Crisis spreads to other countries IMF Fiscal Monitor Background Reading
Sustainable Deficit • If then Debt-to-GDP ratio stays stable. • If > then deficit is “unsustainable” A growing economy allows the government to borrow some money every year and still keep debt in line with overall GDP
Primary Deficit • Simplified Government Budget Primary Expenditure (Total Expenditure less Interest Paid) - Primary Revenue (Total Revenue less Interest Income) Primary Budget Deficit + Net Interest Payments on Existing Debt General Budget Deficit
Sustainable Primary Deficit • If • then stays stable.
Primary Balance % of GDP
Types of Taxes Taxes on Value Added and Imports + Taxes on Income and Wealth (Income Taxes, Corporate Profits Tax, Capital Gains Taxes, Property Taxes) + Social Security Contributions Total Taxes
Greece Tax Revenues Germany % of GDP % of GDP Revenue Statistics - Comparative tables http://stats.oecd.org/Index.aspx
Types of Expenditure Consumption Expenditure + Compensation of Gov’t Employees + Gross Capital Formation + Social Benefits & Transfer Payments Primary Expenditure Goods expenditure measured in GDP
Consequences of Deficits • Austerity • Inflation • Default
Austerity and the Output Gap • Economy in LT equilibrium • Government imposes austerity program – cuts spending, transfers, inceases taxes • AD Curve shifts inward. YP P SRAS 1 2 P* AD AD′ Y* Y Recessionary Gap
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.
Default and RestructuringArgentina 1999-2002 BBC Story IMF Study
Stabilization policy • In 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
Demand Driven Recession w/ Counter-cyclical fiscal policy YP P • Economy in LT equilibrium • Demand shifts in • Government increases spending to shift the AD curve back 3 SRAS 1 2 P* AD AD′ Y* Y Recessionary Gap
Demand Driven Expansion w/ Counter-cyclical fiscal policy YP P • Economy in LT equilibrium • Demand shifts out • Government cuts spending to shift the AD curve back SRAS 2 P* 1 AD′ 3 AD Y* Y 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.
Tax Smoothing • Governments in most economies issue debt to make up for shortfalls in revenues in relation to spending. Budget Deficit = Outlays – Revenues • Tax 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.
Learning Outcomes • Use 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.