Chapter 8 - The Twin Deficits: Fiscal Deficits and the Current Account

What are the two opposing views on the effects of fiscal policy?

1. Twin Deficits: Tax cut increases household income and consumption, leading to a current account deficit. 2. Ricardian Equivalence: Tax cut creates public debt, leading households to save the tax cut for future taxes, keeping consumption unchanged.

What was a significant fiscal action during the Reagan era (1981-1985)?

Massive tax cuts and increased military spending.

What happened to the fiscal deficit during the Reagan era?

It increased from 1% to 6% of GDP.

What change occurred in the current account during the Reagan era?

It shifted from +0.2% to -3.4% of GDP.

What is the intuition behind Ricardian Equivalence?

A tax cut today leads to higher taxes tomorrow, prompting households to save the tax cut.

What are some reasons why Ricardian Equivalence might fail?

Liquidity constraints, myopia, and distortionary taxation.

What does the chapter analyze regarding Ricardian Equivalence?

The conditions under which Ricardian Equivalence is valid and how it relates to twin deficits.

What is the government budget constraint in period 1?

G1 + Bg1 - Bg0 = T1 + r0Bg0.

What is the terminal condition for government debt?

Bg2 = 0 (no assets/debts left).

What is the intertemporal government budget constraint?

G1 + G2/(1 + r1) = (1 + r0)Bg0 + T1 + T2/(1 + r1).

What is the first-order condition for firms' investment?

A2F'(I1) = 1 + r1.

How does investment depend on the interest rate?

Investment I1 is a decreasing function of r1.

What is the household's budget constraint in period 1?

C1 + Bh1 - Bh0 = r0Bh0 + Q1 - T1.

What is the optimal consumption derived from the household's optimization problem?

C1 = 1/2 Ȳ, where Ȳ is the present discounted value of income.

What does the Ricardian Equivalence imply about tax cuts?

Tax cuts do not cause current account deficits; there are no twin deficits.

What is the trade balance equation?

TB1 = Q1 - C1 - G1 - I1.

What does the current account equation include?

CA1 = r0B0 + TB1.

What does the Ricardian Equivalence state regarding taxes and consumption?

Any combination of taxes satisfying the government's intertemporal budget constraint yields the same private consumption.

What happens when the government cuts T1 while keeping G1 and G2 unchanged?

Households anticipate future tax increases and save the tax cut, offsetting the effect on consumption.

What does Ricardian Equivalence state about tax cuts?

Tax cuts do not affect national saving because any increase in private saving offsets the decrease in government saving.

What is the formula for government saving?

Sg1 = r0Bg0 + T1 - G1

How does a change in taxes (T1) affect government saving?

Any change in T1 changes government saving one-for-one: ∆Sg1 = ∆T1.

What is the relationship between private saving and taxes?

Private saving is affected by taxes: Sp1 = Q1 + r0Bh0 - T1 - C1, leading to ∆Sp1 = -∆T1.

What is the overall change in national saving when taxes change?

The change in national saving is zero: ∆S1 = ∆Sg1 + ∆Sp1 = ∆T1 - ∆T1 = 0.

What happens to the current account (CA1) under Ricardian equivalence?

CA1 = S1 - I1, leading to ∆CA1 = 0, indicating no twin deficits.

What are the three types of government spending changes discussed?

Temporary increase, expected future increase, and permanent increase.

What is the effect of a temporary increase in government spending (G1)?

Consumption falls (∆C1 < 0) due to households anticipating future taxes.

How does a permanent increase in government spending affect the current account?

It leads to a small change in the current account: ∆CA1 = -r/2(1 + r)∆G.

What is the main message regarding twin deficits with temporary government spending increases?

Temporary increases in government spending can cause twin deficits if not financed by current taxes.

What conditions must hold for Ricardian equivalence to be valid?

Households must face no borrowing constraints, expect future taxes after tax cuts, and all taxes must be lump sum.

What happens when borrowing constraints are present?

Consumption increases one-for-one with a tax cut, leading to twin deficits.

How does a tax cut affect households under borrowing constraints?

Households cannot smooth consumption intertemporally, so current income directly affects current consumption.

What is the formula for consumption when borrowing constraints bind?

C1 = Q1 - T1.

What is the effect of a tax cut on government saving under borrowing constraints?

Government saving decreases: ∆Sg1 = ∆T1 < 0.

What is the relationship between fiscal deficit and current account deficit under borrowing constraints?

Tax cuts lead to both fiscal and current account deficits, resulting in twin deficits.

What is the effect of expected future increases in government spending on consumption?

Consumption falls, but the decrease is smaller than the expected increase in government spending.

How does a permanent increase in government spending affect household consumption?

Households adjust consumption smoothly over both periods, resulting in minimal twin deficits.

What is the effect of a temporary increase in government spending on domestic absorption?

Domestic absorption increases despite a fall in consumption.

What does the Ricardian equivalence imply about fiscal policy effectiveness?

It suggests that fiscal policy may be ineffective if households anticipate future tax liabilities.

What is the impact of a tax cut on the current account when Ricardian equivalence fails?

The current account deteriorates due to increased consumption with unchanged investment.

What is the effect of a tax cut on private saving?

Private saving decreases by the amount of the tax cut when Ricardian equivalence does not hold.

What happens to the trade balance when government spending increases?

The trade balance may deteriorate if the increase is not financed by current taxes.

What is the intuition behind consumption smoothing in the context of government spending?

Households prefer to smooth consumption over time, anticipating future income changes.

What is the effect of a tax cut on current consumption for households with no borrowing constraints?

Consumption does not increase one-for-one with the tax cut, as households can adjust saving.

What is the significance of the parameter r* in the context of permanent government spending increases?

It influences the magnitude of changes in the current account due to government spending.

What is the relationship between government spending and fiscal deficits?

Increased government spending without corresponding tax increases leads to fiscal deficits.

What is the setup of the Overlapping Generations (OLG) model?

Households live for only one period.

What is the budget equation for period 1 in the OLG model?

C1 + T1 = Q1

What happens to the first generation when there is a tax cut in period 1?

They receive the tax cut and consume it, resulting in ∆C1 = −∆T1 > 0.

What is the impact of a tax increase in period 2 on the second generation?

They pay higher taxes, resulting in ∆C2 = −∆T2 < 0.

What is the consequence of tax cuts on intergenerational equity?

Those who benefit are not those who pay, leading to no saving of the tax cut.

What is the effect of distortionary taxes on consumption?

They distort household consumption decisions across periods.

What is the formula for the after-tax cost of consumption in period 1?

(1 + τ1)C1

How does a tax cut in period 1 affect consumption in period 2?

C1 becomes cheaper relative to C2, leading to increased consumption in period 1 and decreased consumption in period 2.

What is the equilibrium condition for a small open economy?

r1 = r*

What does the government intertemporal budget constraint express?

G1 + G2/(1 + r) = τ1C1 + τ2C2/(1 + r)

What is the key observation regarding consumption and tax rate?

C1 is decreasing in τ1; a tax cut (∆τ1 < 0) leads to an increase in C1 (∆C1 > 0).

What are twin deficits in the context of distortionary taxation?

They occur when a tax cut increases consumption, leading to a current account deficit and a fiscal deficit.

What is the Ramsey problem in optimal taxation?

It seeks to maximize household welfare by choosing tax paths that satisfy the government budget constraint.

What is the optimal tax policy derived from the Ramsey problem?

Tax smoothing, where τ1 = τ2, eliminates intertemporal distortions.

How does the optimal tax policy affect the current account?

A temporary increase in government spending (G1) can lead to twin deficits.

What is the implication of a temporary increase in G1 on household consumption?

It makes households poorer, leading to decreased consumption (C1 and C2).

What is the relationship between government saving and current account under optimal taxation?

Both government saving and current account can decrease due to increased government spending.

What does the Euler equation represent in this context?

C2/C1 = (1 + τ1)/(1 + τ2)(1 + r*)

What is the significance of the intertemporal price perceived by households?

Households perceive the intertemporal price as distorted due to taxes, affecting their consumption choices.

What does tax smoothing achieve in terms of consumption?

It aligns the consumption across periods to eliminate distortions.

What is the effect of an increase in G1 on fiscal deficit?

It leads to an increase in the fiscal deficit as government spending rises.

What does the combined household and government budget constraint imply?

It simplifies the problem by eliminating tax variables, focusing on consumption choices.

What is the optimal consumption allocation derived from the Ramsey problem?

C1 = ¯Y/2 and C2 = (1 + r*)¯Y.

What does the Ramsey optimal policy suggest about taxation?

It suggests that maintaining equal tax rates across periods (τ1 = τ2) is optimal.

What is the key message regarding fiscal policy and temporary spending increases?

It is optimal to run fiscal deficits during temporary spending increases to avoid distortions.

What is the effect of tax smoothing on intertemporal consumption?

It ensures that the true price of consumption is reflected without distortion.

What is a common concern about expansionary fiscal policy?

It can crowd out investment and private consumption by driving up interest rates.

What is the channel through which government spending affects interest rates?

Government increases spending → borrows more → increases demand for loanable funds → raises interest rates.

What happens to private investment when interest rates rise due to government borrowing?

Private investment falls.

What are the two scenarios for studying fiscal policy in this context?

1. Fiscal Policy in Economies with Imperfect Capital Mobility 2. Fiscal Policy in Large Open Economies.

What does the current account schedule formula CA1 = r0B0 + Q1 − C1 − I1 − G1 represent?

It evaluates the current account by considering savings, consumption, investment, and government spending.

What are the effects of expansionary fiscal policy in economies with imperfect capital mobility?

It causes an increase in interest rates, a deterioration in the current account, and some crowding out of investment.

What is the relationship between capital controls and interest rates in a debtor country?

In a debtor country, the interest rate is an increasing function of the country's net debt position.

How does a large open economy differ in fiscal policy effects compared to smaller economies?

Fiscal policy affects the world interest rate (r∗) in large economies.

What happens to the world interest rate when a large economy undergoes fiscal expansion?

The world interest rate rises.

What is the impact of domestic fiscal expansion on the current account of the rest of the world?

The current account of the rest of the world improves (mirror image effect).

What is the mechanism behind the international spillover of domestic fiscal policy?

Domestic fiscal expansion decreases national saving, leading to a global supply of funds decrease and increased global interest rates.

What is the significance of the Liz Truss Mini Budget example?

It illustrates the impact of tax cuts on government borrowing and higher interest rates.

What are twin deficits?

Twin deficits occur when fiscal deficits lead to current account deficits.

Under what conditions do twin deficits occur with tax cuts?

They occur with borrowing constraints and distortionary taxes.

What is Ramsey optimal taxation?

A tax smoothing approach that eliminates intertemporal distortion and achieves the same allocation as lump-sum taxes.

What is the expected effect of temporary government spending increases under optimal policy?

It causes twin deficits.

How does capital mobility affect investment crowding out?

More open economies experience less crowding out and larger current account deficits.

What are the implications of Ricardian equivalence?

Tax timing does not matter under restrictive assumptions, but it fails with borrowing constraints and distortionary taxes.

What is the effect of government spending increases on the current account?

They typically cause current account deficits, especially if temporary.

What happens to investment in both domestic and rest of world during a fiscal expansion?

Investment falls in both regions.

What does the term 'crowding out' refer to in the context of fiscal policy?

It refers to the reduction in private investment due to increased government borrowing and higher interest rates.

What is the relationship between government spending and national saving?

Domestic fiscal expansion typically decreases national saving.

What is the effect of fiscal policy in a small economy with free capital mobility?

There is no crowding out of investment or increase in interest rates.

What is the expected outcome of permanent government spending increases?

They have a small effect on the current account.

What happens to the current account when future government spending is expected to increase?

The current account improves.

What is the significance of the current account schedule CA(r1; Q1, τ1, G1)?

It shows how the current account is affected by interest rates, output, taxes, and government spending.

What is the general principle regarding capital mobility and fiscal policy?

More open economies experience less crowding out and larger current account deficits.