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1MANKIW'S MACROECONOMICS MODULES MANKIW'S MACROECONOMICS MODULESCHAPTER 16Government Debt and Budget DeficitsA PowerPointTutorialTo AccompanyMACROECONOMICS, 7th. EditionN. Gregory MankiwTutorial written by:Mannig J. SimidianB.A. in Economics with Distinction, Duke UniversityM.P.A., Harvard University Kennedy School of GovernmentM.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management
2What is the government debt and the annual budget deficit? When a government spends more than it collects in taxes, it has a budge deficit, which it finances by borrowing from the private sector.The government debtis an accumulationof all past annualdeficits. In 2005, the debt of the U.S. federal government was $4.7trillion.National DebtAnnual Deficit (2007)Annual Deficit (2006)Annual Deficit (2005)Annual Deficit (2004)Annual Deficit (2003)Annual Deficit (2002)
380s increase in government debt Ronald Reagan and the80s increase in government debtWhen Ronald Reagan because president in 1980, he wanted toreduce taxes and increase military expenditures. These policies,coupled with a deep recession attributable to tight monetary policy,began a long period of subsequent higher budget deficits.The increase in government debt during the 1980s caused concernamong policymakers. In response, over the next few years, therewere tax increases, spending restraints, and rapid economicgrowth due to the technology boom, which ultimately, caused thebudget deficits to shrink and eventually turn into surpluses.
4Problems in Measurement The government budget deficit equals governmentspending minus government revenue, which inturn equals the amount of new debt the governmentneeds to issue to finance its operations.A meaningful deficit…Modifies the real value of outstanding public debt to reflect current inflation.Subtracts government assets from government debt.Includes hidden liabilities that currently escape detection in the accounting system.Calculates a cyclically-adjusted budget deficit (based on estimates of what government spending and tax revenue would be if the economy were operating at its natural rate of output and employment).
5The Traditional View of Government Debt How would a tax cut and budget deficit affect the economy and the economic well-being of the country?From Chapter 3, we know that a tax cut stimulates consumer spending and reduces national saving. The reduction in saving raises the interest rate, which crowds out investment. From Chapter 7, the Solow growth model shows that lower investment leads to a lower steady-state capital stock and lower output. From Chapter 8, we know that the economy will then have less capital than the Golden Rule steady-state, which will mean lower consumption and lower economic well-being. Using Chapter 10-11,we can analyze the short-run impact of the policy change via the IS-LM model. Using Chapters 5 and 12, we can see how international trade affects this policy change. When national saving falls, people borrow from abroad, causing a trade deficit. It also causes the dollar to appreciate. The Mundell-Fleming model shows that the appreciation and the resulting fall in net exports reduce the short-run expansionary effect of the fiscal change.
6The Ricardian View of Government Debt +DTlater-DT + DGForward-looking consumers perceive that lower taxes now mean higher taxes later, leaving consumption unchanged. “Tax cuts are simply tax postponements.”When the government borrows to pay for its current spending (higher G), rational consumers look ahead to the future taxes required to support this debt.
7Consumers and Future Taxes The essence of the Ricardian view is that when people choose theirconsumption, they rationally look ahead to the future taxes implied bygovernment debt. But, how forward-looking are consumers?Defenders of the traditional view of government debt believe that theprospect of future taxes does not have as large an influence on currentconsumption as the Ricardian view assumes.Some of their arguments follow.
8Myopic (short-sighted) Consumers Proponents of the Ricardian view assume that people are rational when making decisions such as choosing how much of their income to consume and how much to save. When the government borrows to pay for current spending, rational consumers look ahead to anticipate the future taxes required to support this debt.One argument for the traditional view is that people are myopic: they see a decrease in taxes in such a way that their current consumption increases because of this new “wealth.” They don’t see that when expansionary fiscal policy is financed through bonds, they will have to pay more taxes in the future since bonds are just a tax-postponements.
9Borrowing Constraints The Ricardian view of government debt assumes that consumers basetheir spending not only on current but on their lifetime income, whichincludes both current and expected future income. Advocates of thetraditional view of government debt argue that current consumption ismore important than lifetime income for those consumers who faceborrowing constraints, which are limits on how much an individualcan borrow from banks or other financial institutions.People who want to consume more than their current income must borrow. If they can’t borrow to finance their current consumption, their current income determines what they can consume, regardless of their future income. In this case, a debt-financed tax cut raises current incomeand thus consumption, even though future income is lower. In essence, when a government cuts current taxes and raises future taxes, it is giving taxpayers a loan.
10Balanced Budgets Versus Optimal Fiscal Policy Most economists oppose a strict rule requiring the government to balancethe budget. There are three reasons why optimal fiscal policy may attimes call for a budget deficit or surplus:1) Stabilization2) Tax smoothing3) Intergenerational redistribution
11StabilizationA budget deficit or surplus can help stabilize the economy. A balancedbudget rule would revoke the automatic stabilizing powers of thesystem of taxes and transfers. When the economy goes into a recession,tax receipts fall, and transfers automatically rise. Although theseautomatic responses help stabilize the economy, they push the budgetinto deficit. A strict balanced-budget rule would require that thegovernment raise taxes or reduce spending in a recession, but theseactions would further depress aggregate demand.
12Tax SmoothingA budget deficit or surplus can be used to reduce the distortion ofincentives caused by the tax system. High tax rates impose a cost onsociety by discouraging economic activity. Because this disincentiveis so costly at particularly high tax rates, the total social cost of taxesis minimized by keeping tax rates relatively stable rather than makingthem high in some years and low in others. This policy is calledtax smoothing. To keep tax rates smooth, a deficit is necessary in yearsof unusually low income or unusually high expenditure.
13Intergenerational Redistribution A budget deficit can be used to shift a tax burden from current tofuture generations. For example, some economists argue that if thecurrent generation fights a war to preserve freedom, future generations benefit as well and should therefore bear some of the burden. To pass on the war’s costs, the current generation can finance the war with a budget deficit. The government can later retire that debt by raising taxes on the next generation.
14Fiscal Effects on Monetary Policy One way for a government to finance a budget deficit is to printmoney—a policy that leads to higher inflation. When countriesexperience hyperinflation, the typical reason is that fiscal policymakersare relying on the inflation tax to pay for some of their spending. Theends of hyperinflations almost always coincide with fiscal reforms thatinclude large cuts in government spending and therefore a reduced needfor seigniorage.
15Key Concepts of Chapter 16 Capital BudgetingCyclically adjusted budget deficitRicardian equivalence