Government budget Budget deficits and debt 1 Recall

Government budget Budget deficits and debt 1

§ Recall, when we talked about national savings: § T – G is not a budget surplus § Because it is missing some items § From the beginning, we talked about government in Canada as all levels of government combined § Where does money come from and where does it go? § § § Government purchases of goods and services G Debt-service payments i × D Transfers Tax revenues Borrowing 2

§ Government’s budget constraint: § G + i × D + Transfers = Tax revenues + Borrowing § G + i × D = (Tax revenues – Transfers) + Borrowing § G + i × D = T + Borrowing § Where T = net tax § G + i × D – T = Borrowing § This Borrowing = budget deficit § If Borrowing < 0, budget surplus § The sum of the budget deficits = government debt D § Means ΔD = budget deficit = (G + i × D) – T § Government debt is a stock § Budget deficit is a flow § Budget deficit > 0, means ΔD > 0, debt increases § Budget deficit < 0, i. e. , surplus, means ΔD < 0, debt decreases 3

§ There are two parts to the budget deficit § Debt cannot be changed by policies § G and T can be changed by policies § They are discretionary § G – T = primary budget deficit § Also called program spending § Shows the extent to which taxes cover the discretionary part of expenditure 4

§ Characteristics of fiscal policy § Recall how we talked about fiscal policy with automatic stabilizers § Taxes decline if GDP declines § Transfers increase if GDP declines § Net taxes decline and increase with GDP § T=t×Y § G and i × D are not the functions of Y § But budget deficit = (G + i × D) – T § Thus the budget deficit function § Fiscal policy determines the position of the budget deficit function § Changes in GDP mean moving along a fixed budget deficit function 5

§ Characteristics of fiscal policy § Changes in GDP mean moving along a fixed budget deficit function § Fiscal policy determines the position of the budget deficit function § More contractionary fiscal policy shifts the budget deficit function down § More expansionary fiscal policy shifts the budget deficit function up § We could look at the deficits and judge a policy § But there are changes in GDP § The CAD measures the deficit as if GDP = Y* § Also called structural deficit § Tells you about fiscal policy § Comparison of actual deficit and CAD tells you about business cycles 6

§ Changes in debt-to-GDP ratio d § § Canadian government tries to achieve a reduction in d d = D/GDP Then Δd = x + (r – g) × d The debt-to-GDP ratio changes § If there is a primary budget deficit x § and/or if the debt accumulates faster than real GDP grows § To reduce the debt-to-GDP ratio § It is good to run primary budget surpluses § Spend on current programs less than collected in taxes § It helps if real interest rate r is low § It helps if the real economy grows at high rate g 7

§ What do the deficits do to the economy? § Recall, increase in G => increase in GDP § AE = C + I + G + NX § Positive AD shock § But also, (T – G) = public savings § § § Then, increase in G => decrease in public savings This leads to a decrease in national savings Loanable funds theory of interest: Decrease in national savings => increase in interest rate This is crowding out private investments § In addition, increase in interest rate => decrease in NX § This is crowding out net export § This is referred to as long-term burden of government debt 8

§ Is the long-term burden of government debt bad? § It depends: § Government invests (“better” than private sector) => we are better off § Government spends on current consumption => present generation benefits at expence of future generations § Is that bad? § Capital budgeting is a proposal to restrict borrowing to (“good”) investments only § Does Government Debt Hamper Economic Growth? Read --- not tested 9

§ Formal fiscal rules § Annually balanced budget § Could not really achieve § Taxes and spending cannot be continuously adjusted § And likely a bad idea § Automatic stabilizers would be destroyed § Cyclically balanced budgets § What does it mean about the budget deficit function position? § Can you see the problem? § Formal fiscal rules are not generally followed but there is an understanding that the government strives to approach what they suggest 10