ECOS3997 Interdisciplinary Impact in Economics
Interdisciplinary Impact in Economics
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ECOS3997
Interdisciplinary Impact in Economics
Stream 4: Implications of Macroeconomic Policies
Lecture 8: Implications and Current Issues
of Fiscal policy
Semester 2, 2023
1
This lecture
• Fiscal policy: Summing up
• Dynamics of government debt
– Dynamics of deficits and debt
– Problems with high public debt
• Applications
– Ricardian equivalence
• Reading:
• Blanchard chapter 22
• Mankiw chapter 17
2
Fiscal policy: Summing Up
3
Fiscal policy: Summing Up
• In most advanced economies, the crisis has led to large
budget deficits and a large increase in debt-to-GDP ratios.
• This calls for governments to reduce deficits, stabilize the
debt, and reassure investors.
• The purpose of this lecture is
– to review what we have learned about fiscal policy so far
– to explore in more depth the dynamics of deficits and debt
– to shed light on the problems associated with high public debt
4
Fiscal policy in the short-run
• Economy in the short-run:
– output primarily driven by movements in aggregate demand
– unemployment is negatively related to output
– many prices are sticky (not fully flexible)
• Types of fiscal policy:
– Fiscal contraction, decrease in G and/or increase in T
– Fiscal expansion, increase in G and/or decrease in T
• Fiscal policy affects the position of IS curve, still affects
financial markets through money demand
5
Fiscal policy in the short-run
• Fiscal policy, output, and unemployment
– fiscal expansion increases output, decreases unemployment
– fiscal contraction decreases output, increases unemployment
• Fiscal policy, output, and interest rate
– fiscal contraction leads to lower disposable income
– households decrease consumption
– decrease in demand leads to a decrease in output and income
through a multiplier
– decrease in the policy rate by the central bank can potentially
offset the adverse effects of the fiscal contraction
6
Fiscal policy in the short-run
• Increase in taxes (contractionary fiscal policy) shifts IS curve to the left,
making output ↓, unemployment ↑
7
Fiscal policy in the medium-run
• When the economy is in a liquidity trap,
– a reduction in the interest rate can no longer be used to
increase output
– fiscal policy (i.e., large increases in spending and tax cuts) has
an important role to play
• In the medium-run (that is, taking the capital stock as given),
– a fiscal consolidation has no effect on output
– but is reflected in a different composition of spending
8
Fiscal policy in the medium-run
• Medium run equilibrium: inflation stable, (πt = πt−1), and
shocks at their mean values (εt = vt = 0)
• Because of adaptive expectations, this implies inflation
expectations also stable
Et(πt+1) = πt = πt−1 = Et−1(πt)
• Phillips curve implies output at natural level: Yt = Y¯
• Demand for goods implies real rate at natural rate: rt = ρ
• Fisher equation then implies: it = ρ+ πt
• Monetary policy rule then implies: πt = π∗
9
Fiscal policy in the long-run
• Economy in the long-run:
– trend growth dominates (cf. fluctuations dominate in the
short and medium-run)
– long-run growth is driven by supply-side considerations
– prices are flexible
• Saving (both private and public) affects the level of capital
accumulation and the level of output in the long run
• Once capital accumulation is taken into account, a larger
budget deficit leads to a lower level of output in the long run
– lower national saving rate decreases capital accumulation
10
Fiscal policy and expectations
• Returning to the short-run effects of fiscal policy
• Considering not only fiscal policy’s direct effects through
taxes and government spending, but also its effects on
expectations
• Effects of fiscal policy depend on
– expectations of future fiscal policy
– deficit reduction leads to
• people’s expectations of higher future disposable income
• an increase in output even in the short-run
11
Fiscal policy and open economy
• Fiscal policy affects both output and the trade balance
– fiscal expansion at home reduces national saving, net capital
outflow, and the supply of domestic currency in the exchange
market ⇒ ϵ ↑, NX ↓ (i.e., trade deficit)
• The effects of fiscal policy depend on the exchange rate
– fiscal policy has a stronger effect on output under fixed
exchange rates than under flexible exchange rates
– e.g., fiscal expansion at home
• would raise the exchange rate (if under flexible exchange rate)
• To fix the exchange rate, the central bank increases Ms
• resulting in a higher level of output in the equilibrium
12
Fiscal policy under fixed exchange rates
• Exchange rate fixed at e1 (i.e., ∆ϵ = 0)
• output increases from Y1 to Y2 (i.e., ∆Y > 0)
13
Fiscal policy under floating exchange rates
• Exchange rate increases from e1 to e2 (i.e., ∆ϵ > 0)
• output fixed at Y1 (i.e., ∆Y = 0)
14
Dynamics of government debt
15
Government spending in Australia
• Source: Australian government, Budget strategy and outlook
• Social security and welfare is the largest functional expenditure
16
Trends in expenditure
• Source: Australian government, Budget strategy and outlook
• Prior to 2019-2020, average around 25%. During pandemic, expenditure
grew up to 34.4%
17
Government revenue in Australia
• Source: Australian government, Budget strategy and outlook
• Personal income tax is the major components of government revenue
18
Trends in revenue
• Source: Australian government, Budget strategy and outlook
• Significantly lower revenue during economic crises
19
Government budget constraint
• The budget deficit (inflation-adjusted deficit)
Deficitt = rBt−1︸ ︷︷ ︸
real interest payments
+ Gt − Tt︸ ︷︷ ︸
taxes net of transfers
(1)
– where
r: real interest rate, Bt−1: government debt at the end of year
t− 1, Gt: government spending, Tt: taxes
– Government budget deficit equals to spending, including
interest payments on the debt, minus taxes net of transfers
20
Government budget constraint
• Government budget constraint
Bt −Bt−1︸ ︷︷ ︸
change in debt
= rBt−1︸ ︷︷ ︸
interest payments
+ Gt − Tt︸ ︷︷ ︸
primary deficit
(2)
– The change in government debt during year t equals
the deficit (i.e., RHS) during year t
– or equivalently, Tt −Gt: primary surplus
– If the government runs
• a deficit, government debt ↑ as the govt borrows to fund the
part of spending in excess of revenues
• a surplus, government debt ↓ as the government uses the
budget surplus to repay part of its outstanding debt
21
Government budget constraint
• Then, government budget constraint could be rewritten as
Bt = (1 + r)Bt−1 + (Gt − Tt)︸ ︷︷ ︸
primary deficit
(3)
• This relation states that
– debt at the end of year t equals (1 + r) times the debt at the
end of year t− 1 plus primary deficit during year t
22
Government budget constraint
• Some of implications
– Consider first a one-year decrease in taxes for the path
of debt and future taxes
– Suppose the government has balanced budget, Gt = Tt,
so that initial debt (i.e., Gt − Tt) is equal to zero
– During year 1, the government decreases taxes by 1 for
one year
– Thus, debt at the end of year 1, B1 is equal to 1
– What happens thereafter?
23
Full repayment in year 2
• Suppose the government decides to fully repay the debt
during year 2
• From equation (3), Bt = (1 + r)Bt−1 + (Gt − Tt), the budget
constraint for year 2 is given by
B2 = (1 + r)B1 + (G2 − T2)
• If the debt is fully repaid during year 2, then the debt at the
end of year 2 is equal to zero, B2 = 0. Replacing B1 by 1 and
B2 by 0,
0 = (1 + r) ∗ 1 + (G2 − T2)
T2 −G2 = (1 + r) ∗ 1
= 1 + r
24
Full repayment in year 2
• To repay the debt fully during year 2,
– the government must run a primary surplus equal to 1 + r
• Two ways to make a primary surplus
1- decrease in spending
2- increase in taxes
• Suppose that adjustment comes through taxes. Then, the
decrease in taxes by 1 during year 1 must be offset by an
increase in taxes by 1 + r during year 2
25
Full repayment in year t
• Now suppose the government decides to wait until year t to
repay the debt.
• From year 2 to t− 1, the primary deficit is equal to zero:
taxes are equal to spending.
• Step 1: From equation (3), Bt = (1 + r)Bt−1 + (Gt − Tt) and
the equality condition B1 = 1, debt at the end of year 2 is
B2 = (1 + r)B1 + (G2 − T2)
= (1 + r)B1 + 0
= (1 + r) ∗ 1
= 1 + r
26
Full repayment in year t
• Now suppose the government decides to wait until year t to
repay the debt.
• From year 2 to t− 1, the primary deficit is equal to zero:
taxes are equal to spending.
• Step 2: With the primary deficit still equal to zero, debt at
the end of year 3 is
B3 = (1 + r)B2 + (G3 − T3)
= (1 + r)B2 + 0
= (1 + r) ∗ (1 + r)
= (1 + r)2
27
Full repayment in year t
• Now suppose the government decides to wait until year t to
repay the debt.
• From year 2 to t− 1, the primary deficit is equal to zero:
taxes are equal to spending.
• Step 3: Solving for debt at the end of year 4 and so on, debt
grows at a rate equal to the interest rate (as long as the
government keeps a primary deficit equal to zero)
Then the debt at the end of year t1 is given by
Bt−1 = (1 + r)t−2 (4)
28
Full repayment in year t
• The equation (4) Bt−1 = (1 + r)t−2 implies that
– Even though taxes are cut only in year 1, debt keeps
increasing over time, at a rate equal to the interest rate.
– Although the primary deficit is equal to zero, debt is now
positive, and so are interest payments on it.
• Final step: what happens in year t?