Government Debt and Budget Deficits

ECOS2002 Intermediate Macroeconomics
Week 13:
Christopher Gibbs
University of Sydney
Semester 1, 2021
Government Debt and Budget Deficits
Government Debt
Government Debt and Budget Deficits
• The difference between debts and deficits
– Deficits = Tax Revenue – Government Spending
– Deficits are a flow.
– Debts = The total amount of money owed by a government
to any party.
– Debts are a stock.
Government Debt and Budget Deficits Measurement
• Measurement of Government Debt
– When do we know a government has too much debt?
– Should we think about government debt the same way we
think about personal debt?
Measurement of Government Debt
• The general answer to these questions is
– There appears to be no correct answer for this question.
You have too much debt when people stop lending.
– No, government debt cannot be thought about like personal
debt with the exception of a few cases.
Measurement of Government Debt
• Government debt cannot be thought about like personal
debt because of
– Governments theoretically never die.
– Inflation.
– Legal issues surrounding capital assets.
Measurement of Government Debt
• Governments do not die…
– Governments can always roll over debt.
– This means a government can theoretically always take out
a new loan to pay an old loan.
– Therefore, governments must only pay interest and never
principle.
Measurement of Government Debt
• The role of inflation:
– We should care about real debt and not nominal debt.
– Inflation erodes the real value of the principle the
government owes.
– Therefore, it is possible for the government to balance the
budget in real terms, while still growing the nominal stock
of debt:
Dnew – Dold
Dold
= π
– where D is stock of nominal government debt.
Measurement of Government Debt
• The role of inflation:
– However, inflation does affect the interest rate on the debt.
– Therefore, higher inflation rates will decrease the real value
of the principle, but will increase the interest rate paid to
issue new debts.
Measurement of Government Debt
• The role of inflation:
– A country that issues debt in their own currency can never
default on that debt.
– A debt issued in Australian Dollars is a promise by the
government to pay in Australian Dollars and they can also
turn on the printing press to make the payment.
– A government that does not issue debt in a currency it fully
controls is at risk of experiencing a self-fulling debt crisis
Measurement of Government Debt
• Capital Assets
– Individuals and corporations measure their debts against
their assets.
– Theoretically governments could do the same thing.
– The Australian government has many assets: roads,
insurance companies (Medibank), land.
– The debt can compared to these assets and not just GDP
as the government can sell assets to pay the debt i.e. as
they are about to do with Medibank.
– They could also sell land… like Tasmania to New Zealand
Measurement of Government Debt
• Capital Assets
– Therefore, debt to GDP may not be the only measure to
consider.
– However, political and legal restrictions make it hard for the
government to liquidate assets.
Government Budgets
• A simple model of government budgets and finance
– The Treasury’s Budget Constraint
Gt + it-1BtT-1 = Tt + (BtT – BtT-1) + RCBt (1)
– The Federal Reserve Constraint
(BtM – BtM-1) + RCBt = it-1BtM-1 + (Mt – Mt-1) (2)
– Debt held by the public
B = BT – BM (3)
Where G is government spending, B is bonds, M is the
monetary base (think M1), and RCB is receipts from the
Central Bank.
Government Budgets
• Combining the two yields the Federal Governments Budget
Constraint.

– The sources of government revenue are T taxes, (Bt – Bt-1)
new debt, and (Mt – Mt-1) printing money.
– The uses of government revenue are G spending and
it-1Bt-1 interest on the debt.
Government Budgets
• To address some of the concerns mentioned previously, let
transform the equation into real terms.
– To do this we are going to divide out price and look at each
variable in its proportion to total GDP
Gt
PtYt
+
it-1Bt-1
PtYt
=
Tt
PtYt
+
Bt – Bt-1
PtYt
+
Mt – Mt-1
PtYt
(5)
– Define for any variable A
At
PtYt
= at
Government Budgets
• Note that some of our time subscripts do not match-up,
thus
Bt-1
PtYt
=
Bt-1
PtYt
∗ (Pt-1
Pt-1
Yt-1
Yt-1
)
=
Bt-1
Pt-1Yt-1
Pt-1Yt-1
PtYt
• Where Pt
Pt-1 = (1 + πt) and YYt-t 1 = (1 + gY ). For simplicity
we will assume gY = 0.
Bt-1
PtYt
= bt-1 1
1 + πt
Government Budgets
gt + it-1
bt-1
1 + πt
= tt + bt – bt-1
1 + πt
+ mt –
mt-1
1 + πt
• Thus, the real federal budget constraint is
gt + rt-1bt-1 = tt + (bt – bt-1) + mt – mt-1
1 + πt
(6)
Government Budgets
• The money term of the budget constraint is the seigniorage
term.
• let st stand for seigniorage and rearranging we can get

– The first term represents direct seigniorage. This is the
government changing the real money balances in the
economy and using them to purchase real resources.
– The second term is steady state seigniorage. This is the
amount of real revenue the government collects when it hold
real money balances constant (mt – mt-1 = 0).
Government Budgets
• In normal times a government does not change real money
balances to purchase output.
• Therefore, to estimate the amount of seigniorage in the
economy just calculate
st =
πt
1 + πt
mt-1
• Now, when π is small 1+ππ ≈ π, thus st ≈ π ∗ mb.
Fiscal Theory of the Price Level
• Modeling convention in canonical macro models:
1. Monetary policy can and does control inflation
– Policy is optimal or follows a Taylor-type rule and is
unconstrained or active”
2. Fiscal policy can and does ensure solvency
– Policy is constrained or passive”
These slides largely come from a mini-course taught by Eric Leeper at the
University of Melbourne in November 2016
Fiscal Theory of the Price Level
• What do we learn from a model that includes both fiscal
and monetary policy?
1. Effects of monetary policy|open-market operations|
depend on the sense in which fiscal policy is held constant”
2. Effects of fiscal policy|bond-financed tax cuts|depend on
the sense in which monetary policy is held constant”
3. MP cannot uniquely determine inflation; FP can
4. MP can uniquely determine bounded inflation|if FP
cooperates
5. If FP does not cooperate, MP cannot affect economy in
usual ways
6. Without credible, enforceable fiscal rules that anchor
expectations on appropriate FP behavior, fiscal
disturbances always affect the economy
Three Perspectives on Price Level
An Accounting Perspective
• Nominal government bonds
– Asset to the private sector
– liability to the government
• Real primary surpluses (think taxes)
– liability to the private sector
– asset to the government
• Real assets must equal real liabilities
• Price level must adjust to equalize the real value of debt &
expected present value of surpluses
) Price-level determination arises from the margin between
nominal assets and the real backing for the asset
Three Perspectives on Price Level
An Economic Perspective
• Nominal government bond holdings a source of wealth to
private sector
• Expected stream of taxes is an obligation of private sector
• If bonds rise, but PV taxes does not…
– household feel wealthier
– try to convert higher nominal wealth into higher
consumption path
– increases demand for goods|aggregate demand”
– raises price level
) Wealth effects lie at the heart of price-level determination
Three Perspectives on Price Level
An Asset-Pricing Perspective
• Value of any asset equals expected PV of cash flows
• Primary surpluses|exclusive of interest payments|are
cash flows underlying government debt
• Higher primary surpluses raise value of debt
– induces households to substitute out of buying goods & into
holding bonds
– raises price of bonds in terms of goods
– reduces price level
) Higher real backing for bonds increases their value & drives
down price level
The Price Level as a Relative Price
• Price level, P, is the relative price of goods in terms of
nominal government liabilities
– liabilities = high-powered money (central bank money) +
government bonds
• Private-sector demand for liabilities depends on expected
discounted cash flows
– cash flows” are primary government surpluses
– revenues minus expenditures net of debt service
• Direct link between nominal liabilities and goods”
– the stuff being priced & the stuff that gives them value
• Government|central bank & fiscal authority| controls
both supply of liabilities & goods” that back them
– by varying either nominal supply or real backing, can
achieve any relative price
• This is the essence of P determination in the fiscal theory

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