Fiscal Policy. Can you run a deficit every year?
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Transcript of Fiscal Policy. Can you run a deficit every year?
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Fiscal Policy
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End This Year End Last Year This YearDebt Debt Deficit
=t t tDeficit Outlays Receipts
t tDeficit Surplus
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1
1 1
1
1 (1 )
(1 ) (1 )
(1 )
t t
GDPt
t tGDP GDPt
GDPt
tGDPt
dy dy
Deficitgdy dy
g g GDP
Deficit gdy
GDP g
1
1
(1 )t t
t tGDPt t
Debt Deficitdy dy
GDP g GDP
Can you run a deficit every year?
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If
then Debt-to-GDP ratio stays stable.
If > then deficit is “unsustainable”
1(1 )
GDPt
tGDPt
General Deficit gdy
GDP g
Sustainable Deficit
A growing economy allows the government to borrow some money every year and still keep debt in line with overall GDP
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Figure 2. Sovereign Bond Yield Spreads over German Bunds(Basis points)
Sources: Bloomberg L.P.; Datastream.Note: 10-year sovereign bond yields.
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Jan -10 Ap r-10 Jul-10 Oct-10 Jan -11 Ap r-11 Jul-11
Countries w ith Programs Supported by EU/IMF
Greece
Irelan d
Po rtug al
Latv ia
Ro man ia
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Selected European Countries
Sp ain
Belg iumItaly
Fin landNeth erlands
IMF Fiscal Monitor
Crisis spreads to other countries
Background Reading
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Primary Deficit Simplified Government Budget
Primary Outlays (Total Expenditure less Interest Paid)
- Primary Receipts (Total Revenue less Interest Income)
Primary Budget Deficit
+ Net Interest Payments on Existing Debt
General Budget Deficit
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1(1 )
GDPt
tGDPt
Primary Deficit g idy
GDP g
t t t
t t t
General Deficit Primary Deficit Net Interest
GDP GDP GDP
Sustainable Primary Deficit
~
1(1 )
Average Interest
ttGDP
t
Net Interest idy
GDP g
• If
then stays stable.Debt
GDP
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Primary Balance
%
of
GD
P
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Consequences of DeficitsAusterityInflationDefault
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P
Y
Y*
AD
Austerity and the Output Gap
P*
SRAS
YP
AD′
1
2
1. Economy in LT equilibrium
2. Government imposes austerity program – cuts spending, transfers, inceases taxes
3. AD Curve shifts inward.
Recessionary Gap
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Austerity has a negative effect on business cycles.
IMF
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Deficits and Inflation
Government generates revenues by printing new money (referred to as seignorage).
Government facing borrowing constraints may be forced to rely on inflation tax for deficit financing and real returns to owning money.
Explain the link between deficits and inflation.
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Israel 1970-1990
Inflation
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Israel 1970-1990
Surplus (% of GDP)
-30.00%
-25.00%
-20.00%
-15.00%
-10.00%
-5.00%
0.00%
5.00%19
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1971
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Default and RestructuringArgentina 1999-2002
IMF Study
BBC Story
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Argentina GDP
4E+11
4.2E+11
4.4E+11
4.6E+11
4.8E+11
5E+11
5.2E+11
5.4E+11
1997 1998 1999 2000 2001 2002 2003 2004 2005
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Stabilization policyIn an economy subject to shocks to
aggregate demand (animal spirit shocks, external shocks, asset market shocks), the economy will have a self-correcting mechanism.
However, if this self-correction mechanism takes a long time to work, then government may use policy to speed adjustment.◦Use expansionary policy to close a
recessionary gap◦Use contractionary policy to close an
inflationary gap
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P
YY*
AD
Demand Driven Recession w/ Counter-cyclical fiscal policy
P*
SRAS
YP
AD′
1
2
1. Economy in LT equilibrium
2. Demand shifts in
3. Government increases spending to shift the AD curve back
3
Recessionary Gap
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P
YY* AD
Demand Driven Expansion w/ Counter-cyclical fiscal policy
P*
SRAS
YP
AD′1
2
1. Economy in LT equilibrium
2. Demand shifts out
3. Government cuts spending to shift the AD curve back 3
Inflationary Gap
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Lags and Fiscal Policy
Administrative lags for fiscal policy may likely be large.
Except in absolute dictatorships, government will have mechanisms for building a consensus for expenditures. Adjusting this consensus will be time consuming.
If lags are too long, stabilizing government spending or transfer payments may have a destabilizing effect, shifting out demand after the economy has already recovered.
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Automatic StabilizationGovernments in most economies
issue debt to make up for shortfalls in revenues in relation to spending.
Budget Deficit = Outlays – RevenuesTax collection is cyclical so the
budget deficit tends to be counter-cyclical.
Maintaining a balanced budget over the cycle means raising taxes in a recession an cutting taxes in a boom which makes the business cycle more extreme.
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Counter-cyclical deficits
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Learning OutcomesUse growth rate of GDP, interest
rates, and the debt to GDP ratio to identify the sustainable general and primary deficit level.
Use AS-AD model to identify the effects of fiscal policy on the output gap and the inflation rate.