1. Fiscal Policy

5. Can you run a deficit every year?

6. If then Debt-to-GDP ratio stays stable. If > then deficit is “unsustainable” Sustainable Deficit A growing economy allows the government to borrow some money every year and still keep debt in line with overall GDP

7. IMF Fiscal Indicators

8. IMF Fiscal Monitor Crisis spreads to other countries Background Reading

9. Primary Deficit Simplified Government Budget Primary Outlays (Total Expenditure less Interest Paid) - Primary Receipts (Total Revenue less Interest Income) Primary Budget Deficit + Net Interest Payments on Existing Debt General Budget Deficit

10. Sustainable Primary Deficit If then stays stable.

11. Primary Balance % of GDP

12. Consequences of Deficits Austerity Inflation Default

13. P Y Y*Y* AD Austerity and the Output Gap P*P* SRAS YPYP AD ′ 1 2 1.Economy in LT equilibrium 2.Government imposes austerity program – cuts spending, transfers, inceases taxes 3.AD Curve shifts inward. Recessionary Gap

14. Austerity has a negative effect on business cycles. IMF

15. Deficits and Inflation Government generates revenues by printing new money (referred to as seignorage). Government facing borrowing constraints may be forced to rely on inflation tax for deficit financing and real returns to owning money. Explain the link between deficits and inflation.

16. Israel 1970-1990

18. Default and Restructuring Argentina 1999-2002 IMF Study BBC Story

20. Stabilization policy In an economy subject to shocks to aggregate demand (animal spirit shocks, external shocks, asset market shocks), the economy will have a self-correcting mechanism. However, if this self-correction mechanism takes a long time to work, then government may use policy to speed adjustment. ◦ Use expansionary policy to close a recessionary gap ◦ Use contractionary policy to close an inflationary gap

21. P Y Y*Y* AD Demand Driven Recession w/ Counter-cyclical fiscal policy P*P* SRAS YPYP AD ′ 1 2 1.Economy in LT equilibrium 2.Demand shifts in 3.Government increases spending to shift the AD curve back 3 Recessionary Gap

22. P Y Y*Y* AD Demand Driven Expansion w/ Counter-cyclical fiscal policy P*P* SRAS YPYP AD ′ 1 2 1.Economy in LT equilibrium 2.Demand shifts out 3.Government cuts spending to shift the AD curve back 3 Inflationary Gap

23. Lags and Fiscal Policy Administrative lags for fiscal policy may likely be large. Except in absolute dictatorships, government will have mechanisms for building a consensus for expenditures. Adjusting this consensus will be time consuming. If lags are too long, stabilizing government spending or transfer payments may have a destabilizing effect, shifting out demand after the economy has already recovered.

24. Automatic Stabilization Governments in most economies issue debt to make up for shortfalls in revenues in relation to spending. Budget Deficit = Outlays – Revenues Tax collection is cyclical so the budget deficit tends to be counter-cyclical. Maintaining a balanced budget over the cycle means raising taxes in a recession an cutting taxes in a boom which makes the business cycle more extreme.

25. Counter-cyclical deficits

26. Learning Outcomes Use growth rate of GDP, interest rates, and the debt to GDP ratio to identify the sustainable general and primary deficit level. Use AS-AD model to identify the effects of fiscal policy on the output gap and the inflation rate.