1 Introduction to Macroeconomics
2 Measuring the Macroeconomy
3 An Overview of Long-Run Economic Growth
4 A Model of Production
5 The Solow Growth Model
6 Growth and Ideas
7 The Labor Market, Wages, and Unemployment
8 Inflation
9 An Overview of the Short-Run Model
10 The IS Curve
11 Monetary Policy and the Phillips Curve
12 Stabilization Policy and the AS/AD Framework
13 The Global Financial Crisis: Overview
14 The Global Financial Crisis and the Short-Run Model
15 The Government and the Macroeconomy
16 International Trade
17 Exchange Rates and International Finance
18 Parting Thoughts




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Chapter 15: The Government and the Macroeconomy

Chapter Summary

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Key Concepts

  1. The current U.S. fiscal situation is relatively typical of recent decades: spending and taxes are low relative to most other rich countries, there is a modest budget deficit, and the debt-GDP ratio is not especially high.
  2. Absent changes in policy, this situation is likely to change significantly and for the worse in coming decades. The main reason is growth in transfer payments, especially for health care but also for Social Security.
  3. The government's intertemporal budget constraint says that the budget must balance in a present discounted value sense. That is, the present discounted value of spending must equal the present discounted value of taxes, if the economy begins with no debt. To the extent that debt is initially present, tax revenues must exceed spending.
  4. Very large debts are potentially problematic, leading to dangers of default and high inflation. However, there is no magic level of debt at which this occurs. An economy's size and growth prospects are important considerations, as is the ability of the government to collect taxes and restrain spending.
  5. The extent to which government deficits crowd out investment is unclear. The Ricardian equivalence argument says that private spending should rise to offset temporary deficits, holding spending constant. This offset seems to be incomplete in the short run, however, as government saving and the investment rate move together.

1. Introduction

  • The government is allowed to borrow or lend in a given year but the government's budget must balance in present discounted value.
    • Budget deficits today must be offset by budget surpluses.
  • Recent forecasts suggest current U.S. policies are unsustainable and will result in an explosion of deficits.

2. U.S. Government Spending and Revenue

  • In 2005, federal spending was about 20 percent of GDP, or approximately $8,300 per person.
  • Slightly more than 17 percent of GDP was collected in the form of taxes.
  • The budget balance is the difference between tax revenues and spending.
    • A budget surplus is the case when taxes exceed spending.
    • A budget deficit is the case when spending exceeds taxes.
    • When spending equals taxes, the budget is balanced.
  • To finance a budget deficit, the government borrows from lenders in the United States and abroad by selling government bonds.
  • a. Spending and Revenue over Time

    • Taxes and expenditures rose sharply during World War II.
    • Following World War II, spending and revenues were an approximately stable fraction of GDP.
    • Systematic budget deficits emerged starting around 1970.

    b. The Debt-GDP Ratio

    • Government debt is the outstanding stock of bonds that have been issued in the past.
    • As of 2005, the debt-GDP ratio was just over 37 percent -- more than $15,000 per person.
      • Half of the debt is owed to U.S. entities and the other half to foreigners.
    • The net debt is the government debt that is held outside of the government.
      • The government itself holds a large amount of bonds and including these would raise the debt-GDP ratio to 64 percent.

3. International Evidence on Spending and Debt

  • Among the richer OECD countries, the United States has a lower than average government spending to GDP ratio and a lower debt-GDP ratio.
  • The debt-GDP ratio for South Korea is negative, which means that the government is a net lender - it uses its extra revenues to accumulate financial assets.
    • Norway also has a negative debt-GDP ratio and it saves its surpluses.

4. The Government Budget Constraint

  • The flow version of the government budget constraint holds in each period and is based on a standard accounting identity that says the sources of funds to the government must equal the uses of funds.
    • The government can use its funds on government purchases, transfers, and to pay interest on government debts.
    • The government can obtain funds through taxes, new borrowing, and the change in the money stock.
  • Assume for this chapter that the change in the stock of money is zero.
  • Also, assume that transfer payments are zero.
  • Therefore, the stock of debt at the start of next year is equal to the stock of debt this year including interest payments plus the amount by which government purchases exceeds tax revenues.
  • The primary deficit is the difference between government purchases and taxes.
    • It excludes spending on interest.
  • The total deficit is government purchases plus interest payments on bonds minus taxes.
  • a. The Intertemporal Budget Constraint

    • Suppose an economy exists for only two periods.
      • The budget constraint for period 2 must equal zero because no one is willing to lend to the government in the final period because loans can never be repaid.
    • The intertemporal budget constraint is derived from substituting the second-period budget constraint into the first-period budget constraint.
      • It says that the present discounted value of spending (purchases) and initial debt must equal the present discounted value of tax revenues.
      • It implies that uses must equal sources, but now in present discounted value.
    • Rewriting the intertemporal budget constraint will show that the government's budget must balance - not period by period, but rather in a present discounted value sense.
      • In other words, the government must have surpluses in the future to pay off deficits today.

5. How Much Can the Government Borrow?

  • When considering economic consequences of deficits and debts, we must consider economic growth, the possibility of high inflation or default, intergenerational equity, and the extent to which deficits crowd out investment.
  • a. Economic Growth and the Debt-GDP Ratio

    • The amount the government can borrow is limited by the amount it can credibly be expected to pay back.
      • In part, this depends on how large the economy's GDP is.
    • It is possible for the stock of debt to grow over long periods of time if GDP is growing even faster - in which case the debt-GDP ratio will fall.

    b. High Inflation and Default

    • If the debt-GDP ratio becomes too high, lenders worry about the ability of the government to repay.
      • If they stop lending, the government may use the printing press to satisfy the budget constraint - generating inflation.
      • Investors demand higher interest rates when they doubt the ability of repayment.
    • Default is when a government declares that they will not repay certain debts or will repay them at less than face value.
    • There is no specific level of the debt-GDP ratio that triggers default and the level varies with each economy's credibility, history, and growth prospects.

    c. Generational Accounting

    • When the government borrows, it is possible that the people benefiting from the borrowing are not the same as the people repaying the debt.
    • It is arguably fair that future generations paid for World War II because the generation that fought the war made large sacrifices and future generations benefited from them.
    • Generational accounting is an approach that seeks to calculate the extent to which current policies pass on tax burdens to future generations.
      • High and rising debt-GDP ratios imply higher taxes rates on future generations.

    d. Deficits and Investment

    • Investment can be financed through saving from the private sector, government saving, and saving by foreigners.
    • Disposable income is the difference between income net of taxes and consumption.
    • Crowding out is when budget deficits may absorb some of the savings in the private sector and from foreigners - and reduce investment.
      • However, this does account for the possibility that private or foreign savings may increase in response to additional demands for funds by the government.
    • Ricardian equivalence implies that while holding the present value of government spending constant, the timing of taxes does not affect consumption.
      • This implies that budget deficits need not crowd out investment.
    • Further, if the MPK is high in the United States but there are not enough funds in the United States to finance investment, it is likely foreign savers will.
    • Economists still debate the extent to which budget deficits crowd out investment.

    e. Case Study: The War in Iraq

    • Estimates of the financial cost of the war are between $500 billion and $2 trillion - not including the costs to the Iraqis.
      • This must be compared to the cost of the alternative to a war and any possible gains from the war.

6. The Fiscal Problem of the Twenty-First Century

  • In the coming decades, with current policies in place, it is likely that the share of government spending will rise to 40 percent of GDP.
    • If taxes do not change, annual budget deficits could reach 20 percent of GDP.

    a. The Problem

    • The reason for the unsustainability of current policies is the projected rise in entitlement spending on Social Security, Medicare, and Medicaid.
    • The reasons for this rise include the increased generosity of entitlement programs and a larger fraction of the population qualifying for eligibility.
    • By 2070, if no changes are made, health and retirement spending will exceed the percentage of GDP collected in taxes.
    • Although Social Security accounts for some of the rise, the main factor is health care expenditures.
      • It is assumed that health care costs per recipient will grow at a rate that is 1 percentage point faster than the rate of GDP growth.

    b. Case Study: Financing the Social Security Program

    • Social Security is financed by an employment tax on wage income.
    • Pay-as-you-go is the system where current workers pay the benefits of the current recipients.
    • As baby boomers retire, the ratio of workers to retirees will fall and some combination of increased taxes and/or reduced benefits will be needed.
    • Yet, the problem of funding Social Security is much less severe than the problem facing health expenditures.

    c. Possible Solutions

    • To balance the budget, tax revenues would have to rise by about 9 percent of GDP by 2075.
    • Health spending is growing in all advanced economies - and that includes health spending for the economy as a whole and not just by government.
    • Waste and fraud in the health system probably does not explain the fact that health spending is growing is virtually all rich countries.
    • Another explanation of the rise is that new expensive medical technologies are raising expenditures, but people do not have to consume these technologies unless they want to nor would people invent them if they were not valuable.
    • A better alternative explanation is that health care expenditures rise faster than consumption as income grows.
      • Consumption is subject to diminishing returns.
      • Adding additional months of life is not subject to diminishing returns.
        • More time to enjoy high incomes is increasingly valuable.
      • Thus, health spending will rise by more than consumption.
    • It is likely optimal for health care expenditures to rise as a fraction of GDP as incomes rise.
    • Possible solutions, other than raising taxes, include private health insurance or mandated savings in individual health-spending accounts - although they may create new problems of their own.

7. Conclusion

  • Economic growth is a factor that helps to solve budgetary problems.
  • Yet, economic growth cannot help to solve the problem of rapidly growing expenditures on health care.

8. Additional Resources

  1. Summary
  2. Key Concepts
  3. Review Questions
  4. Exercises
  5. Worked Exercises
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