The Government Budget, Foreign Borrowing, and the Twin Deficits Chapter 5 The Government Budget, Foreign Borrowing, and the Twin Deficits

Key Questions How does fiscal policy affect the budget surplus or deficit? How is the government budget interact with net exports and foreign lending? Why does a negative current account deficit generally lead to an increase in countrıes indebtedness to foreigners? Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Budget Deficit Actual government budget deficit, as measured by the excess of government expenditure over tax revenues (G – T). Budget deficit can be decomposed into two distinct parts. This distinction is necessary because changes in the budget deficit arise from two distinct sources. The cyclical component, Which occurs because national income changes over the business cycle. The cyclical component is tempered, however, because of the presence of automatic stabilization. Automatic stabilization increases tax revenues and decreases transfers (and thus G < T) whenever income rises. It decreases tax revenues and increases transfers (and thus G > T) whenever income falls. The structural deficit, Which is the actual budget deficit minus the cyclical deficit. Changes in the structural deficit arise from changes in discretionary fiscal policy. Discretionary fiscal policy includes changes in government spending and in the tax rates. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Budget Deficit (and Surplus) Definitions The Structural Deficit is the what the deficit of the economy would be if the economy were operating at natural real GDP. The structural deficit is sometimes call the Natural Employment Deficit (NED). The Cyclical Deficit is the amount by which the actual government budget deficit exceeds the structural deficit. The Structural Surplus (or equivalently, the Natural Employment Surplus (NES)) and the Cyclical Surplus are the same as the deficit concepts with the signs reversed. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Natural Employment Deficit NED is independent of actual GDP. It is the deficit (or surplus) that would occur at natural GDP for the existing government spending and tax levels. Thus, NED changes only because of discretionary fiscal policy. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Effects of a Budget Deficit Recall the “Magic Equation” from Chapter 2: (Leakages) S + T = I + G + NX (Injections) if T = G (T-G=0): then national saving is equal to domestic and foreign investment S + (T = G)  I + NX. The Magic Equation suggests 3 ways to finance a budget deficit (i.e. T – G < 0) T – G = (I + NX) – S Private saving (S) can go up Investment (I) can fall Foreign investment (NX) can fall Because an increase in the budget deficit increases the total public debt, persistent budget deficits can lead to higher taxes in the future. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Automatic vs. Discretionary Fiscal Policy Algebraically, the Budget surplus = T – G = tY – G (where t = the average net tax rate). Automatic stabilization of the budget deficit occurs because government tax revenues depend on income. If Y  T which helps to restrain expansions If Y  T which helps to dampen recessions Discretionary fiscal policy alters tax rates and/or government expenditures in a deliberate attempt to influence real output and unemployment. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 5-2 The Relation Between the Government Budget Surplus or Deficit and Real Income Changes in real income reflect a movement along the BB, curve while changes in discretionary fiscal policy shift the BB curve. It is important to measure whether a change in the actual surplus or deficit is due to a change in national income (the cyclical surplus or deficit) or a change in discretionary fiscal policy (the structural surplus or deficit). Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 5-3 Effect on the Budget Line of an Increase in Government Expenditures Source: Bureau of Economic Analysis, and Congressional Budget Office. Details in Appendix C-4 Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

National Saving National Saving is the sum of private and government saving: NS = S + (T – G) Recall the Magic Equation: T – G = (I + NX) – S Rearranging yields  S + (T – G) = I + NX  NS = I + NX Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

National Saving, Investment, and r Recall: Investment depends negatively on r. National saving has two components: (T – G) does not depend on r S increases with a higher r In a closed economy, NS = I at equilibrium. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 5-5 National Saving and Domestic Investment in a Closed Economy Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 5-6 Effect of a Fiscal Expansion in a Closed Economy Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Fiscal Policy in a Small Open Economy Recall: An Open Economy sells exports to other nations, buys imports, and experiences capital flows in and out of the country. A Small Open Economy (or SOE) is considered too small for its domestic policies to affect the world interest rate. Therefore, the local r must equal the world interest rate, rf . The “Magic Equation” written to reflect changes in its component parts is: ∆NS = ∆I + ∆NX But since r = rf is unaffected by domestic policies  ∆I = 0  ∆NS = ∆NX Implication: If G  NS  NX, but I unaffected Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 5-7 Effect of a Fiscal Expansion in an Open Economy (1 of 2) Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 5-7 Effect of a Fiscal Expansion in an Open Economy (2 of 2) Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 5-7 Effect of a Fiscal Expansion in an Open Economy Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

The Current Account and the BOP The Current Account (CA) records the nation’s current international transactions including exports and imports of goods and services (i.e. NX), net income from abroad and net unilateral transfer payments. The Capital Account (KA) records international capital flows, which consist of purchases and sales of foreign assets by domestic residents, as well as purchases and sales of domestic assets by foreign residents. The Balance of Payments (BOP) is the record of a nation’s international transactions. Algebraically: BOP = CA + KA Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Foreign Borrowing and Int’l Indebtedness A current account deficit must be financed either by: Net borrowing from foreigners This is recorded as a capital account surplus. Net borrowing from foreign central banks This is recorded as a balance of payments deficit. A nation’s Net International Investment Position is the difference between all foreign assets owned by a nation’s citizens and domestic assets owned by foreign citizens. ∆ Net Int’l Investment Position = CA Balance + Net Revaluations (where Net Revaluations is the change in the dollar value of financial assets due to fluctuations in financial markets and the exchange rate) Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Solutions to the National Saving Squeeze How can national saving be increased to stimulate domestic investment and long-run economic growth? Two Obvious Solutions: Raise the private saving rate Raise the government saving rate by: Increasing T and/or Decreasing G Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Chapter Equations Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Chapter Equations Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Chapter Equations Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Chapter Equations Copyright © 2009 Pearson Addison-Wesley. All rights reserved.