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Macroeconomics ECO 403

LESSON 36

GOVERNMENT DEBT (Continued...)

Traditional view of govt. debt.

How would a tax cut and budget deficit affect the economy and the economic well-being of the

country?

· A tax cut stimulates consumer spending and reduces national saving. The reduction in

saving raises the interest rate, which crowds out investment.

· The Solow growth model shows that lower investment leads to a lower steady-state

capital stock and lower output.

Solow Growth Model

Change in capital stock= investment depreciation

Δk = i δk

Since i = sf (k), this becomes:

Δk = s f(k) δk

Solow Growth Model

Investment and

Δk = sf (k) - δk

depreciation

δK

sf (k)

Δk

investment

depreciation

Capital per

worker, k

The economy will then have less capital than the Golden Rule steady-state which will

mean lower consumption and lower economic well-being.

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Macroeconomics ECO 403

Starting with too little capital

If K* < K* gold, then increasing c* requires an increase in s.

Future generations enjoy higher consumption, but the current one experiences an initial drop

in consumption.

time

Then we analyze the short-run impact of the policy change via the IS-LM model.

A Tax Cut

We Have C = C (Y -T)

At any value of r, ↓T⇒↑C ⇒ ↑E ⇒ ↑Y

...so the IS curve shifts to the right. The horizontal distance of the IS shift equals

ΔY = MPC/(1 MPC) ΔT

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Macroeconomics ECO 403

E =Y

E =C2+I (r1 )+G

E =C1 +I (r1 )+G

ΔY

IS2

IS1

Next, we can see how international trade affects this policy change. When national

saving falls, people borrow from abroad, causing a trade deficit. It also causes the local

currency to appreciate.

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Macroeconomics ECO 403

International Trade

S2 I(r*)

S1 I(r*)

ε2

ε1

NX(ε )

NX 1

NX 2

The Mundell-Fleming model shows that the appreciation and the resulting fall in net

exports reduce the short-run expansionary effect of the fiscal change.

Mundell-Fleming Model

Y = C (Y - T ) + I (r *) + G + NX (e )

M P = L (r *,Y )

At any given value of e, a fiscal expansion increases Y, shifting IS* to the right. Results: Δe >

0, ΔY = 0

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Macroeconomics ECO 403

LM*1

IS*2

IS*1

The Ricardian View of Government Debt

Forward-looking consumers perceive that lower taxes now mean higher taxes later, leaving

consumption unchanged. "Tax cuts are simply tax postponements."

When the government borrows to pay for its current spending (higher G), rational

consumers look ahead to the future taxes required to support this debt.

Another view

Govt. borrows Rs. 1,000 from a citizen to give him a Rs. 1,000 tax cut (similar to as

giving him a Rs. 1,000 govt. bond as a gift)

On one side the government owes him Rs. 1,000 plus interest. On the other side, he

owes Rs. 1,000 plus interest.

Overall no change in citizen's wealth because the value of the bond is offset by the

value of the future tax liability

General Principal (Ricardian equivalence)

Government Debt is equivalent to future taxes

If consumers are forward looking, future taxes are equivalent to current taxes

Financing govt. by debt is equivalent to financing it by taxes.

Consumers and Future Taxes

· The essence of the Ricardian view is that when people choose their consumption, they

rationally look ahead to the future taxes implied by government debt. But, how forward-

looking are consumers?

· Defenders of the traditional view of government debt believe that the prospect of future

taxes does not have as large an influence on current consumption as the Ricardian

view assumes.

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Macroeconomics ECO 403

Myopia

Ricardian view assumes that people are rational when making decisions. When the govt.

borrows to pay for current spending, rational consumers look ahead to anticipate the future

taxes required to support this debt.

Traditional view is that people are myopic, meaning that they see a decrease in taxes in

such a way that their current consumption increases because of this new "wealth." They

don't see that when expansionary fiscal policy is financed through bonds, they will just have

to pay more taxes in the future since bonds are just a tax-postponements.

Borrowing Constraints

· The Ricardian view assumes that consumers base their spending not only on current but

on their lifetime income, which includes both current and expected future income.

· Advocates of the traditional view argue that current consumption is more important than

lifetime income for those consumers who face borrowing constraints, which are limits on

how much an individual can borrow from financial institutions.

· A person who wants to consume more than his current income must borrow. If he can't

borrow to finance his current consumption, his current income determines what he can

consume, regardless of his future income. So, a debt-financed tax cut raises current

income and thus consumption, even though future income is lower.

· In essence, when a government cuts current taxes and raises future taxes, it is giving tax

payers a loan.

Future Generations

According to traditional view of government debt, consumers expect the implied future taxes

to fall not of them but on future generations. This behavior raises the lifetime resources of

the current generation as well as their consumption.

In essence, the debt-financed tax cut stimulates the consumption because it gives the

current generation the opportunity to consume at the expense of the next generation

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