The Government Budget, Foreign Borrowing, and the Twin Deficit Chapter 5 Instructor: MELTEM INCE

1. The Government Budget, ForeignBorrowing, and the Twin Deficit Chapter 5 Instructor: MELTEM INCE

2. Budget Deficit (and Surplus) • The Structural Deficit is the what the deficit of the economy would be if the economy were operating at natural real GDP. • The structural deficit is sometimes call the Natural Employment Deficit (NED). • The CBO uses “Standardized Budget Deficit” for the structural budget deficit. • The Cyclical Deficit is the amount by which the actual government budget deficit exceeds the structural deficit. • The Structural Surplus (or equivalently, the Natural Employment Surplus (NES)) and the Cyclical Surplus are the same as the deficit concepts with the signs reversed.

3. Budget Deficit (and Surplus) • “Magic Equation” from Chapter 2: T – G = (I + NX) – S • The Magic Equation suggests 3 ways to finance a budget deficit (i.e. T – G < 0) • Private saving (S) can go up • Investment (I) can fall • Foreign investment (NX) can fall • Because an increase in the budget deficit increases the total public debt, persistent budget deficits can lead to higher taxes in the future.

4. The Arithmetic of Deficits and Debt The budget deficit in year t equals: • Bt-1 is government debt at the end of year, t – 1 or, equivalently, at the beginning of year t ; r is the real interest rate, which we shall assume to be constant here. Thus rBt-1 equals the real interest payments on the government debt in year t. • Gt is government spending during year t • Tt is taxes minus transfers during year t.

5. The Arithmetic of Deficits and Debt We measure interest payments as real interest payments rather than as actual interest payments. The correct measure of the deficit is sometimes called the inflation-adjusted deficit. G does not include transfer payments.

6. The Arithmetic of Deficits and Debt • The government budget constraint states that the change in government debt during year t is equal to the deficit during year t: • Using the definition of the deficit • we can rewrite the government budget constraint as

7. The Arithmetic of Deficits and Debt It is often convenient to decompose the deficit into the sum of two terms: • Interest payments on the debt, rBt-1 • The difference between spending and taxes, Gt – Tt. This term is called the primary deficit (equivalently, Tt – Gt is called the primary surplus).

8. Primary Deficit The Arithmetic of Deficits and Debt Change in the debt Primary deficit Interest payments

9. Automatic vs. Discretionary Fiscal Policy Budget surplus = T – G = tY – G (where t = the average net tax rate) • Automatic stabilization of the budget deficit occurs because government tax revenues depend on income. • If Y T which helps to restrain expansions • If Y  T which helps to dampen recessions • Discretionary fiscal policy alters tax rates and/or government expenditures in a deliberate attempt to influence real output and unemployment.

10. National Saving • National Saving is the sum of private and government saving: NS = S + (T – G) • Recall the Magic Equation: T – G = (I + NX) – S Rearranging yields  S + (T – G) = I + NX  NS = I + NX • National saving has two components: • (T – G) does not depend on r • S increases with a higher r • In a closed economy, NS = I at equilibrium.

11. Effect of a Fiscal Expansion in a Closed Economy

12. Fiscal Policy in a Small Open Economy • An Open Economy sells exports to other nations, buys imports, and experiences capital flows in and out of the country. • A Small Open Economy (or SOE) is considered too small for its domestic policies to affect the world interest rate. • Therefore, the local r must equal the world interest rate, rf . • The “Magic Equation” written to reflect changes in its component parts is: ∆NS = ∆I + ∆NX • But since r = rf is unaffected by domestic policies  ∆I = 0  ∆NS = ∆NX • Implication: If G  NS  NX, but I unaffected

13. Effect of a Fiscal Expansion in an Open Economy

14. The Current Account and the BOP • The Current Account (CA) records the nation’s current international transactions including exports and imports of goods and services (i.e. NX), net income from abroad and net unilateral transfer payments. • The Capital Account (KA) records international capital flows, which consist of purchases and sales of foreign assets by domestic residents, as well as purchases and sales of domestic assets by foreign residents. • The Balance of Payments (BOP) is the record of a nation’s international transactions. • Algebraically: BOP = CA + KA

15. Foreign Borrowing and Int’l Indebtedness • A current account deficit must be financed either by: • Net borrowing from foreigners • This is recorded as a capital account surplus. • Net borrowing from foreign central banks • This is recorded as a balance of payments deficit. • A nation’s Net International Investment Position is the difference between all foreign assets owned by a nation’s citizens and domestic assets owned by foreign citizens. • ∆Net Int’l Investment Position = CA Balance + Net Revaluations (where Net Revaluations is the change in the dollar value of financial assets due to fluctuations in financial markets and the exchange rate)

16. YN= 10.900 Y=10.600 t=0.16 G= 1890 • actual real GDP = 0.16(10,600) = 1,696 natural real GDP= 0.16(10,900) = 1,744 • natural employment deficit = 1,744 - 1,890 = -146 • actual deficit =1,696 - 1,890 = -194 actual real GDP < natural real GDP cyclical deficit cyclical deficit= actual deficit - natural deficit cyclical deficit= -194 - (-146) = -48 • Natural real GDP= 0.14 (10,900) = 1,526 • natural employment deficit = 1,526 - 1,890 = -364

17. net exports = 40, TP= 20, NI= -15 current account balance = NX + TP + NI CAB= 40+20-15 CAB= 45 capital account balance = balance – current account capital account balance = 10 - 45 = -35