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FISCAL POLICY

FISCAL POLICY. D = i*B -1 + G – T D = today’s deficit G = Government Expenditure T = Tax Revenue i = interest payments on debt B -1 = Debt level inherited from yesterday D = B – B -1 (deficit is the additional debt). Government budget constraint. B = (1+i)B -1 + (G – T)

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FISCAL POLICY

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  1. FISCAL POLICY D = i*B-1 + G – T • D = today’s deficit • G = Government Expenditure • T = Tax Revenue • i = interest payments on debt • B-1 = Debt level inherited from yesterday • D = B – B-1 (deficit is the additional debt)

  2. Government budget constraint • B = (1+i)B-1 + (G – T) • Consider a two-year model: • On year 1 Gov. borrows (accumulates debt) • On year 2 Gov. pays back its debt • On year two Gov. must satisfy B2 = 0: • B2 = 0 = (1 + i)B1 + (G2 + T2) • Gov. Must pay back debt with primary surplus (raise taxes or cut spending)

  3. Government Budget Constraint • If Gov wants to keep debt level constant (B2=B1) then primary surplus must equal i: • Accumulation of deficits leads to debt • To stabilize debt: contain primary deficit • Primary surplus must equal interest on debt to keep it stable. • Debt today means higher taxes tomorrow; or…

  4. Debt Sustainability • Debt may be sustained with higher growth Bt/Yt = (1+i) Bt-1/Yt +(Gt - Tt)/Yt Bt/Yt = (Yt-1/Yt-1)(1+i) Bt-1/Yt +(Gt - Tt)/Yt • Since Yt= Yt-1(1+g) where g is growth rate Bt/Yt = (1+i)/(1+g) Bt-1/Yt-1 +(Gt - Tt)/Yt

  5. Fiscal Sustainability • Ricardian Equivalence: consumers realize that a tax cut today implies more taxes tomorrow. • Consumer internalize this and adjust their spending • As Government saving falls, private savings compensates and increases

  6. Fiscal Sustainability • Full-employment deficit refers to the expected deficit when the economy is at its “natural” rate (is there such thing?) • Compare Italy’s growth rate with its natural rate. • Structural conditions may vary during a business cycle.

  7. Fiscal Sustainability • High debt alone does not imply unsustainable path (see Belgium) • High deficit alone does not imply unsustainable path (see Greece) • High debt, high deficit, and low growth is a bad recepy (see Italy).

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