Fiscal Policy

End This Year End Last Year This YearDebt Debt Deficit

=t t tDeficit Outlays Receipts

t tDeficit Surplus

1

1 1

1

1 (1 )

(1 ) (1 )

(1 )

t t

GDPt

t tGDP GDPt

GDPt

tGDPt

dy dy

Deficitgdy dy

g g GDP

Deficit gdy

GDP g

1

1

(1 )t t

t tGDPt t

Debt Deficitdy dy

GDP g GDP

Can you run a deficit every year?

If

then Debt-to-GDP ratio stays stable.

If > then deficit is “unsustainable”

1(1 )

GDPt

tGDPt

General Deficit gdy

GDP g

Sustainable Deficit

A growing economy allows the government to borrow some money every year and still keep debt in line with overall GDP

IMF Fiscal Indicators

Figure 2. Sovereign Bond Yield Spreads over German Bunds(Basis points)

Sources: Bloomberg L.P.; Datastream.Note: 10-year sovereign bond yields.

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Jan -10 Ap r-10 Jul-10 Oct-10 Jan -11 Ap r-11 Jul-11

Countries w ith Programs Supported by EU/IMF

Greece

Irelan d

Po rtug al

Latv ia

Ro man ia

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Selected European Countries

Sp ain

Belg iumItaly

Fin landNeth erlands

IMF Fiscal Monitor

Crisis spreads to other countries

Background Reading

Primary Deficit Simplified Government Budget

Primary Outlays (Total Expenditure less Interest Paid)

- Primary Receipts (Total Revenue less Interest Income)

Primary Budget Deficit

+ Net Interest Payments on Existing Debt

General Budget Deficit

1(1 )

GDPt

tGDPt

Primary Deficit g idy

GDP g

t t t

t t t

General Deficit Primary Deficit Net Interest

GDP GDP GDP

Sustainable Primary Deficit

~

1(1 )

Average Interest

ttGDP

t

Net Interest idy

GDP g

• If

then stays stable.Debt

GDP

Primary Balance

%

of

GD

P

Consequences of DeficitsAusterityInflationDefault

P

Y

Y*

AD

Austerity and the Output Gap

P*

SRAS

YP

AD′

1

2

1. Economy in LT equilibrium

2. Government imposes austerity program – cuts spending, transfers, inceases taxes

3. AD Curve shifts inward.

Recessionary Gap

Austerity has a negative effect on business cycles.

IMF

Deficits and Inflation

Government generates revenues by printing new money (referred to as seignorage).

Government facing borrowing constraints may be forced to rely on inflation tax for deficit financing and real returns to owning money.

Explain the link between deficits and inflation.

Israel 1970-1990

Inflation

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Israel 1970-1990

Surplus (% of GDP)

-30.00%

-25.00%

-20.00%

-15.00%

-10.00%

-5.00%

0.00%

5.00%19

70

1971

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Default and RestructuringArgentina 1999-2002

IMF Study

BBC Story

Argentina GDP

4E+11

4.2E+11

4.4E+11

4.6E+11

4.8E+11

5E+11

5.2E+11

5.4E+11

1997 1998 1999 2000 2001 2002 2003 2004 2005

Stabilization policyIn an economy subject to shocks to

aggregate demand (animal spirit shocks, external shocks, asset market shocks), the economy will have a self-correcting mechanism.

However, if this self-correction mechanism takes a long time to work, then government may use policy to speed adjustment.◦Use expansionary policy to close a

recessionary gap◦Use contractionary policy to close an

inflationary gap

P

YY*

AD

Demand Driven Recession w/ Counter-cyclical fiscal policy

P*

SRAS

YP

AD′

1

2

1. Economy in LT equilibrium

2. Demand shifts in

3. Government increases spending to shift the AD curve back

3

Recessionary Gap

P

YY* AD

Demand Driven Expansion w/ Counter-cyclical fiscal policy

P*

SRAS

YP

AD′1

2

1. Economy in LT equilibrium

2. Demand shifts out

3. Government cuts spending to shift the AD curve back 3

Inflationary Gap

Lags and Fiscal Policy

Administrative lags for fiscal policy may likely be large.

Except in absolute dictatorships, government will have mechanisms for building a consensus for expenditures. Adjusting this consensus will be time consuming.

If lags are too long, stabilizing government spending or transfer payments may have a destabilizing effect, shifting out demand after the economy has already recovered.

Automatic StabilizationGovernments in most economies

issue debt to make up for shortfalls in revenues in relation to spending.

Budget Deficit = Outlays – RevenuesTax collection is cyclical so the

budget deficit tends to be counter-cyclical.

Maintaining a balanced budget over the cycle means raising taxes in a recession an cutting taxes in a boom which makes the business cycle more extreme.

Counter-cyclical deficits

Learning OutcomesUse growth rate of GDP, interest

rates, and the debt to GDP ratio to identify the sustainable general and primary deficit level.

Use AS-AD model to identify the effects of fiscal policy on the output gap and the inflation rate.