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    Lecture 36

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    abaidullah bhatti

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    © All Rights Reserved
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    Lecture 36

    Uploaded by

    abaidullah bhatti
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    Lecture36

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    6 views29 pages

    Lecture 36

    Uploaded by

    abaidullah bhatti

    Copyright:

    © All Rights Reserved
    Download as PPS, PDF, TXT or read online from Scribd
    Download as pps, pdf, or txt
    of 29

    Review of the Previous

    Lecture
    • Government Debt and Budget Deficit
    – Components of Budget Debt
    – Size of Govt. Debt
    – Problems in measurement
    • Inflation
    • Capital Assets
    • Uncounted Liabilities
    • Business Cycle
    Topics under Discussion
    • Traditional View of Government Debt
    • Ricardian View of Government Debt
    • Myopia
    • Borrowing Constraints
    • Other Perspectives
    – Fiscal Policy
    – Monetary Policy
    The Traditional View of
    Government 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
    k = i – k

    Since i = sf(k) , this becomes:

    k = s f(k) – k
    Solow Growth Model

    Investment
    and k = sf(k)  k
    k
    depreciation
    sf(k)

    k
    investment

    depreciation

    Capital per
    k1 k *
    The Traditional View of
    Government Debt
    • The economy will then have less capital
    than the Golden Rule steady-state which
    will mean lower consumption and lower
    economic well-being.
    Starting with too little capital
    If k *  k gold
    *

    then increasing c*
    requires an y
    increase in s. c
    Future generations
    enjoy higher
    consumption, i
    but the current one
    experiences an initial t0 time
    drop in consumption.
    The Traditional View of
    Government Debt

    • Then we analyze the short-run impact


    of the policy change via the IS-LM
    model.
    A Tax Cut
    • We Have E E =Y E =C +I (r )+G
    2 1
    C = C (Y -T)
    E =C1 +I (r1 )+G
    • At any value of r,
    ↓TC  E  Y
    …so the IS curve
    Y1 Y2 Y
    shifts to the right. r
    r1
    • The horizontal
    distance of the Y
    IS1 IS2
    IS shift equals Y
    Y1 Y2
    MPC
    Y
    T
    1 MPC
    The Traditional View of
    Government Debt

    • 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.
    International Trade
    S2 – I(r*)
    ε S1 – I(r*)

    ε2

    ε1

    NX(ε )

    NX
    NX 2 NX 1
    The Traditional View of
    Government Debt

    • 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 )
    e LM 1*
    At any given value of e, a
    e2
    fiscal expansion increases
    Y, shifting IS* to the right. e1
    IS 2*
    IS 1*
    Results: Y
    Y1
    e > 0, Y = 0
    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.
    The Ricardian View of
    Government 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
    The Ricardian View of
    Government Debt
    • 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.
    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.
    Myopia
    • 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.
    Borrowing Constraints
    • 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
    Balanced Budgets Versus
    Optimal Fiscal Policy
    Most economists oppose a strict rule requiring
    the government to balance the budget. There are
    three reasons why optimal fiscal policy may at
    times call for a budget deficit or surplus:

    1) Stabilization

    2) Tax Smoothing

    3) Intergenerational redistribution
    Stabilization
    A budget deficit or surplus can help stabilize the
    economy. A balanced budget rule would revoke
    the automatic stabilizing powers of the system of
    taxes and transfers. When the economy goes into
    a recession, tax receipts fall, and transfers
    automatically rise. Although these automatic
    responses help stabilize the economy, they push
    the budget into deficit. A strict balanced budget
    rule would require that the government raise
    taxes or reduce spending in a recession, but
    these actions would further depress aggregate
    demand.
    Tax Smoothing
    A budget deficit or surplus can be used to reduce
    the distortion of incentives caused by the tax
    system. High tax rates impose a cost on society
    by discouraging economic activity. Because this
    disincentive is so costly at particularly high tax
    rates, the total social cost of taxes is minimized
    by keeping tax rates relatively stable rather than
    making them high in some years and low in
    others. This policy is called tax smoothing. To
    keep tax rates smooth, a deficit is necessary in
    years of unusually low income or unusually high
    expenditure.
    Intergenerational
    Redistribution
    A budget deficit can be used to shift a tax burden
    from current to future generations. For example,
    some economists argue that if the current
    generation fights a war to maintain freedom,
    future generations benefit as well, and should
    therefore bear some of the burden. To pass on
    the war’s costs, the current generation can
    finance the war with a budget deficit. The
    government can later retire that debt by raising
    taxes on the next generation.
    Fiscal Effects on Monetary
    Policy
    One way for a government to finance a budget
    deficit is to print money-- a policy that leads to
    higher inflation. When countries experience
    hyperinflation, the typical reason is that fiscal
    policymakers are relying on the inflation tax to
    pay for some of their spending. The ends of
    hyperinflation almost always coincide with fiscal
    reforms that include large cuts in government
    spending and therefore a reduced need for
    seigniorage.
    Summary
    • Traditional View of Government Debt
    • Ricardian View of Government Debt
    • Myopia
    • Borrowing Constraints
    • Other Perspectives
    – Fiscal Policy
    – Monetary Policy
    Upcoming Topics
    • Consumption
    – Irving Fisher and Intertemporal Choice
    – Consumer’s Budget Constraints

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