Robert J. Gordon, Macroeconomics, 10 th edition, 2006, Addison-Wesley

Robert J. Gordon, Macroeconomics, 10th edition, 2006, Addison-Wesley Chapter 5: National Saving, the Government Budget, Foreign Borrowing and the Twin Deficits

The pervasive effects of the government budget • Crowding out of net exports • The IS-LM model emphasized that a fiscal expansion is likely to crowd out domestic private investment. In addition, a fiscal expansion can crowd out net exports. Note: T - G ≡ ( I + NX ) – S • Government surplus is the excess of domestic investment I and foreign investment NX over private saving S, or government surplus is available to finance excess investment over private saving (I-S) or to lend foreigners (positive NX). • If T<G, there will be 3 ways to finance the deficit, • S can go up • I can go down

Foreign investment can go down (in case of being negative we will borrow) • Impact on future generations • Persistent budget deficits have another implication. It raises the public debt, future generations will be obliged to pay higher taxes so the government can pay the interest on the debt. • Persistent deficit have pervasive consequences on private investment, foreign investment or borrowing and the wealth of future generations.

The structural budget • There are two types of changes in budget deficit; • Cyclical surplus or deficit • Structural surplus or deficit; which is what the surplus or deficit remains will be if the economy is operating at its natural (not actual) level. • Automatic stabilization • If T can rise when Y is high and fall when Y is low, we can express net taxes T as: T = tY • This implies that: Budget surplus = T-G = tY-G

There are two main sources of change in the surplus or deficit: • Automatic stabilization (changes in Y). • Discretionary fiscal policy (changes in G and t). • Automatic stabilization • In an economic expansion, T rises (R rise and benefits fall), which helps to restrain the boom. • In a recession T falls (R fall and Benefits rise) which help to restrain the recession and boast the economy. • See figure 5-2. BB is the budget line which illustrates the automatic stabilization relationship between the budget and Y, its slope is t0. at B the economy would move to A as the government is running a deficit equals the vertical distance between B and A.

Figure 5-2 The Relation Between the Government Budget Surplus or Deficit and Real Income Slope isto

Discretionary fiscal policy. • Comes from alterations in G and t. • How discretionary changes affect budget line. • Look at figure 5-3. If G is higher, deficit will be larger at Y0. There are 3 ways to reduce the deficit: • Increase Y to YN movement from C to D. • A movement from C to B which reduces G (less deficit). • Increase t0 which shifts the budget line upward (more tax). • Note that changes in budget deficit is not a necessary indication of specific discretionary fiscal policy actions, since the actual budget deficit can also change as real income increases or decreases with no change in tax rates or government expenditures as from C to D or B to A.

Figure 5-3 Effect on the Budget Line of an Increase in Government Expenditures Higher taxes push BB up, higher G pushes BB down Cyclical deficit at BB0 Cyclical deficit at BB1

The natural employment surplus or deficit • The natural employment surplus (NES) and Deficit (NED) are those levels that would occur if actual real GDP Y equals natural real GDP YN. Hence NES is: NES = tYN – G • Look at figure 5-3. For original BB0,NED is zero. While NED for BB1 is AD. • Note that: • structural deficit is another name of NED. It changes whenever there is a change in G or t. • Cyclical deficit is the difference between actual and naturalemployment deficit. The cyclical deficit is the vertical distance between A and B on BB0 and D and C on BB1.

Automatic stabilization is represented by the slope of the budget line (t). • National Saving and the consequences of the government budget • Fiscal policy and national saving • National saving NS consists of private saving S and government saving (T-G), which is available to finance domestic investment I and foreign investment NX, i.e., S+(T-G) ≡ I+NX, or NS = I+NX • Crowding out in a closed economy • We know that an increase in G or a reduction in T reduces NS.

In a closed economy NX is zero. Now Look at figure 5-5. National saving is composed of S and budget surplus (T-G). Government saving does not depend on r, but S does. • Since Ca is negatively related to r, for any level of Yd, as r increases S, will increase. • Therefore, NS (private + government (does not depend on r)) are positively related to r. • According to figure the economy is in equilibrium at point E0, whereinvestment demand Idcrosses NS.

Figure 5-5 National Saving and Domestic Investment in a Closed Economy

Now look at figure 5-6. • What happens when G increase by ∆G, as shown in the figure, NS sifts from NS0 to NS1. the new equilibrium is at E1, there will be a decline in I from I0 to I1, which is the crowding out effect of the fiscal policy expansion. • Note also that the change in NS is less than the increase in G, this is the result of the positive effect of higher r on S, and the change in NS is ( ∆NS =∆S -∆G)

Figure 5-6 Effect of a Fiscal Expansion in a Closed Economy

Fiscal policy in a small open economy • Small economies are those whose domestic policy changes have no influence on world interest rates. • Domestic r in these countries is the world one (rf) which is not affected by fiscal policy. • An increase in G or decrease in T that reduces S has no effect on r or on I; NX decline by the exact amount of the increase in national saving. Note that ∆NS = ∆I + ∆NX • In a small open economy with a fixed r, we can solve for the change in NX as ∆NS = ∆NX • Where ∆I = 0 because r is fixed. Look at figure 5-7.

Change in NS is caused by the change in G. Since r = rf there will be no crowding out ∆I = 0 . The new equilibrium of the economy will be the same point E1 as the original E0. the increase in G is exactly balanced by a decline in NS that equals the decline in NS (∆G = ∆NS = ∆NX). • It is borrowing from foreigners that allows domestic investment to remain unchanged despite a change in NS.

Figure 5-7 Effect of a Fiscal Expansion in an Open Economy (1 of 2)

Fiscal policy in a large open economy • Changes in monetary and fiscal policy can alter foreign interest rate. Suppose that the world consisted half of the US and half of foreign countries. • A fiscal stimulus in US will put pressures on rf. Look at figure 5-8. fiscal stimulus causes an increase in rf by half as much as domestic fiscal stimulus in a closed economy (figure 5-6). • There is a partial crowding out, but not as much as the closed economy case. • To summarize we can use the magic equation ∆(T-G) = ∆I + ∆NX - ∆S

Figure 5-8 Effect of a Fiscal Expansion in an Open Economy (2 of 2)

Figure 5-4 A Comparison of the Actual Budget and the Natural Employment Budget, 1960–2004

Figure 5-8 Components of Net Saving and Investment, 1960–2004

International Perspective Saving, Investment, and Government Budgets Around the World

International Perspective Saving, Investment, and Government Budgets Around the World (1 of 3)

International Perspective Saving, Investment, and Government Budgets Around the World

Figure 5-1 Real Government Expenditures, Real Government Revenues, and the Real Government Budget Deficit, 1900–2005 (1 of 2)

Figure 5-1 Real Government Expenditures, Real Government Revenues, and the Real Government Budget Deficit, 1900–2005 (2 of 2)

Figure 5-1 Real Government Expenditures, Real Government Revenues, and the Real Government Budget Deficit, 1900–2005

Robert J. Gordon, Macroeconomics, 10 th edition, 2006, Addison-Wesley