Deck 26: Fiscal Policy: a Summing up

Question 1

Using information in this chapter, label each of the following statements true, false, or uncertain. Explain briefly.
a. Tax smoothing and deficit finance help spread the burden of war across generations.
b. The government should always take immediate action to eliminate a cyclically adjusted budget deficit.
c. If Ricardian equivalence holds, then an increase in income taxes will affect neither consumption nor saving.
d. The ratio of debt to GDP cannot exceed 100%.
e. Because the United States is able to finance investment by borrowing from abroad, the low U.S. saving rate is not a cause for concern.
f. Based on current projections, the Social Security Trust Fund is large enough to pay full benefits (as defined by current law) to retirees for 100 years.

Answer 1

(a) True. During wartime governments typically need to run budget deficits to finance the war. These deficits will need to be paid off over time, passing some of the burden on to the next generations. The government could just increase taxes sharply to pay off the deficit but instead they rely on tax smoothing. Tax smoothing spreads the deficit on many generations by keeping taxes consistent over time. This implies that when government increases spending it will run deficits and when spending is low it will run surpluses and pay off these deficits.
(b) False. There are times when taking immediate action to reduce a cyclically adjusted deficit to zero. First, in a recession, it sometimes makes sense to have an above zero cyclically adjusted deficit in an attempt to increase consumption. However, in cases where the government runs a cyclically adjusted deficit above zero, it will likely have to take special steps to decrease this deficit such as raising taxes or reducing spending.
(c) Uncertain. The Ricardian equivalence theorem relies heavily on timing. If an increase in income taxes in one period is followed by a drop in taxes next period, then the Ricardian equivalence theorem states that the tax increase will not affect consumption or savings. However, if the tax increase is followed by a decrease in taxes in 30 years, then it is unlikely that the Ricardian equivalence theorem will hold, as consumers most likely won't plan that far ahead.
(d) False. If a country runs high enough deficits for a long enough period of time, the ratio of debt to GDP can absolutely exceed 100%. There is no specific number that debt to GDP must remain under, but a level of debt to GDP of 100% is very high and specific steps will likely need to be taken to reduce this. In fact, in1996, Belgium had a debt to GDP ratio of 115%.
(e) False. Although the United States is able to finance investment by borrowing from abroad, it has to run a current account deficit to do so. Since it has done this for so long it has become the largest debtor nation in the world, and has to make high interest payments on the loans it has been extended by the rest of the world. If the United States savings rate were higher it would be able to forego borrowing from the rest of the world and save money on the interest payments it has to make.
(f) False. Under current predictions, the Social Security Trust Fund will peak in 2016 and run out in 2041, well under 100 years. Much of this depletion is due to the aging of America, or the rapid increase in the proportion of people over 65. This is because the Baby Boomer generation is reaching retirement age.

Question 2

Consider the following statement:
"A deficit during a war can be a good thing. First, the deficit is temporary, so after the war is over; the government can go right back to its old level of spending and taxes. Second, given that the evidence supports the Ricardian equivalence proposition, the deficit will stimulate the economy during wartime, helping to keep the unemployment rate low."
Identify the mistakes in this statement. Is anything in this statement correct

Answer 2

A deficit during wartime can be a good thing. Deficits during wartime are a choice between how the government wants the war to impact the economy. If they raised taxes to finance the war, consumption would drop and investment would remain unchanged. If they took on deficits, investment would drop but consumption would remain relatively unchanged. However, governments don't necessarily go back to the same old level of spending and output. If investment drops, there is a lack of capital in the economy now, and investment will be much higher. Additionally, the government can only reduce the deficit by increasing taxes in the future, so consumption will be lower than the prewar capital level into the future, as the successive generations help pay the cost of the war.
In this case, evidence does not necessarily support the Ricardian equivalence proposition because the tax smoothing that occurs after a war can span many generations. Since the Ricardian equivalence proposition fails when there is a long time span between tax cuts and tax increases, using it to explain wartime deficits does not necessarily make sense. The successive generations who incur higher taxes were not around during the period of high deficits, so they do not have a two period experience. All they know is higher taxes, and thus there consumption has always been lower.
The statement is correct in the assumption that wartime deficits can be good. Wartime deficits can produce a situation where many generations bear the cost for war. This can be good for the economy as taxing a generation fighting the war is not fair. Additionally, it puts a lot of strain on the economy, whereas deficits can distribute a great burden over long periods of time, helping to minimize the effects on the economy. Additionally, a wartime deficit can help reduce tax distortions caused by high taxation during wartime. These tax distortions include working less to avoid being taxed at very high rates.

Question 3

Consider an economy characterized by the following facts.
i. The official budget deficit is 4% of GDP
ii. The debt-to-GDP ratio is 100%.
iii. The nominal interest rate is 10%.
iv. The inflation rate is 7%.
a. What is the primary deficit/surplus ratio to GDP
b. What is the inflation-adjusted deficit/surplus ratio to GDP
c. Suppose that output Is 2% below its natural level. What is the cyclically adjusted, inflation-adjusted deficit/ surplus ratio to GDP
d. Suppose instead that output begins at its natural level and that output growth remains constant at the normal rate of 2%. How will the debt-to-GOP ratio change over time

Answer 3

(a) Calculating the primary deficit/surplus ratio to GDP is simply taking the percentage of deficit and dividing it by 100. Thus, in this economy the primary deficit ratio to GDP is 4/100.
(b) Calculating the inflation adjusted deficit/surplus ratio to GDP is a little trickier. To do this, you can use the following equation: Note that the last term of this equation is given, it is the deficit and it equals 4%. Also, observe that the second terms of the equation B divided by Y equals 1 since debt-to-GDP ratio is 100%. Now, you can determine the inflation-adjusted deficit/surplus ratio as follows: The inflation-adjusted deficit/surplus ratio is 7%.
(c) If the output is 2% below its natural output, this is a negative growth ratio of 2%. You can use the same formula that you used in part (b) to do this calculation. Inflation-adjusted deficit/surplus ratio when growth is 2% below the natural level is 9%.
(d) The calculation for this part is exactly the same as it was for part (c), but instead of a growth rate of -2%, the growth rate is positive 2%. The inflation-adjusted deficit/surplus ratio when the growth rate is 2% is 5%.

Question 4

b. Suppose that domestic inflation remains the same. What happens to the domestic real Interest rate What is likely to happen to the growth rate
c. What happens to the official budget deficit What hap-pens to the Inflation-adjusted deficit
d. Suppose the growth rate decreases from 2% to 0%. What happens to the change in the debt ratio (Assume that the primary deficit/surplus ratio to GDP Is unchanged. even though the fall ingrowth may reduce tax revenues.)
e. Were the fears of investors justified

Question 5

Ricardian equivalence and fiscal policy
First consider an economy In which Picardie,: equivalence does not hold (Le., an economy like the one we have described In this book).
a. Suppose the government starts with a balanced bud-get. Then, there Is an increase in government spending, but there Is no change in taxes. Show In an IS-LM diagram the effect of this policy on output in the short run. How will the government finance the increase in government spending
b. Suppose• as in Pan (a). that the government starts with a balanced budget and then increases government spending. This time, however, assume that taxes increase by the same amount as government spending. Show in an IS-LM diagram the effect of this policy on output in the short run. (It may help to recall the discussion of the multiplier In Chapter 3. Does government spending or tax policy have a bigger multiplier ) How does the out-put effect compare with the effect in part (a)
Now suppose Picardie.' equivalence holds In this econ• 011Uf Farts (c) and do not require use of diagrams.]
c. Consider again an increase in government spend; with no change In taxes. How does the output effect compare to the output effects in parts (a) and (b)
d. Consider again an Increase in government spending combined with an increase in taxes of the same amount. How does this output effect compare TO the output effects In pans (a) and (b)
Comment on each of the following statements:
I. "Under Ricardian equivalence, government spending has no effect on output."
II. "Under Ricardian equivalence, changes in axes have no effect on output."

Question 6