ECON5102 Macroeconomics
Lecture 8
THE GOVERNMENT
AND THE MACROECONOMY
(Fiscal Policy)
T3 2021
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1 Introduction
• In this chapter, we learn (Jones Chapter 18):
Government spending, taxation, budget deficits, and the debt-
GDP ratio
The government’s intertemporal budget constraint
The economic consequences of budget deficits
The fiscal problem of the twenty-first century: how to finance
rising health expenditures
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Introduction
• The government can borrow or lend
But the government’s budget must balance in PDV
Budget deficits today must be offset by budget surpluses in the
future
• Recent forecasts suggest current U.S. policies are unsustainable
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2 U.S. Government Spending and Revenue
• In 2015, government spending in the United States
Was $6.0 trillion
20.6 percent of GDP
More than $18,500 per person
• Tax revenues were 18 percent of GDP
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The U.S. Federal Government Budget, 2015
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Australia Government Budget, 2008-2017
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Australia Government Debt, 2008-2017
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Australia Budget Composition 2016-2017
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Australia: Revenue vs Expenditure 1989-2018
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Government Spending and Revenue
• The budget balance
The difference between tax revenues and spending
• A budget surplus
Tax revenues is greater than Spending
• A budget deficit
Tax revenues is lower than Spending
The government must borrow by selling bonds
• A balanced budget
Tax revenues equal Spending
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Spending and Revenue over Time
• World War II
Taxes and expenditures rose sharply
• After the war:
spending and revenues were an approximately stable fraction of
GDP
• Budget deficits emerged starting around 1970
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U.S. Federal Government Revenue and Spending
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The Debt-GDP Ratio-1
• Government debt
The outstanding stock of bonds that have been issued in the
past
• In 2005
The debt-GDP ratio was 35 percent
• In 2011
The debt-GDP ratio was 74 percent
• Half of the debt is owed to foreigners
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The Debt-GDP Ratio-2
• The net debt:
Government debt that is held outside of the government
• In 2015, including debt held by the government, total debt-
GDP was more than 100 percent
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Federal Debt and Deficits in the United States
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3 International Evidence on Spending and Debt
• Among the richer OECD countries, the United States has a
lower than average:
Government spending to GDP ratio (40 percent)
Debt-GDP ratio
• Norway
Negative debt-GDP ratio
Saves its surpluses
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Government Spending Around the World, 2014
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Debt-GDP Ratios around the World
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4 The Government Budget Constraint
• The flow version of the government budget constraint holds in
each period
• The sources of funds to the government must equal the uses of
funds
Gt + Trt + iBt︸ ︷︷ ︸
uses
= Tt + ∆Bt+1 + ∆Mt+1︸ ︷︷ ︸
sources
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4 The Government Budget Constraint (cont.)
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The Government Budget Constraint
• Assume for this chapter
The change in the stock of money is zero
Transfer payments are zero
• Therefore: Bt+1 = (1 + i)Bt +Gt − Tt︸ ︷︷ ︸
deficit
• The primary deficit: Gt − Tt
It excludes spending on interest
• The total deficit: Gt = iBt − Tt
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The Intertemporal Budget Constraint 1
• Suppose an economy exists for only two periods
The budget constraint for period 1 is:
B2 = (1 + i)B1 = G1 − T1
• The budget constraint for period 2 must equal zero:
B3 = (1 + i)B2 = G2 − T2
No one is willing to lend to the government in the final period
because loans can never be repaid
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The Intertemporal Budget Constraint-2
• Substitute the budget constraint for period 2 into period 1
G1 +
G2
1 + i︸ ︷︷ ︸
pdv of spending
+ (1 + i)B1︸ ︷︷ ︸
initial debt
= T1 +
T2
1 + i︸ ︷︷ ︸
pdv of taxes
• Uses must equal sources, in PDV
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The Intertemporal Budget Constraint-3
• Collect the tax and spending terms on the same side of the
equation:
T1 −G1︸ ︷︷ ︸
period 1 balance
+
T2 = G2
1 + i︸ ︷︷ ︸
period 2 balance
= 1 + i︸︷︷︸
initial debt
The government’s budget must balance
It balances not period by period, but in PDV
The government must have surpluses in the future to pay off
deficits today
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5 How Much Can the Government Borrow?
• When considering economic consequences of deficits and debts,
we must consider
Economic growth
The possibility of high inflation or default
Intergenerational equity
The extent to which deficits crowd out investment
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Govt bond spread
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Govt bond spread (cont.1)
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Govt bond spread (cont.2)
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Economic Growth and the Debt-GDP Ratio
• The amount the government can borrow is limited by:
The amount it can credibly be expected to pay back
Partly on how large the economy’s GDP is
• Stock of debt can grow over time if GDP is growing even faster.
The debt-GDP ratio will fall if this happens.
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High Inflation and Default-1
• If the debt-GDP ratio becomes too high:
Lenders worry about the ability of the government to repay.
Investors demand higher interest rates.
• If lenders stop:
The government may print more money to satisfy the budget.
This generates inflation.
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High Inflation and Default-2
• Default:
Government declares it will not repay certain debts
Or will repay them at less than face value
• When the government borrows:
The beneficiaries of borrowing may not be the same people who
repay the debt
• Example: World War II
The generation that fought the war made large sacrifices
Future generations benefited from the victory
Future generations paid for the war
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Generational Accounting
• Generational accounting:
Calculates the extent to which current policies pass on tax bur-
dens to future generations
• High and rising debt-GDP ratios imply higher taxes rates on
future generations
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Deficits and Investment
• The national income identity
Investment equals total saving:
Y − C −G+ (IM − EX) = I
• Add and subtract tax revenues from the left side of the equa-
tion:
(Y − T − C)︸ ︷︷ ︸
private saving
+ (T −G)︸ ︷︷ ︸
government saving
+ (IM − EX)︸ ︷︷ ︸
foreign saving
= I
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Deficits and Investment-2
• Investment can be financed through
Saving from the private sector
Government saving
Saving by foreigners
• Disposable income
Difference between income and taxes
• Crowding out
Budget deficits may absorb some of the savings and reduce in-
vestment
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Deficits and Investment-3
• Ricardian equivalence implies:
Holding the present value of government spending constant, the
timing of taxes does not affect consumption
Budget deficits need not crowd out investment
• Economists still debate the extent to which budget deficits
crowd out investment
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U.S. Investment and the Budget Deficit
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6 The Fiscal Problem of the Twenty-First Century
• In the coming decades, with current policies in place, it is likely
that:
Government spending will rise to 40 percent of GDP
Annual budget deficits could reach 20 percent of GDP
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The Problem
• Reasons for the unsustainable current policies:
Increased generosity of entitlement programs
Rise in Social Security
I Larger fraction of the population qualifying
Rise in health care expenditures (Medicare/Medicaid)
I Health care costs will grow at a rate 1 percentage point faster
than the rate of GDP growth
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U.S. Federal Spending and Revenues, 1950-2075
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Components of Federal Spending, 1950-2075
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Case Study: Financing the Social Security Program
• Social Security
Financed by an employment tax on wage income
Pay-as-you-go is the system
I current workers pay the benefits of the current recipients
• As baby boomers retire:
The ratio of workers to retirees will fall
Need increased taxes and/or reduced benefits
• Yet, the problem of funding health expenditures is more severe
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Possible Solutions-1
• Could the budget be balanced?
Tax revenues would have to rise by about 9 percent of GDP by
2075
• Health spending is growing in all advanced economies
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Health Spending as a Share of GDP in Five Countries
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Health Spending as a Share of GDP in Five Countries
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Possible Solutions-2
• Explanations for increasing health care costs:
Expensive medical technologies are raising expenditures
Waste and fraud in the health system probably does not explain
increasing expenses
I health spending is growing in virtually all rich countries
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Possible Solutions-3
• A better alternative story:
Consumption is subject to diminishing returns
Adding additional months of life is not subject to diminishing
returns
More time to enjoy high incomes is increasingly valuable
Thus, health spending will rise by more than consumption
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Possible Solutions-4
• It is likely optimal for health care expenditures to rise as a
fraction of GDP as incomes rise
• Possible solutions, other than raising taxes, include:
Private health insurance
Mandated savings in individual health-spending accounts
These may create new problems of their own
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7 Conclusion
• Economic growth is a factor that helps to solve budgetary prob-
lems.
• Yet, economic growth cannot help to solve the problem of
rapidly growing expenditures on health care.
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