CHAP 16

• The Government’s Budget Constraint

  Gov Expenditure = Tax Revenue + Borrowing
• Government expenditures must be financed by income or by borrowing
• Government expenditure categories

  • Purchases of goods and services, G
  • Interest payments on the outstanding stock of debt (debt-service payments)
• Debt-service payments


  Interest payments on the outstanding stock of debt (i x D)
• Government’s net tax revenue


  Transfers included as part of T
• Budget Deficit


  ΔD = (G + i × D) − T
• Primary budget deficit


  The difference between the government’s overall budget deficit and its debt-service payments
• Primary budget surplus or deficit


  Shows the extent to which current tax revenues can cover the government’s current program spending
• Large and persistent budget deficits began in the mid-1970s and continued throughout the 1980s and early 1990s
• The federal budget was in surplus from 1998 to 2008, but returned to deficit in 2009 mostly due to a major recession
• The COVID-19 pandemic in 2020 led to an enormous increase in the budget deficit
• The budget deficit increased to about 18 percent of GDP during the COVID-19 pandemic
• Fiscal policy


  The use of government spending and tax policies
• Changes in the budget deficit are due to changes in the government’s fiscal policy and changes in the level of economic activity
• For a given set of expenditure and taxation policies

  The budget deficit rises as real GDP falls, and falls as real GDP rises
• Budget deficit function


  A relationship that plots the government’s budget deficit as a function of the level of real GDP
• Structural budget deficit


  The deficit that exists when real GDP equals Y* and expenditure and taxation policies were unchanged
• During recessionary gaps (Y < Y*), the actual budget deficit is more than the structural budget deficit
• During inflationary gaps (Y > Y*), the actual budget deficit is less than the structural budget deficit
• Changes in the stance of fiscal policy are best identified by the resulting change in the structural budget deficit
• Debt-to-GDP ratio


  The expression that relates the government budget deficit to the change in the debt-to-GDP ratio is Δd = x + (r − g) × d
• Debt dynamics


  Two forces that tend to increase the debt-to-GDP ratio:

  - if r > g

  - if the government has a primary budget deficit
• If the real interest rate on government debt is approximately equal to the growth rate of real GDP, reductions in the debt-to-GDP ratio require the government to run primary budget surpluses
• Government budget deficits may crowd out private-sector activity and may harm future generations by reducing the economy’s long-run growth rate
• Crowding out


  The offsetting reduction in private expenditure caused by the rise in interest rates that follows an expansionary fiscal policy
• Budget surpluses may crowd in private-sector activity and be beneficial to future generations by increasing the economy’s long-run growth rate
• In a closed economy:

  An increase in the budget deficit is assumed to cause a reduction in the supply of national saving
• In a closed Economy:

  A reduction in the supply of national saving will increase the equilibrium real interest rate and reduce the amount of investment in the economy
• In an open economy, the government budget deficit attracts foreign financial capital and appreciates the domestic currency
• The long-run result of a government budget deficit is a crowding out of net exports
• Government debt generates a redistribution of resources away from future generations toward the current generations
• Whether there is a burden on future generations depends on the nature of the government spending being financed by the deficit
• Debt incurred to finance public investment may result in no burden for future generations
• Example of beneficial debt


  • The government’s financing of an electric-powered public transit network in turn reducing greenhouse gas emissions and improving mobility for the future
• Fears of future debt monetization will likely lead to expectations of future inflation and put upward pressure on nominal interest rates and on some prices and wages
• A large government debt may lead to the expectation of future inflation, hampering the task of the central bank in keeping inflation and inflationary expectations low
• A large and rising stock of government debt could “tie the hands” of the government in times when it would otherwise want to conduct counter-cyclical fiscal policy
• In January of 2020, the federal government’s debt-to-GDP ratio was about 33 percent
• The massive increase in spending during the pandemic pushed the debt ratio up by almost 20 percentage points in a single year
• There is support for the idea that legislation should be amended to impose restrictions on the size of budget deficits