Fiscal Policy

Th e Ev olut ion of t he
De bt /GD P Ra tio

The Government Budget Constraint in Terms of

GDP
Lets divide both sides of equation by real
output, Yt, to get:

Rewriting:

By defining g, the growth rate of output, we

have
Yt1/Yt = 1/(1 + g). Moreover, by approximating
(1 + r)/(1 + g) with 1+rg:
The Government Budget Constraint
The Evolution of the Debt Ratio

B B B G T
t
(r g )
t 1
t 1 t t

Y Y
t t 1
Y Y t 1 t

This equation implies that the increase in the

ratio of debt to GDP will be larger:

the higher the real interest rate,

the lower the growth rate of output,

the higher the initial debt ratio,

Th e Ev olut ion of t he
De bt /GD P Ra tio (Co nti nu e d)

The Debt Ratio in the Long Run

We want to study the evolution of the debt ratio,

given all other variables

We assume that the government runs primary

deficits
(or surpluses) in relation to GDP that are constant
over time, namely that (Gt Tt)/Yt is constant. We
also assume that r and g are constant.
Th e E v olu t io n of t h e
D eb t /G DP Ra t io ( C o n t in u ed )

The Debt Ratio in the Long Run

1. The growth rate of GDP is smaller than the real

interest rate.
2. The GDP growth rate exceeds the real interest rate.
 The evolution of debt is given by

Consider a country with a high debt

ratio, say 100%. Suppose that the
real interest rate is equal to 3%, and
that the growth rate is 2%.
The term on the right hand side of
equation is equal to (3% 2%)
100% = 1% of GDP
 Suppose further that the government
generates a primary surplus of 1%, a level
just sufficient to maintain a constant debt
ratio in this case, the right side of the
equation is equal to 1% + (1%) = 0%.
Suppose CB increases the interest rate
from 3% to 6%
Finally, suppose that the higher interest
rate triggers a recession, so that the
growth rate falls to 0%.
 r g is equal to 6% 0% = 6%. With an increase
of r g to 6%, to maintain a constant debt ratio,
the government should increase its primary surplus
by five points, from 1% to 6%.
To increase the primary surplus, the government
raises taxes, but tax hikes are unpopular; they
generate even more political uncertainty and
further increase the risk premium and, therefore,
interest rates.
The fiscal tightening induced by the first increase in
interest rates then generates an even deeper
recession, further reducing the rate of growth.
 Budget Deficits and Money Creation

A government can finance its budget deficit either by:

Borrowing (issuing bonds), or by creating money.

Debt monetization is the process by which the

government issues bonds and asks the central bank
to buy them; then, the central bank pays the
government with money it creates, and the
government uses that money to finance the deficit.
Chapter 23: High Inflation

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard
 Budget Deficits and Money Creation

Seignorage is the amount of real revenue the government

can generate from money creation.

M
s e ig n o r a g e
P
Chapter 23: High Inflation

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard
 Budget Deficits and Money Creation

The rate of nominal money growth required to

generate a given amount of seignorage is:

M M M

P M P
M M
Seignorage
M P
In words, seignorage is the product of the rate of
nominal money growth and real money balances.
Chapter 23: High Inflation

Seignorage M M / P

Y M Y
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard
 Inflation and Real Money Balances

What determines the amount of real money balances people will hold?

M
Y L (i)
P ()

Real money balances depend (positively) on income

and (negatively) on the nominal interest rate.

A higher nominal interest rate increases the opportunity cost

of holding money and leads people to reduce their
Chapter 23: High Inflation

real money balances.

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard
 Inflation and Real Money Balances

In times of inflation, the amount of money balances

people will hold depends primarily on expected inflation.

i r e

M
Y L (r e )
P
M
Y L (r e )
P ()
Chapter 23: High Inflation

When the expected rate of inflation is very high, people will try
to get rid of their money holdings as soon as possible.

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard
 Deficits, Seignorage, and Inflation

We have derived two relations:

The relation between seignorage, nominal money

growth, and real money balances.

The relation between real money balances and

expected inflation.

Combining the two equations gives

M M

Chapter 23: High Inflation

M
Seignorage YL r
e

M P M

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard
 Deficits, Seignorage, and Inflation
The Case of Constant Nominal Money Growth

M M
Seignorage YL (r M
M

Nominal money growth has two opposite effects on

seignorage:

M
S e ig n o r a g e
M

M M
Chapter 23: High Inflation

L (r )
e e
S e ig n o r a g e
M P

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard
 Deficits, Seignorage, and Inflation
The Case of Constant Nominal Money Growth

Figure
Seignorage and Nominal
Money Growth
Seignorage is first an
increasing function, then a
decreasing function of
nominal money growth.
Chapter 23: High Inflation

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard
 Deficits, Seignorage, and Inflation
The Case of Constant Nominal Money Growth
The Laffer curve is the relation between tax revenues
and the tax rate.

A simple analogy can be made between the Laffer

curve and inflation versus money balances. Inflation
can be thought of as a tax on real money balances.

The product of these two variables, MP is called the

inflation tax.

M M
Chapter 23: High Inflation

M
In fla tio n ta x S e ig n o r a g e
P M P

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard
 India Fiscal Policy
The government expenditure is divided
into two parts (a) revenue expenditure
(b) capital expenditure.
Revenue expenditure can be classified
into three categories
(a) Government spending on consumption
goods and services. Includes government
spending on good as well as services
(police, civil servants etc)
 (b) Second Category of revenue
expenditure is transfer payments.
Subsidies would come under this
category
(c) Third category of revenue
expenditure is interest on
government debt.
The second form of government
expenditure is capital expenditure.
This is expenditure on buildings
 Government Revenues
Two categories
Revenue receipts and Capital receipts
Revenue receipts comprise of tax and non
tax revenues
Non tax revenues are interest and dividends
from its various investments for center.
Lotteries user charges etc for states.
Revenue receipts account for about 25% of
all revenues
 Capital receipts include recover of loans
and revenues from disinvestments.
Two types of taxes (a) direct (b) indirect
Direct taxes levied on income and
income related assets. Income tax
property tax, capital gains tax.
Progressive in nature. As income rise
percentage of tax as proportion of
income rises.
 Indirect taxes are levied on goods
and services produced.
For state governments it is sales tax
excise duties, stamp duty etc
Central Governments customs and
excise duties.
These tend to be regressive in
nature.