Chapter 22​.

​Fiscal Policy: A SUMMING UP

I. MOTIVATING QUESTION

What do macroeconomists know about fiscal policy?

Fiscal policy affects output in the short run—through its effect on aggregate demand—and in the long
run—through its effect on investment. Fiscal policy is limited by the government budget constraint, which links
the deficit to the increase in debt. Given the budget constraint, prudence suggests that governments should run
fiscal surpluses during booms to balance deficits during recessions. Such a policy allows the government to
stimulate the economy during recession, but avoids the dangers inherent in accumulating a large debt.  

II. WHY THE ANSWER MATTERS

The major long-term policy issue facing U.S. economic policymakers is how to finance expenditures associated
with the retirement of the baby boomers and the continued aging of the population. This chapter alerts students to
what lies ahead.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS

1. Tools and Concepts
i​. The ​inflation-adjusted deficit is the deficit measured in real terms. It equals real interest payments plus
the (real) primary deficit, defined below.

ii. The ​primary deficit​ is government spending minus taxes.

iii. The ​cyclically-adjusted deficit​ measures what the deficit would be if output were at its natural level.

iv​. Ricardian equivalence is the proposition that neither deficits nor debts have any effect on economic
activity.

v. ​Debt restructuring​, or ​debt rescheduling occurs when interest payments are deferred rather than
cancelled.

vi . ​Debt monetization ​occurs when the central bank then pays the government with money it creates, and the
government uses that money to finance its deficit.

vii​. ​Hyperinflatio​n is a very high level of inflation.

IV. SUMMARY OF THE MATERIAL

 
1. What We Have Learned
This section offers a brief review of fiscal policy as covered throughout the text. The authors highlight the role of
fiscal policy during short run, medium run, and long run time periods.
● In the short run, an increase in the deficit increases aggregate demand and real output, with the strength
of the initial impact depending on expectations. In the medium run, output returns to its natural level,
but with a higher real interest rate and a lower rate of investment. In the long run, output may be lower
 (than it would be otherwise) because a higher deficit leads to less investment and therefore less capital
accumulation.
● Also the authors highlight the important role of fiscal policy during a case when the interest rate is
equal to zero and the economy is in a liquidity trap (see Chapter 6).

2. The Government Budget Constraint: Deficits, Debt, Spending, and Taxes

The inflation-adjusted deficit is defined as
 
Deficit ​= ​rB​t​-1 ​+ ​G​t​ - ​Tt​ (22.1)

where all variables are expressed in real terms, ​B is real debt, and ​r is the real interest rate. The text notes that
official deficit measures typically substitute nominal interest payments (​iB​t-​ 1​) for real interest payments (​rB​t​-1​) in
equation (26.1). The deficit is linked to the increase in debt by the government budget constraint:
 
B​t-​​ B​t​-1 =
​ ​rB​t​-1 +
​ ​G​t ​- T
​ ​t (22.2)

Defining the primary deficit as (​G​t -​ ​Tt​ ),

​ government debt can be expressed as
 
B​t =
​ (1 + ​r​)​B​t​-1 +
​ ​Primary Deficit​. (22.3)
 
This relationship implies that, starting from zero debt and a zero primary deficit, a one-unit increase in the
t​
primary deficit for one period will generate a debt of ​B​t =
​ (1 + ​r​)​ after ​t periods. To repay this debt after ​t periods,
t​
the government must run a primary surplus of (1 + ​r​)​ . If spending is unchanged, this means that a reduction in
taxes today implies an increase in future taxes of equal present value. If the government seeks to stabilize the debt
instead of repaying it, then the government must run a primary surplus equal to the real interest payment on the
debt in every future period. In other words, the government must eliminate the inflation-adjusted deficit, defined
as the primary deficit plus real interest payments on the debt (or equivalently, as the official deficit minus inflation
times real debt.)

To examine the evolution of the debt-to-GDP ratio, rewrite the government budget constraint as

B​t/​​ Y​t =
​ (1 + ​r​)(​Y​t​-1​/​Y​t)(​
​ B​t​-1​/​Yt​ ​-1​) +
​ ​(G
​ ​t -​ ​T​t)/​
​ Y​t,​
 
which can be approximated as
 
(​B​t/​​ Y​t)​ - (​B​t​-1​/​Y​t​-1​) = (​r ​- ​g​)(​B​t​-1​/​Yt​ ​-1​) + (​G​t ​- ​T​t)/​
​ Y​t,​ (22.5)
 
where ​g is the growth rate of output. Given some initial debt, equation (22.5) implies that the debt-to-GDP ratio
will grow when there is a primary deficit and when the real interest rate exceeds the growth rate of output. To
understand the latter effect, suppose the primary deficit is zero. Then, debt (the numerator) will grow at rate ​r and
output (the denominator) will grow at rate ​g​. The difference in growth rates is approximately the change in the
debt-to-GDP ratio.

3. Ricardian Equivalence, Cyclical Adjusted Deficits, and War Finance

i. Ricardian equivalence. Ricardian equivalence is the proposition that neither deficits nor debt affect
economic activity. For example, given unchanged government spending, a tax cut today implies a tax increase of
equal present value in the future. Therefore, consumer wealth is unchanged, and private consumption is
unaffected. An increase in today's government deficit will be matched with an equal increase in private saving.
In practice, however, tax increases that are distant and uncertain are likely to be ignored by consumers, because
they may not live to see them or because they do not think that far into the future. As a result, although
expectations certainly affect economic behavior, it is unlikely that Ricardian equivalence holds in strict form.

ii. Deficits, output stabilization, and the cyclically-adjusted deficit. ​The fact that deficits reduce investment
does not mean that they should be avoided at all times, but rather that deficits during recessions should be offset
by surpluses during booms. In this way, fiscal policy will not lead to a steady increase in debt. The
cyclically-adjusted deficit removes the effect of the business cycle from the deficit. Thus, it can be used to assess
whether fiscal policy is consistent with no systematic increase in debt over time. Estimating the
cyclically-adjusted deficit requires knowledge of two facts: the reduction in the deficit that would occur if output
were to increase by 1% and the difference between current output and its natural level. The first fact is relatively
easy to determine. As a rule of thumb, a 1 percent decrease in output increases the deficit by 0.5% of GDP. The
deficit increases because most taxes are proportional to output, but most spending does not depend on output.

The second fact is more difficult to ascertain, because the natural level of output depends on the natural rate of
unemployment, which changes over time.

iii. Wars and deficits. There are two good reasons to run deficits during wars. First, deficits shift part of the
burden of paying for a war to future generations (because they inherit a smaller capital stock). Second, by using
debt instead of tax financing, the government avoids imposing very large and distortionary tax rates. Borrowing
permits tax increases to be smoothed over time.

4. The Dangers of High Debt

High debt ultimately requires higher taxes in the future but it can also lead to vicious cycles. The text explains
how the ​presence of a large debt leaves government​s in a vulnerable position. For example, a government may
increase debt to the point where investors begin to worry about the government’s ability to repay the debt. These
initial groundless fears about the government's ability to repay its debt can lead to an increase in the risk premium,
which will start the process in motion. This process can turn into a vicious cycle​ ​which​ ​can become ​ ​self-fulfilling.

Figure 22-2 plots the ​spread​s between the two-year interest rate on Italian and Spanish two-year government
bonds over the interest rate of two-year German bonds. The figure shows that over the time period spanning from
March 2012 to December 2012, the spread for these countries fluctuated between 150 and 660 basis points. The
increase in the spread and volatility makes it harder for these countries to stabilize their debt ratios

● If a government does not succeed in stabilizing the debt, historically, one of two things happens: 1.)
Either the government explicitly defaults on its debt; or (2.) the government relies increasingly on money
finance (i.e. debt monetization), which typically leads to very high inflation.
1. Debt Default: Default is often partial, and creditors take what is known as a ​haircut​: A haircut of
30%, for example, means that creditors receive only 70% of what they were owed.
2. Money Finance: Entails the central bank finding itself in the ​fiscal dominance case where the
central bank must do what the government tells it to do. The government issues new bonds and tells
the central bank to buy them. The central bank then pays the government with money it creates, and
the government uses that money to finance its deficit. This process is called ​debt monetization​.
a. The revenue from money creation is called ​seignorage. ​Equation 22.6 gives us the nominal
money and real money balances relative to monthly GDP. Therefore, if a country needed to
finance a deficit of 10% of GDP through seignorage, given a ratio of central bank money to
monthly GDP of 1, the monthly growth rate of nominal money must be equal to 10%.
 Inflation is likely to follow. And very high inflation is likely to lead people to want to reduce
their demand for money, and in turn the demand for central money.
b. Chapter 22 concludes with the economic costs of hyperinflation, which are: the decline
transaction system; price signals become less and less useful; and swings in inflation become
larger and larger and harder to predict.
V. PEDAGOGY

1. Points of Clarification
It is worthwhile to emphasize that Ricardian equivalence implies that the size of the deficit has no effect on
economic activity, not that fiscal policy has no effect on economic activity. For example, starting from a position
of budget balance, the balanced budget multiplier implies that an increase in government spending fully financed
by taxes would increase aggregate demand and thus output. Ricardian equivalence implies that the effect will be
the same regardless of whether the increase in government spending is financed by tax increases or debt.

2. Alternative Sequencing
It is easy for instructors to pick and choose from this chapter. Any of the theoretical topics—for example,
Ricardian equivalence—can be examined independently. Alternatively, instructors could limit attention to the
U.S. budget deficit and ignore the theoretical sections. The 6​th edition also offers a section that explains the risk
countries facing when running a high debt.

VI. EXTENSIONS

1. The Global Crisis

Clearly, the fiscal picture is an ongoing issue. Instructors may wish to supplement the material with current
articles from the Wall Street Journal and The Economist, which highlight fiscal deficit, debt and spending issues
within the U.S. and Europe. And of course, incorporating the most recent budget projections is advisable.

2. Points of Clarification
The concept of the inflation-adjusted deficit provides instructors an opportunity to review the Fisher effect. For a
given nominal interest rate, the inflation-adjusted deficit will be less than the official deficit when inflation is
positive. Thus, it seems that the government can reduce its real deficit and its real debt burden through inflation.
In fact, historically inflation has been an important means for governments to reduce their real debt burdens.
Although governments can use inflation in this way for some period of time, they cannot do so indefinitely. In the
long run, the Fisher effect implies that the nominal interest rate will increase one-for-one with the inflation rate.
Thus, in the long run, an increase in inflation will simply increase the nominal deficit and have no effect on the
inflation-adjusted deficit.