Ch. 28 - Fiscal Deficits

• Accumulated fiscal deficit over the years is called government debt
• If debt is used to pay other debt, it becomes unsustainable than to finance government projects and capital investments
• With significant deficit,

  • the ability of government to stimulate economy through expenditure increase or tax cuts is reduced
  • reduced ability to increase public investments (esp. infrastructure)
• total expenditure excludes payment for principal for regular debt payment; only includes interest expense
• How to address deficit?

  • manage expenditures (practice austerity in expenditure)
  • raise revenue (impose new tax)
• Presidential Decree 1177 - requires automatic appropriation (pay whole principal and interest every year since no one would lend otherwise)

  • credit ratings will go down
• debt servicing ratio - debt as percentage of national government revenue
• debt-to-GDP ratio is used to asses the ability of a country to repay its debt
• Evaluating budget deficit

  Proposed by Eisner - real debt value (adjusting debt for inflation)

  • decrease in real value of outstanding debt should be deducted from the increase in debt due to deficit
  • Positive inflation rates erode the real value of public debt; govt that are net debtors can have rising net worth even while they continue to run with deficits
  • Increasing interest rates erode the market value of the previously issued fixed-interest debt
• Evaluating budget deficit

  Structural deficit – difference in average when the economy is in a full employment situation and when it is not; deficit because of imbalance in revenues and expenditures (Exclude business cycle effects; Debt to GDP ratio)

  • goal is to reduce structural deficit
• Evaluating budget deficit

  Primary deficit = deficit - interest payments (excluding inherited debt)
• Implications of government borrowing

  • Crowding out private investment - Increase in government borrowing leads to higher interest rates. Higher interest rates result in less investment of firms. Which in turn results in less growth.
  • Economic stimulus/ crowding in - But if there are high levels of unemployment, public investments (increase govt spending) complements private investment. They increase the productivity of private investment.
• Crowding out happens at full employment while crowding in occurs at economic downturns
• In an open economy, interest rate is determined internationally and therefore, not be significantly affected by government deficit, which reduces crowding out effect, but translates to decrease in gross national product
• External borrowings are also affected by changes in exchange rate
• Balanced budget multiplier – stimulating the economy without increasing the deficit.


  economy is stimulated if we simultaneously increase the taxes and expenditure by the same amount (contractionary effect of increasing tax is outweighed by expansionary effect of increase in expenditure)
• Ricardian equivalence theorem


  David Ricardo suggests that when government deficits are high, parents increase their bequests to their children who will be paying the deficit in the future. They increase their household savings by exactly the amount of the increase in deficit. (not validated by evidence)
• Government deficit can:

  1. Passing burden of current expenditures to future generation
  2. Decrease investment
  3. Increase foreign indebtedness will reduce standards of living
  4. Government dissaving is not offset by private savings

  But can also:

  1. Complement private investment and increase productivity
  2. Stimulate the economy