Fiscal Policy: A Summing Up Prepared by: Fernando Quijano and vonn Quijano CHAPTER CHAPTER26 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard
Chaper 26: Fiscal Policy: A Summing Up 26-1 The Governmen udge Consrain Dynamics of deficis and deb Relaion beween defici and deb Eliminaing he deb Sabilizing he deb Evoluion of deb/gdp raio Four issues in fiscal policy Ricardian Equivalence Cyclically adjused deficis War finance and ax smoohing Dangers of very high deb 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 2 of 45
Chaper 26: Fiscal Policy: A Summing Up The Arihmeic of Deficis and Deb The budge defici in year equals: 1 r 1 G T defici = r + G T 1 The deb a he end of year -1. Are he ineres paymens during year. is governmen spending during year. is axes minus ransfers during year. 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 3 of 45
Chaper 26: Fiscal Policy: A Summing Up Working Wih Real Variables and Real Ineres Rae Noe he following of defici = r + G T 1 We measure ineres paymens as real ineres paymens raher han as acual ineres paymens. The correc measure of he defici is someimes called he inflaionadjused defici. ecause governmen expendiure and ax paymens are in real erms, he ineres rae should also be real 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 4 of 45
Chaper 26: Fiscal Policy: A Summing Up Defici=Ineres Paymens+Primary Defici defici = r + G T 1 I is ofen convenien o decompose he defici ino he sum of wo erms: Ineres paymens on he deb, r -1 The difference beween spending and axes, G -T. This erm is called he primary defici (equivalenly, T G is called he primary surplus). 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 5 of 45
Chaper 26: Fiscal Policy: A Summing Up The Arihmeic of Deficis and Deb The governmen budge consrain saes ha he change in governmen deb during year is equal o he defici during year : = defici 1 So, deficis lead o building up of deb 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 6 of 45
Chaper 26: Fiscal Policy: A Summing Up The Arihmeic of Deficis and Deb = r + G T 1 1 change in he deb ineres paymens Primary defici Or: = ( + r) + G T 1 1 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 7 of 45
Chaper 26: Fiscal Policy: A Summing Up Figure 1 Official and Inflaion-Adjused udge Deficis for he Unied Saes, 1968-2004 Inflaion Accouning and he Measuremen of Deficis 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 8 of 45
Chaper 26: Fiscal Policy: A Summing Up Curren Versus Fuure Taxes Le s look a he implicaions of a 1-year decrease in axes for he pah of deb and fuure axes. We sar wih a balanced budge, and end he year wih he governmen decreasing axes by 1 for 1 year. Wha happens hereafer? 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 9 of 45
Chaper 26: Fiscal Policy: A Summing Up Full Repaymen in ear 2 = ( 1 + r) + ( G T ) 2 1 2 2 Replacing 2 =0 and 1 =1, and rearranging: T2 G2 = ( 1 + r) 1 = ( 1 + r) In words, o repay he deb fully in year 2, he governmen mus run a primary surplus equal o (1+r). 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 10 of 45
Chaper 26: Fiscal Policy: A Summing Up Full Repaymen in ear 2 Figure 26-1 Tax Cus, Deb Repaymen, and Deb Sabilizaion (a) If deb is fully repaid during year 2, he decrease in axes of 1 in year 1 requires an increase in axes equal o (1+r) ) in ear 2. T2 G2 = ( 1 + r) 1 = ( 1 + r) 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 11 of 45
Chaper 26: Fiscal Policy: A Summing Up Full Repaymen in ear Deb a he end of year 1 is given by: 1 = ( 1 + r) 2 In year, when he deb is repaid, he budge consrain is: = ( + r) + ( G T ) 1 1 Deb a he end of year equals zero: 2 0 = ( 1 + r)( 1 + r) + ( G T ) which implies ha he necessary surplus in year o repay he deb mus be: T G = ( 1 + r) 1 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 12 of 45
Chaper 26: Fiscal Policy: A Summing Up Full Repaymen in ear 2 Figure 26-1 Tax Cus, Deb Repaymen, and Deb Sabilizaion (b) If deb is fully repaid during year 5, he decrease in axes of 1 in year 1 requires an increase in axes equal o (1+r) 4 during year 5. 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 13 of 45
Chaper 26: Fiscal Policy: A Summing Up Full Repaymen in ear Our firs se of conclusions: If governmen spending is unchanged, a decrease in axes mus evenually be offse by an increase in axes in he fuure. The longer he governmen wais o increase axes, or he higher he real ineres rae, he higher he evenual increase in axes. 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 14 of 45
Chaper 26: Fiscal Policy: A Summing Up Deb Sabilizaion in ear = ( + r) + G T 1 1 From, he budge consrain for year 2 is = ( 1 + r) + ( G T ) 2 1 2 2 Under our assumpion ha deb is sabilized in ear 2, 2 = 1 = 1. Replacing in he preceding equaion: 1 = ( 1 + r) + ( G2 T2 ) Reorganizing and bringing ( G2 T2 ) o he lef side: T2 G2 = ( 1 + r) 1 = r 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 15 of 45
Chaper 26: Fiscal Policy: A Summing Up Deb Sabilizaion in ear 2 Figure 26-1 Tax Cus, Deb Repaymen, and Deb Sabilizaion (c) If deb is sabilized from ear 2 on, hen axes mus be permanenly higher by r from ear 2 on. 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 16 of 45
Chaper 26: Fiscal Policy: A Summing Up Deb Sabilizaion in ear From he preceding arihmeic of deficis and deb we can draw hese conclusions: Deb sabilizaion requires he governmen o run a primary surplus equal o he size of he ineres paymens on he deb 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 17 of 45
Chaper 26: Fiscal Policy: A Summing Up Deb Sabilizaion in ear From he preceding arihmeic of deficis and deb we can draw hese conclusions: The legacy of pas deficis is higher governmen deb. To sabilize he deb, he governmen mus eliminae he defici. To eliminae he defici, he governmen mus run a primary surplus equal o he ineres paymens on he exising deb. 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 18 of 45
Chaper 26: Fiscal Policy: A Summing Up The Evoluion of he Deb-o-GDP Raio In an economy in which oupu grows over ime, i makes sense o focus on he raio of deb o oupu. The deb-o-gdp raio, or deb raio gives he evoluion of he raio of deb o GDP. Focusing on deb-o-gdp raios shows ha i is logical o focus on real ineres raes, as GDP is also in real erms 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 19 of 45
Chaper 26: Fiscal Policy: A Summing Up 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 20 of 45 The Arihmeic of he Deb Raio To derive he evoluion of he deb raio akes a few seps. r G T = + + ( ) 1 1 r G T = + + 1 1 1 1 1 ( ) r g G T = + + ( ) 1 1 1 r g G T = + 1 1 1 1 ( )
Chaper 26: Fiscal Policy: A Summing Up The Arihmeic of he Deb Raio r g 1 1 = ( ) + 1 This ook many seps, bu his final relaion has a simple inerpreaion: The change in he deb raio over ime is equal o he sum of wo erms. The firs erm is he difference beween he real ineres rae and he growh rae imes he iniial deb raio. The second erm is he raio of he primary defici o GDP. So, he difference wih he deb level expression is he g erm 1 G T 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 21 of 45
Chaper 26: Fiscal Policy: A Summing Up The Evoluion of he Deb Raio in OECD Counries r g 1 1 = ( ) + 1 1 This equaion implies ha he increase in he raio of deb o GDP will be larger: he higher he real ineres rae, he lower he growh rae of oupu, he higher he iniial deb raio, he higher he raio of he primary defici o GDP G T 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 22 of 45
Chaper 26: Fiscal Policy: A Summing Up The Evoluion of he Deb-o-GDP Raio in OECD Counries r g 1 1 = ( ) + 1 In he 1960s, GDP growh was srong. As a resul, r g was negaive. Counries were able o decrease heir deb raios wihou having o run large primary deficis. 1 In he 1970s, r g was again negaive due o very low ineres raes, leading o a furher decrease in he deb raio. G T 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 23 of 45
Chaper 26: Fiscal Policy: A Summing Up The Evoluion of he Deb-o-GDP Raio in OECD Counries r g 1 1 = ( ) + 1 In he 1980s, real ineres raes increased and growh raes decreased, hus, deb raios increased rapidly. Throughou he 1990s, ineres raes remained high and growh raes low. However, mos counries ran primary surpluses sufficien o imply a seady decline in heir deb raios. So far, during he 2000s, real ineres raes are low, bu many counries are running primary deficis, and heir deb raios are again going up. 1 G T 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 24 of 45
Chaper 26: Fiscal Policy: A Summing Up The Evoluion of he Deb-o-GDP Raio in OECD Counries Table 26-1 Deb and Primary Surpluses for he Unied Saes, he European Union, and Seleced Counries, 1981-2003 (Percen of GDP) Counry Deb/GDP Primary Surplus/GDP 1981 1995 2000 2003 2003 Unied Saes 25.8 49.2 34.7 36.1-1.4 European Union 24.0 53.5 47.7 52.0 0.3 Ialy 56.4 108.7 98.7 93.5 2.3 elgium 82.2 125.2 103.0 94.2 5.5 Greece 26.1 108.7 106.2 103.0 2.1 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 25 of 45
Chaper 26: Fiscal Policy: A Summing Up 26-2 Four Issues in Fiscal Policy Having looked a he mechanics of he governmen budge consrain, we can now ake up four issues in which his consrain plays a cenral role. 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 26 of 45
Chaper 26: Fiscal Policy: A Summing Up Ricardian Equivalence The Ricardian Equivalence, furher developed by Rober arro, and also known as he Ricardo-arro proposiion, is he argumen ha, once he governmen budge consrain is aken ino accoun, neiher defici nor deb has an effec on economic aciviy. axes omorrow. 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 27 of 45
Chaper 26: Fiscal Policy: A Summing Up Ricardian Equivalence Consumers undersand he budge consrain of he governmen. If he governmen decreases axes oday, hey will have o raises axes omorrow for given level of governmen expendiures. Hence, consumers do no change heir consumpion in respond o a ax cu if he presen value of afer-ax labor income is unaffeced. The effec of lower axes oday is cancelled ou by higher omorrow Hence, consumers will save he money from ax cus o pay for he higher axes in he fuure Implicaions for effeciveness curren fiscal simulus 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 28 of 45
Chaper 26: Fiscal Policy: A Summing Up Deficis, Oupu Sabilizaion, and he Cyclically Adjused Defici The fac ha budge deficis have adverse effecs implies ha deficis during recessions should be offse by surpluses during booms. The defici ha exiss when oupu is a he naural level of oupu is called he fullemploymen defici. Oher erms used are midcycle defici, sandardized employmen defici, srucural defici, or cyclically adjused defici. 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 29 of 45
Chaper 26: Fiscal Policy: A Summing Up Deficis, Oupu Sabilizaion, and he Cyclically Adjused Defici Composing he cyclically adjused defici requires wo seps: 1)Deermine how much higher he defici is when oupu is 1% lower 2)Deermine how much oupu deviaes from is naural level The second sep is ricky as he naural level of oupu can vary over ime. In he beginning of he 80s he naural unemploymen level increased and so he naural oupu level decreased. Therefore oupu was no so much below rend and he cyclically adjused defici was higher han iniially calculaed 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 30 of 45
Chaper 26: Fiscal Policy: A Summing Up Deficis, Oupu Sabilizaion, and he Cyclically Adjused Defici A reliable rule of humb is ha a 1% decrease in oupu leads auomaically o an increase in he defici of 0.5% of GDP. If oupu is, say 5% below is naural level, he defici as a raio of GDP will herefore be abou 2.5% larger han i would be if oupu was a he naural level of oupu. This effec of he defici on economic aciviy has been called he auomaic sabilizer. 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 31 of 45
Chaper 26: Fiscal Policy: A Summing Up Wars and Deficis The economic burden of a war affecs consumers and firms differenly depending on how he war is paid for. There are wo good reasons o run deficis during wars: The firs is disribuional. Defici finance is a way o pass some of he burden of he war o hose alive afer he war. The second is more narrowly economic. Defici spending helps reduce ax disorions. 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 32 of 45
Chaper 26: Fiscal Policy: A Summing Up Passing on he urden of he War Wars lead o large increases in governmen spending. Suppose he governmen relies on defici finance. Wih governmen spending sharply up, here will be a very large increase in he demand for goods. Wih governmen borrowing up, he ineres rae also goes up. As a resul invesmen falls sharply Suppose insead ha he governmen finances he spending increase hrough an increase in axes. Then consumpion will decline sharply. 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 33 of 45
Chaper 26: Fiscal Policy: A Summing Up Reducing Tax Disorions Very high ax raes can lead o very high economic disorions. People will work less, and engage in illegal, unaxed aciviies. Tax smoohing is he idea ha i is beer o mainain a relaively consan ax rae, o smooh he ax disorions Tax smoohing implies large deficis when governmen spending is high and small surpluses he res of he ime. Implicaion for ageing: reduce deb oday, as pension and healh care spending will be higher in 20 years 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 34 of 45
Chaper 26: Fiscal Policy: A Summing Up The Dangers of Very High Deb r g 1 1 = ( ) + 1 ( G T ) The higher he raio of deb o GDP, he larger he poenial for caasrophic deb dynamics. Expecaions of higher and higher deb give a hin ha a problem may arise. As a resul he ineres rae required may rise sharply As is clear from he formula, deb accumulaes much faser hen 1 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 35 of 45
Chaper 26: Fiscal Policy: A Summing Up The Dangers of Very High Deb r g 1 1 = ( ) + 1 ( G T ) Deb repudiaion consiss of canceling he deb, in par or in full. Deb repudiaion can be a self-fulfilling sory: when he marke becomes afraid of deb repudiaion, hey will require a much higher ineres rae As a resul he public deb rises much faser and i migh become aracive for he governmen o indeed defaul on is deb Hence, here can be muliple equilibria, a good equilibrium (no deb defaul) and a bad equilibrium (deb defaul) Wih higher deb levels, he bad equilibrium is more likely 1 2006 Prenice Hall usiness Publishing Macroeconomics, 4/e Olivier lanchard 36 of 45