Chapter 14 The Government Budget

2 Introduction Static Analysis : Analysis of how the economy behaves at a given point in time. Dynamic Analysis : The study of how the economy behaves at different points in time.

3 Introduction Although static analysis can go a long way toward answering questions that interest economists and policy maker, some issues in macroeconomics are explicitly dynamic. The Government Budget Neoclassical and Endogenous Growth Theory Unemployment, Inflation and Growth Rational Expectations

4 Introduction The General Theory - Keynesian economists advocated a policy of stabilization. if u u*  G↑ Following WWII, the pursuit of these policies made deficits grow as the government found it politically more expedient to increase spending than to raise taxes.

5 Introduction Difference equations enable us to know how these deficits accumulated and led to a crisis in the early 1990s that cause the government to raise taxes to balance the budget.

6 The Relationship of Debt and Deficits The primary deficit is equal to the value of government expenditures plus transfer payments minus the value of government revenues. The reported deficit is equal to the value of the primary deficit plus the value of interest payments on outstanding debt.

7 Table 14.1 ©2002 South-Western College Publishing

8 The Debt and the Deficit The U.S. evidence -- the government’s budget was on average approximately balanced from 1940 through the national debt grew dramatically in the 1980s. -- policymakers in the mid-1990s were concerned with the debt and the deficit.

9 ©2002 South-Western College Publishing Figure 14.1 The Debt and the Deficit

10 The Debt and the Deficit Figure 14.1 overstates how important this problem really was. Because the ultimate source of the government’s ability to repay is its ability to tax GDP, the appropriate measures of debt and the deficit of the U.S. are relative to GDP , WWII , peace time

11 ©2002 South-Western College Publishing Figure 14.2 The Debt and the Deficit Measured Relative to GDP

12 Using the GDP as a Unit of Measurement

13 The debt-to-GDP ratio grows for two reasons: 1.The government must issue debt to cover a primary deficit. ( d ) 2.The government must pay interest on existing debt.( (1+i)/(1+n) ) Using the GDP as a Unit of Measurement

14 Suppose that the primary deficit is equal to zero, ( d = 0 ) if i > n  the debt-to-GDP ratio will grow. if i < n  the debt-to-GDP ratio will shrink. Using the GDP as a Unit of Measurement

15 Solving a Difference Equation A difference equation describes how a (state) variable that changes over time depends on its own past value and on a number of parameters.

16 Solving a Difference Equation The solution to a difference equation is a list of values for the state variable, one for each date in the future, given the initial value of the debt-to-GDP ratio. Then we can predict what policy changes are necessary. By Iterations.

17 Steady State Solution A steady state solution is a value of the state variable that satisfies the government budget equation and that is independent of time. Condition :

18 ©2002 South-Western College Publishing Figure 14.3 How To Solve a Difference Equation with a Graph

19 Stable and Unstable Steady State If the steady state is stable, the state variable moves closer toward the steady state over time, regardless of where it starts from. Conditions : -- Stable : -- Unstable :

20 Figure 14.4A ©2002 South-Western College Publishing Stable and Unstable Steady States

21 Figure 14.4B ©2002 South-Western College Publishing Stable and Unstable Steady States

22 ©2002 South-Western College Publishing Figure 14.5 The Nominal Interest Rate and the Nominal Growth Rate in the United States, 1940–2000 (%/Year)

23 ©2002 South-Western College Publishing Table 14.2

24 The Sustainability of the Budget Deficit Budget Equation At the end of WW Ⅱ, debt was equal to 120% of GDP. For 30 years thereafter, the debt-to-GDP ratio fell steadily because i < n. d=-1.2%, n=7.5% > i=4.1%, 

25 ©2002 South-Western College Publishing Figure 14.6 The Dynamics of the Budget, 1946–1979

26 The Sustainability of the Budget Deficit The Budget Crisis of the 1980s The Fed raised the interest rate to control inflation through 1993.(monetary policy tightens) The debt-to-GDP ratio in 1979 was 30%. d=0.7%, n=6.8 < i=7.5%,  move farther away from.

27 ©2002 South-Western College Publishing Figure 14.7 The Dynamics of the Budget, 1979–1993

28 The Sustainability of the Budget Deficit The Budget Surplus Since 1993 In 1993, Congress passed the Omnibus Budget Reconciliation Act in an attempt to get deficit under control. (fiscal policy tightens) The Fed also began to lower the interest rate. d=-1.9%, n=5.5% > i=4.9%. 

29 ©2002 South-Western College Publishing Figure 14.8 The Budget Surplus Since 1993

30 Different Perspectives on Debt and Deficits Ricardian Equivalence -If government spending is financed by debt, household will choose to hold all of this increased debt without reducing the amount of saving that they devote to investments. -The reason is that they anticipate that they will need extra wealth in the future to pay increased taxes.

31 Different Perspectives on Debt and Deficits The relationship between the Budget and the Rate of Interest After 1979, - the productivity growth slowed down. ( n↓ ) -the world capital markets are linked and a high deficit in the U.S. influenced the interest rate throughout the world economy. ( i↑ ) -n < i

32 Homework Question 5, 7, 11, 12

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