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

2. 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?
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3. 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.
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4. 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.
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5. 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.
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6. 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.
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7. 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.
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8. 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).
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9. 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
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10. 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
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11. 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.
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12. Figure 5-5 National Saving and Domestic Investment in a Closed Economy
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13. Figure 5-6 Effect of a Fiscal Expansion in a Closed Economy
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14. 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
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15. Figure 5-7 Effect of a Fiscal Expansion in an Open Economy (1 of 2)
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16. Figure 5-7 Effect of a Fiscal Expansion in an Open Economy (2 of 2)
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17. Figure 5-7 Effect of a Fiscal Expansion in an Open Economy
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18. 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
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19. 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)
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20. 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
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21. Chapter Equations
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22. Chapter Equations
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23. Chapter Equations
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24. Chapter Equations
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