplus to repay part of its outstanding debt
21
Government budget constraint
• Then, government budget constraint could be rewritten as
Bt = (1 + r)Bt−1 + (Gt − Tt)︸ ︷︷ ︸
primary deficit
(3)
• This relation states that
– debt at the end of year t equals (1 + r) times the debt at the
end of year t− 1 plus primary deficit during year t
22
Government budget constraint
• Some of implications
– Consider first a one-year decrease in taxes for the path
of debt and future taxes
– Suppose the government has balanced budget, Gt = Tt,
so that initial debt (i.e., Gt − Tt) is equal to zero
– During year 1, the government decreases taxes by 1 for
one year
– Thus, debt at the end of year 1, B1 is equal to 1
– What happens thereafter?
23
Full repayment in year 2
• Suppose the government decides to fully repay the debt
during year 2
• From equation (3), Bt = (1 + r)Bt−1 + (Gt − Tt), the budget
constraint for year 2 is given by
B2 = (1 + r)B1 + (G2 − T2)
• If the debt is fully repaid during year 2, then the debt at the
end of year 2 is equal to zero, B2 = 0. Replacing B1 by 1 and
B2 by 0,
0 = (1 + r) ∗ 1 + (G2 − T2)
T2 −G2 = (1 + r) ∗ 1
= 1 + r
24
Full repayment in year 2
• To repay the debt fully during year 2,
– the government must run a primary surplus equal to 1 + r
• Two ways to make a primary surplus
1- decrease in spending
2- increase in taxes
• Suppose that adjustment comes through taxes. Then, the
decrease in taxes by 1 during year 1 must be offset by an
increase in taxes by 1 + r during year 2
25
Full repayment in year t
• Now suppose the government decides to wait until year t to
repay the debt.
• From year 2 to t− 1, the primary deficit is equal to zero:
taxes are equal to spending.
• Step 1: From equation (3), Bt = (1 + r)Bt−1 + (Gt − Tt) and
the equality condition B1 = 1, debt at the end of year 2 is
B2 = (1 + r)B1 + (G2 − T2)
= (1 + r)B1 + 0
= (1 + r) ∗ 1
= 1 + r
26
Full repayment in year t
• Now suppose the government decides to wait until year t to
repay the debt.
• From year 2 to t− 1, the primary deficit is equal to zero:
taxes are equal to spending.
• Step 2: With the primary deficit still equal to zero, debt at
the end of year 3 is
B3 = (1 + r)B2 + (G3 − T3)
= (1 + r)B2 + 0
= (1 + r) ∗ (1 + r)
= (1 + r)2
27
Full repayment in year t
• Now suppose the government decides to wait until year t to
repay the debt.
• From year 2 to t− 1, the primary deficit is equal to zero:
taxes are equal to spending.
• Step 3: Solving for debt at the end of year 4 and so on, debt
grows at a rate equal to the interest rate (as long as the
government keeps a primary deficit equal to zero)
Then the debt at the end of year t1 is given by
Bt−1 = (1 + r)t−2 (4)
28
Full repayment in year t
• The equation (4) Bt−1 = (1 + r)t−2 implies that
– Even though taxes are cut only in year 1, debt keeps
increasing over time, at a rate equal to the interest rate.
– Although the primary deficit is equal to zero, debt is now
positive, and so are interest payments on it.
• Final step: what happens in year t?
29
Full repayment in year t
• Step 4: In year t, government decides to repay the debt.
Then,
Bt = (1 + r)Bt−1 + (Gt − Tt)
0 = (1 + r)(1 + r)t−2 + (Gt − Tt)
which implies
Tt −Gt = (1 + r)t−1 (5)
– To repay the debt, the government must run a primary surplus
equal to (1 + r)t−1
– Initial decrease in taxes of 1 during year 1 leads to an increase
in taxes of (1 + r)t−1 during year t
30
Full repayment in year t
• Important implications from debt repayment
1- If government spending is unchanged, a decrease in taxes must
eventually be offset by an increase in taxes in the future.
• Assumption: the adjustment comes through taxes
2- The longer the government waits to increase taxes, or the
higher the real interest rate is, the higher the eventual increase
in taxes must be.
31
Tax cuts and debt repayment
• Decrease in taxes in year 1 offset by increase in taxes by 1 + r in year 2
• Debt grows at a constant rate of interest, decrease in taxes offset by
increase in taxes of (1 + r)t−1 in year t
32
Current issues about government debt
• The legacy of past deficits is higher government debt today
• To stabilize the debt, the government must eliminate the
deficit.
• To eliminate the deficit,
– the government must run a primary surplus equal to the
interest payments on the existing debt
– this requires higher taxes forever.
33
Debt-to-GDP ratio
• Indebtness of the world’s governments
– So far, focus is on the evolution of the level of debt
– Debt as a % of income (or GDP)
• Debt to GDP ratio using equation (4)
Bt
Yt
= (1 + r)
Bt−1
Yt
+
Gt − Tt
Yt
= (1 + r)
(
Yt−1
Yt
)
Bt−1
Yt−1
+
Gt − Tt
Yt
Assume that output Y grows at g, then
Bt
Yt
= (1 + r − g)Bt−1
Yt−1
+
Gt − Tt
Yt
34
Debt-to-GDP ratio
• Reorganize the previous equation, we get
Bt
Yt
− Bt−1
Yt−1︸ ︷︷ ︸
change in debt ratio
= (r − g) ∗ Bt−1
Yt−1︸ ︷︷ ︸
initial debt ratio
+
Gt − Tt
Yt︸ ︷︷ ︸
primary deficit to GDP
(6)
• This implies that ↑ in the debt to GDP ratio will be larger
– the higher the real interest rate, r
– the lower the growth rate of output, g
– the higher initial debt ratio
– the higher the ratio of the primary deficit to GDP
35
Indebtedness of the world’s economy
• Source: OECD Economic outlook, no. 96 (November 2014)
• Debt-to-GDP ratio (net financial liabilities as % of GDP) in year 2016
36
Debt-to-GDP trend in Australia
• Source: FRED, Central government debt, total (% of GDP)
37
The dangers of high debt
• Today, debt is indeed high in many advanced economies,
often in excess of 100% of GDP
• When a government finds itself unable to repay the
outstanding debt, it may decide to default
– Default also comes under different names: debt restructuring,
debt rescheduling, private sector involvement
38
The dangers of high debt, cont
• The government can also finance itself by printing money
• Money finance, debt monetization, or fiscal dominance
– The government issues bonds and then forces the central bank
to buy its bonds in exchange for money
– Seignorage: The revenue, in real terms, that the government
generates with money creation
• The relation between seignorage, the rate of nominal money
growth, and real money balances
– to finance a deficit (e.g., 10% of GDP) through seignorage, the
growth rate of nominal money must be equal to 10%
– As money growth increases, inflation typically follows
⇒ Hyperinflation (i.e., very high inflation)
39
The challenges facing the fiscal policy today
• In the U.S., the gross debt (i.e., debt issued by the federal
government) was 104% of GDP
• Looking forward, two major government spending items look
set to substantially increase
1- Social security payments reflecting the aging of America
2- Medicare projected to increase
40
The challenges facing the fiscal policy today
• How much and at what rate should primary deficits be
reduced?
1- The real interest rate the government pays on its debt is
currently very low, indeed lower than the growth rate
• While government debt is high, interest paid on the debt is
still low. If the interest rate remains lower, government can
decrease the debt-to-GDP ratio
2- The ratio of government investment to GDP was the lowest
(in 2018) it had been since 1950
3- To avoid a decrease in output in response to a reduction in the
budget deficit, the central bank must lower the interest rate
41
The challenges facing the fiscal policy today
• How much and at what rate should primary deficits be
reduced?
1- The real interest rate the government pays on its debt is
currently very low, indeed lower than the growth rate
2- The ratio of government investment to GDP was the lowest
(in 2018) it had been since 1950
• One of the ways the government deficit was reduced was by
cutting public investment. If we increase the investment, it
would increase the current primary deficits
3- To avoid a decrease in output in response to a reduction in the
budget deficit, the central bank must lower the interest rate
42
The challenges facing the fiscal policy today
• How much and at what rate should primary deficits be
reduced?
1- The real interest rate the government pays on its debt is
currently very low, indeed lower than the growth rate
2- The ratio of government investment to GDP was the lowest
(in 2018) it had been since 1950
3- To avoid a decrease in output in response to a reduction in the
budget deficit, the central bank must lower the interest rate
• A large reduction in primary deficits would require a large
decrease in the policy rate, a decrease that may be infeasible
when near the zero lower bound
43
Government debt
and the Ricardian equivalence
44
Is government debt really a problem?
• Consider an expansionary fiscal policy (a tax cut) with a
corresponding increase in the government debt
• Two viewpoints:
1- Traditional view
2- Ricardian view
45
Traditional view
• Short-run: Y ↑, u ↓
• Long-run:
– Y and u back at their natural rates
– closed economy: r ↑, I ↓
– open economy: ϵ ↑, NX ↓ (or high trade deficit)
• Very long-run:
– slower growth until the economy reaches a new steady state
with lower income per capita
46
Ricardian view
• David Ricardo (1820), advanced more recently by Robert
Barro
Ricardian equivalence
• a debt-financed tax cut has no effect on consumption,
national saving, the real interest rate, investment, net
exports, or real GDP, even in the short run
47
The logic of Ricardian equivalence
• Key assumption: consumers are forward-looking
– know that a debt-financed tax cut today ⇒ an increase in
future taxes (that is equal to the tax cut (in present value)).
• The tax cut does not make consumers better off, so they do
not increase consumption spending.
• Instead, they save the full tax cut in order to repay the future
tax liability.
• Results:
– Private saving rises by the amount public saving falls,
leaving national saving unchanged.
48
Problems with Ricardian equivalence
1- Myopia
• Not all consumers think so far ahead; some see the tax cut as
a windfall of disposable income
2- Borrowing constraints
• Some consumers cannot borrow enough to achieve their
optimal consumption, so they spend a tax cut
3- Future generations
• If consumers expect that the burden of repaying a tax cut will
fall on future generations, then a tax cut now makes them feel
better off, so they increase spending
49
Evidence against Ricardian equivalence
• Early 1980s, Reagan tax cuts increased the deficit in the U.S.
– As a result, national saving fell, the real interest rate rose, the
exchange rate appreciated, and NX fell
• In 1992, income tax withholding was reduced to stimulate
the economy
– This delayed taxes but didn’t make consumers better off
– Almost half of consumers increased consumption
• Discussion behind the Ricardian equivalence
– Proponents: Reagan tax cuts didn’t provide a fair test
– Consumers may have expected the debt to be repaid with
future spending cuts instead of future tax hikes
– Private saving may have fallen for reasons other than the tax
cut, such as optimism about the economy