1. Deficit Financing, National Debt and Ricardian Equivalence
Economic Modelling
Lecture 11
Deficit Financing, National Debt and Ricardian Equivalence

2. Reasons for Public Debt
No debt if the budget is balanced every time: G - T= 0  ΔB =0
Debt (B) accumulates when G > T.
Change in debt has two components
Primary deficit (ΔB = G -T)
Debt servicing rB
ΔB = (G -T) + r B (1)

3. Debt and Primary Surplus

4. Debt Dynamics: Determinants of Debt/GDP Ratio
(5)
Higher the interest rate causes a rise in B/Y
Lower the growth rate of output causes a rise in B/Y
Higher the current deficit (G -T) leads to higher B/Y
Higher initial B/Y implies higher B/Y in subsequent years
Example
Debt ratio = 100% r = 3% g = 2%
T-G = 1% is required to keep B/Y constant

5. Proof of the Debt Dynamics Formula
(5)

6. Inflationary Finance of Public Budget Deficit
Higher the interest rate causes a rise in B/Y
Higher inflation rate lowers the debt/GDP ratio
Lower the growth rate of output causes a rise in B/Y
Higher the current deficit (G -T) leads to higher B/Y
Higher initial B/Y implies higher B/Y in subsequent years
Higher growth rate of money supply lowers the debt/gdp ratio.
Example
Debt ratio = 100% i = 5% g = 2%  =2%
G-T = 4% then money supply should increase by 3% to keep B/Y constant

7. Proof for Inflationary Finance of Public Budget Deficit
Formula:
Proof:
and

8. Revenue from Inflation Tax and Its Limitations
Inflation rate equals
growth rate of money
supply in the steady state.
S-Max
Seigniorage
S-low
S = F()
-max
Inflation tax
-low
-high

9. Seigniorage (Inflation Tax) : A Numerical Example Si
1000
905
0.01
9.05
819
0.02
16.38
607
0.05
30.35
368
0.1
36.8
135
0.2 27 82
0.25
20.5 7
0.5
3.5

10. Macroeconomic Problem: High Inflation
Average Average Monthly Inflation Monthly Money Country Beginning End PT/PO rate (%) Growth (%)
Austria Oct Aug
Germany Aug Nov x
Greece Nov Nov x
Hungary I Mar Feb
Hungary II Aug Jul x ,800 12,200
Poland Jan Jan
Russia Dec Jan x
Average Monthly Inflation Rate (%)
Argentina
Brazil
Nicaragua
Peru
Source: Blanchard (2000)

11. Ricardian Equivalence Theorem: Questions
Should government finance public budget deficit by borrowing or by raising taxes?
is it possible to cut tax rates without a cut in public spending?
David Ricardo. British economist, who wrote about 180 years ago that it is not.
Ricardian Equivalence Theorem states that borrowing more from private sector or taxing more have equivalent outcome.

12. Basic Proposition of the Ricardian Equivalence Tax or Borrowing Does not Make Any Difference
Tomorrow C2
Before Borrowing
Budget Constraint
After borrowing
budget constraint C1
Today

13. Ricardian Equivalence: Main Proposition
It does not matter whether public deficit is financed by raising tax rates or by borrowing from the private sector.
More Borrowing now means higher rates of tax in the future for repayment of debt.
With higher amount of public debt now private households save more in anticipation of higher taxes in the future that government will impose on them to repay the debt.
Private households optimise intertemporally and completely internalise public policy.
Borrowing now or raising tax now are equivalent strategies if both the government and household honour their own inter temporal budget constraints.

14. Limitations of Ricardian Equivalence Theorem
Why was there a big concern on accumulation of public debt in 1970 and early 1980s? Also to debt accumulation in many developing economies?
By Ricardian Equivalence private saving rises against an increase in the public sector deficit.
If private sector saving compensates for public sector deficit then there is no alteration in national saving in response to public debt.
There is no crowding out between public and private sector.
This does not hold when private agents face inter generational borrowing-lending constraint or if it takes long time for government to increase taxes to repay debt.
By choosing deficit financing by borrowing government is promoting inter generational transfers because current debts may be paid by taxing people in the far distant future generation.
Main issue in this intergenerational transfer is that how many people save for their children, grand children or grand-grand children?

15. References Ricardo David, Principles of Political Economy
Blanchard(26)
Aghevli B B (1977), Inflationary Finance and Growth, Journal of Political Economy, vol. 85, no.6 pp
Barro, R. J. (19740, "Are Government Bonds Net Wealth?," Journal of Political Economy pp
Bhattarai K. (2002) Welfare Impacts of Equal-yield Tax Reforms in the UK Economy, mimio, University of Hull.
Bhattarai (2003) Macroeconomic Impacts of Taxes: A General Equilibrium Analysis, University of Hull.
Clark Tom , M Elsby and S Love (2001) Twenty Five Years of Falling Investment? Trends in Capital Spending on Public Services, Institute of Fiscal Studies.
Dilnot A, C.Emmerson and H.Simpson (2002) The IFS Green Budget: January 2002, Institute of Fiscal Studies, Commentary 87, 7 Ridgemount Street, London WC1E 7AE.
HM Treasury (2002) Reforming Britain’s Economic and Financial Policy, Palgrave.
Institute for Fiscal Studies (2002), The IFS Green Budget, January.
Ricardo David, Principles of Political Economy