Chapter 16: Government Debt and Deficits Study Notes

16.1 Facts and Definitions

• The Government's Budget Constraint

  • What it means: The government must cover its spending either by collecting taxes or by borrowing money.

  • The basic rule:
    $\text{Government Tax Revenue} + \text{Borrowed Money} = \text{Total Spending}$

• What the Government Spends Money On:

  1. Buying Goods and Services (G): Things like roads, military equipment, or government salaries.

  2. Interest Payments on Debt: This is the cost of borrowing money for previous spending.

     • Shown as $i \times D$, where $i$ is the interest rate and $D$ is the total amount of outstanding debt.

     • We consider transfers (like welfare payments) as part of net tax revenue (T).

     • The budget rule rephrased:
       $G + i \times D = T + \text{New Borrowing}$

     • Rearranging this, we see:
       $G + i \times D - T = \text{New Borrowing}$

16.2 Debt and Deficits

• What is a Government Budget Deficit?

  • It's when the government spends more money than it collects in taxes in one year.

  • The amount of this yearly deficit is exactly how much the government has to borrow that year.

• How Borrowing Works:

  • When the government borrows, it adds to its total outstanding debt.

• Formula for Budget Deficit:

  • $\text{Budget Deficit} = \Delta D = (G + i \times D) - T$

  • (Here, $\Delta D$ means 'change in debt' or 'new borrowing for the year').

16.3 The Primary Budget Deficit

• What it is: This is the government's budget deficit before counting the interest payments it makes on its existing debt.

• How to calculate it:

  • $\text{Primary Budget Deficit} = \text{Total Budget Deficit} - \text{Interest Payments on Debt}$

• Another way to look at it:

  • $\text{Primary Budget Deficit} = G - T$

  • (This is part of the larger equation: $(G + i \times D) - T$)

16.4 Deficits and Debt in Canada

• History:

  • Canada had ongoing budget deficits from the mid-1970s until the early 1990s.

  • From 1998 to 2008, the federal budget had a surplus (collected more than it spent).

  • This changed in 2009 due to a major recession, leading back to deficits.

  • COVID-19 Impact: In 2020, the budget deficit jumped dramatically to about 18% of GDP, the highest since World War II.

16.5 The Stance of Fiscal Policy

• What is Fiscal Policy?

  • It's how the government uses its spending and tax decisions to influence the economy.

  • Changes in the budget deficit can happen because the government changes its fiscal policy or because the economy itself changes.

• How Deficits Relate to Economic Activity:

  • When the economy slows down (real GDP falls), the budget deficit tends to get larger.

  • When the economy grows (real GDP rises), the budget deficit tends to shrink.

• The Budget Deficit Function:

  • This is a graph that shows how the government's budget deficit changes with different levels of real GDP.

  • It typically shows a negative relationship: higher GDP means a smaller deficit, assuming government policies stay the same.

16.6 Structural and Cyclical Budget Deficits

• Structural Budget Deficit:

  • This is the deficit that would exist if the economy were operating at its full potential (where real GDP equals potential GDP, $Y^*$).

  • It's also called the cyclically adjusted deficit because it removes the effects of booms and recessions.

• Cyclical Budget Deficit explained:

  • During a recessionary gap ( Y < Y^* ): The actual budget deficit will be larger than the structural deficit because tax revenues are lower and spending on programs like unemployment benefits might be higher.

  • During an inflationary gap ( Y > Y^* ): The actual budget deficit will be smaller than the structural deficit because tax revenues are higher and some spending might be lower.

  • Changes in the structural budget deficit are what truly show if the government has made a change in its fiscal policy.

16.7 The Structural Budget Deficit and Changes in Fiscal Policy

• What happens with Expansionary Fiscal Policy?

  • If the government implements policies to stimulate the economy (like more spending or lower taxes), it shifts the budget constraint (e.g., from B0 to B1).

  • This action increases the structural deficit.

16.8 Debt Dynamics

• Key Equation: How the Debt-to-GDP Ratio Changes

  • $\text{Change in Debt-to-GDP Ratio: } \Delta d = x + (r - g) \times d$

  • Let's break down the symbols:

    • $d$ = the total government debt compared to the country's GDP (Debt-to-GDP ratio)

    • $\Delta d$ = how much this debt-to-GDP ratio changes

    • $x$ = the primary budget deficit (G-T) as a percentage of GDP

    • $r$ = the real interest rate on government bonds (adjusted for inflation)

    • $g$ = the growth rate of the country's real GDP

• Two things that make the Debt-to-GDP Ratio Go Up:

  1. If r > g : If the real interest rate on debt is higher than the rate at which the economy is growing, the debt grows faster than the economy, increasing the ratio.

  2. A primary budget deficit: When the government spends more than it collects in taxes (excluding interest payments), it has to borrow more, which adds to the debt and increases the ratio.

• When can the Debt-to-GDP Ratio Be Reduced?

  • If the real interest rate (r) is roughly equal to the GDP growth rate (g), the government generally needs to run primary budget surpluses (collect more in taxes than it spends on goods and services, excluding interest) to bring down the ratio.

16.9 The Effects of Government Debt and Deficits

• What is "Crowding Out"?

  • Large budget deficits can make it harder for the private sector (businesses and individuals) to invest and grow.

  • This happens because expansionary fiscal policies can push up interest rates, which then reduces private spending and investment.

  • This can slow down long-term economic growth.

• What are Surpluses and "Crowding In"?

  • The opposite is true for budget surpluses.

  • If the government collects more than it spends, this can free up resources for the private sector, encourage investment, and boost long-term growth.

16.10 Investment in Closed Economies

• How Deficits Affect Investment:

  • In a closed economy (one that doesn't trade much with other countries), an increase in the budget deficit means less national saving is available.

  • This scarcity of savings drives up real interest rates, which in turn makes it more expensive for businesses to borrow and invest, leading to decreased investment.

16.11 Crowding Out of Investment

• Long-Term Impact of Deficits:

  • When we look at the long run in a closed economy, bigger budget deficits typically lead to higher real interest rates and less private investment.

16.12 Net Exports in Open Economies

• How Deficits Affect International Trade:

  • In an open economy, government budget deficits can attract money from foreign investors.

  • This inflow of foreign money can strengthen the domestic currency (make it more valuable).

  • A stronger currency makes domestic goods more expensive for foreigners and foreign goods cheaper for domestic buyers, leading to a decrease in net exports (exports minus imports).

  • Important note: If the government's fiscal expansion also increases the economy's potential output, this can help reduce the negative impact of crowding out private spending and net exports.

16.13 Do Deficits Harm Future Generations?

• Shifting Resources:

  • Government debt can mean that resources are taken from future generations to pay for current spending.

• When Debt Might Not Be a Burden:

  • If the debt is used to fund public investments that benefit future generations (like building a new electric transit system that reduces emissions), then it might not be a burden for them.

16.14 Does Government Debt Hamper Economic Policy?

• Challenges for Monetary Policy:

  • If people expect the government to print more money in the future to deal with its debt (debt monetization), this can lead to higher inflation expectations and higher nominal interest rates.

  • This makes it harder for the central bank to manage monetary policy effectively.

• COVID-19 Context:

  • The large government spending during the 2020-2021 pandemic raised concerns about future inflation.

16.15 Fiscal Policy Dynamics

• Using Fiscal Policy to Counter Economic Cycles:

  • Good fiscal policy means increasing spending or cutting taxes during recessions and doing the opposite during economic booms.

  • However, if government debt gets too high, it can limit the government's ability to use these policies when needed during a recession.

• Debt-to-GDP Ratio History (COVID-19):

  • In January 2020, Canada's debt-to-GDP ratio was around 33%.

  • Due to pandemic spending, it surged almost 20 percentage points within just one year.

16.16 Formal Fiscal Rules

• Ideas for Regulation:

  • Some people believe that laws should be passed to limit the size of budget deficits.

• Problems with Annually Balanced Budgets:

  • Requiring the budget to be balanced every single year would remove "automatic fiscal stabilizers" (like higher unemployment benefits during a recession).

  • This would make the up and down swings in GDP even bigger.

16.17 Cyclically Balanced Budgets

• A Better Goal:

  • It's generally better to try and balance the budget over the entire business cycle (meaning running deficits during recessions and surpluses during booms that average out to balance over time).

  • This allows for short-term economic stability while also being fiscally responsible in the long term.

  • Because it's hard to precisely define a "business cycle," this should be a guiding principle rather than a strict, unbreakable rule.

16.18 Maintaining a Prudent Debt-to-GDP Ratio

• Economists' View:

  • Many economists think that having a low and stable debt-to-GDP ratio is a sign of good financial management by the government.

  • This approach allows for temporary budget deficits as long as the total debt doesn't grow faster than the economy (GDP).