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Fiscal Policy

Fiscal Policy. 1. The overall federal budget. Deficit. Structural v Actual Budget. Actual budget is actual spending and receipts Structural budget records spending, taxes, and deficit that would occur if economy at potential output

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Fiscal Policy

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  1. Fiscal Policy 1

  2. The overall federal budget Deficit

  3. Structural v Actual Budget • Actual budget is actual spending and receipts • Structural budget records spending, taxes, and deficit that would occur if economy at potential output • Important because taxes, spending programs respond to state of economy

  4. Structural and Actual Budget A substantial part of the deficit is cyclical.

  5. Debt bathtub Spending Debt (end of year) = Debt (beginning) + deficit Debt (beginning of year) Revenues

  6. Debt algebra Basic identity: Change in Debt (end of t) = Deficit (t) + ε Government budget constraint: Debt = PV(future taxes) – PV(future expenditures) Unstable dynamics: Debt is explosive if when debt-GDP ratio (β) grows steadily, which occurs when the ratio grows rapidly:

  7. CBO, September 2009

  8. How Quickly the Budget Picture Can Change From CBO reports, 1997 2009.

  9. National saving is falling sharply … Data from BEA.

  10. Current projection of debt/GDP

  11. Long-term projection of debt/GDP

  12. What is responsible for the fiscal problem?

  13. What is responsible for the fiscal problem?

  14. Presidential (or near-so) views “It’s a public debt… we owe it to ourselves… therefore, we never have to pay it back.” [F.D.Roosevelt] “There are myths also about our public debt. Borrowing can lead to over-extension and collapse--but it can also lead to expansion and strength. There is no single, simple slogan in this field that we can trust.” [J.F.Kennedy, Yale Commencement Address, 1962] "But most of all because I think this [deficit spending] can only be described as generational theft.“ [John McCain]

  15. Preliminary Considerations • Deficits (and therefore higher debt) may be necessary to stabilize the business cycle (particularly in liquidity trap situations). • However, burden and impact of debt should be considered in long-run. Impacts on AD can be offset by fiscal and monetary policy. • One cost of debt is the efficiency losses (deadweight losses) from higher taxation (micro/public finance) • Ricardian debt theory holds that people offset it in saving (next slide) • Don’t blame it on the Chinese! (next week) • The main macro cost is the “crowding out” of capital (today) • Higher debt displaces capital from portfolios • This lowers growth of K and potential Q

  16. 1. Do Deficits Matter? The Ricardian Theory of the Debt • Robert Barro (Chicago/Harvard) introduced a theory in which deficits do not affect national saving or output. • Chicago view of households: They are "clans" or "dynasties" in which parents have children’s welfare in utility function: Ui = ui (ci, Ui+1) where Ui is utility of generation i and ci is consumption of generation i 3. This implies by substitution: Ui = ui (ci, ui+1(ci+1, Ui+2)) = vi(ci, ci+1, ci+2, ...) which is just like an infinitely lived person! 4. Important result: Barro consumers are like a life-cycle model with infinitely lived agents with perfect foresight: there will be no impact of anticipated taxes (or deficits) on consumption or on aggregate demand. 5. Controversial, but empirically questionable. Reasons are myopia, singles, liquidity constraints, non-altruistic parents.

  17. Mechanism of Crowding Out • Assume closed economy with full employment • Government borrows for consumption G • wars, food stamps, ice cream, … • Wealth accounting: W = K + GD • Wealth is owned in form of private assets (houses, bonds, stocks) and government debt; non-Ricardian consumers • Demand for K by firms for production. • Demand for K is downward-sloping function of real interest rate, r • Supply of capital and wealth: • Households accumulate wealth in K and GD for life cycle and other purposes • For simplicity, assume supply is interest-inelastic • Increased government debt then “crowds out” equities/capital from portfolio • Higher GD with constant W reduced K • Higher GD → lower K → lower potential output

  18. Before increase in GD Firm Balance Sheet Assets Liabilities Capital Stock 5000 Equities (stock) 5000 Net worth 0 Government Balance Sheet Assets Liabilities Assets 0 Debt (bonds) 1000 Net worth -1000 Household Balance Sheet Liabilities Assets Equities 5000 Net worth 6000 Govt bonds 1000

  19. After increase in GD Firm Balance Sheet Assets Liabilities -100 -100 Capital Stock 5000 Equities (stock) 5000 Net worth 0 Government Balance Sheet Assets Liabilities Assets 0 Debt (bonds) 1000 +100 Net worth -1000 -100 Household Balance Sheet Liabilities Assets -100 Equities 5000 Net worth 6000 Govt bonds 1000 +100 Net effect: +100 in GD → -100 of capital stock

  20. r K = W r0 r = f′(K) Capital stock K0

  21. r K = W - GD K = W r1 r0 r = f′(K) Capital stock K0 K1

  22. r K = W - GD K = W r1 Loss of NNP = r ΔK r0 r = f′(K) Capital stock K0 K1

  23. ln K, ln GD ln K ln K’ ln GD’ ln GD time

  24. ln Q, ln C ln Q ln Q’ ln (C+G) ln (C+G)’ Note that govt spending first raises (C+G), but then lowers (C+G)’ time

  25. A word on the open economy • In open economy: W = K + GD + NFA (NFA = net foreign assets) • Higher GD reduces (K+NFA) • Therefore, govt. debt displaces domestic K and/or foreign capital

  26. The deficit dilemma Suppose that we increase G by $1. Short run: • Increases Y by mult x 1 = 1.5 • Taxes rise by t x 1.5 = 0.5 • So deficit and debt rises by 0.5 Long-run: • National saving down by (say) 0.5, decreasing K by 0.5, for annual loss of r x 0.5 = 0.05 x 0.5 = $0.025 per year • Taxes rise to service debt by (r – g) 0.5 = 0.03 x 0.5 = 0.015 per year • Dead weight loss on taxes of (say) 50 % = $0.0075 per year Total: Short run gain of 1.5 Long run loss of (0.025 + 0.0075). At discount rate of 5%, = -$0.65 Net gain = + $0.85

  27. Conclusions on Fiscal Policy and Economic Growth • Fiscal policy affects economic growth through impact of government surplus through national savings rate • Deficits and higher govt debt lowers national saving • Decreases potential output through: • Lower capital stock for domestic investment • Lower income on foreign assets for foreign investment in open economy • Consumption (C + G) increases at first and then declines with the lower growth rate • Deficit dilemma of stimulus package 27

  28. Readings David Wessel, In Fed We Trust William Cohen, House of Cards Alessandri and Haldane Banking on the State (web page)

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