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Government Debt

Government Debt. Stocks & Flows. Flow – measured over a period of time (annual, monthly) Stock – measure at a point in time Income vs. wealth Investment vs. capital Gov’t debt vs. deficit. Gov’t deficit and debt. Deficit G – T Each year adds to the debt

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Government Debt

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  1. Government Debt

  2. Stocks & Flows Flow – measured over a period of time (annual, monthly) Stock – measure at a point in time Income vs. wealth Investment vs. capital Gov’t debt vs. deficit

  3. Gov’t deficit and debt Deficit G – T Each year adds to the debt How big is the deficit and debt? Debt $400b? Measure as a percent of GDP

  4. Debt Problems How can you tell if a corporation is in danger of defaulting on its debt? - balance sheet info? - bond yields Same for gov’ts.

  5. Debt Crisis What happens if government debt is too high? • Must pay high interest rates • Higher risk • Increases the deficit/debt • “Solutions” • Repudiation • Gov’t refuses to pay • Time consistency problem • Borrow from the Fed (central bank) • Inflation • Seingorage – profit to gov’t from inflation

  6. Lending and inflation One good – pens price of pens today is $0.20 The bank loans Jane $10 at 10% interest to be paid next year. During the year inflation is 25% - the price of pens rises $0.25 Jane makes the loan payment of $11. What’s the point? The $10 today could buy 50 pens The $11 a year later buys 44 pens. The payment the bank gets is worth less than the loan. To gain value the bank must lend at a rate higher than inflation.

  7. Real Interest Rates The real interest rate is adjusted for inflation. We use expected inflation since future inflation will affect debts agreements. ir= i – pe = nominal rate – expected inflation The real interest rate is a more accurate measure of the cost of borrowing.

  8. U.S. Real and Nominal Interest Rates

  9. How much Gov’t debt is too much? • Hard to judge • Japan (2009) • 200% Debt/GDP ratio • Real interest rates under 2% • Argentina repudiated (2002) • Debt/GDP ratio peaked near 150% • Expected probability of repudiation • Many factors involved • Trust in the gov’t • Future deficit/debt • Healthcare • Social security

  10. Retirement and Medical Care • Entitlement programs are programs that require the payments of benefits to all who meet the eligibility requirements established by the law.

  11. Debt Dynamics D(debt/GDP) = (r – g) (debt/GDP) + deficit/GDP r – real interest rate g – growth rate of real GDP If g > r ....

  12. Policy What is the effect of an increase in G on debt/GDP? • Higher deficit (raises debt/GDP) • higher r • possible exceptions • liquidity trap • hysteresis (De Long) • Higher productivity – g rises (lowers debt/GDP)

  13. Policy What is the effect on debt/GDP of an increase in T? • Lower deficit (& lower r) • possible exceptions • rates already very high • wrong side of the Laffer curve • lower productivity – g falls (raises debt/GDP)

  14. Gov’t debt • 30% - 50% of GDP is OK • Too high - crisis • interest rates rise • inflation and/or repudiation • how high is too high • Pay down debt • low deficits, surplus • growth • the higher the debt, the harder it is • Liquidity trap? Labor supply?

  15. Long Run Growth

  16. Deep History

  17. Real GDP in the U.S.

  18. Long Run Short run – fluctuations around potential GDP Medium run - adjustment to potential GDP - changes in potential GDP Long run - What determines the growth rate trend of potential GDP?

  19. AS-AD • SR fluctuations – AD shifts • MR – adjustment to Yn • LR – What changes Yn? Which of these matters for LR growth?

  20. The standard of living has increased significantly since 1950. • Growth rates of output per capita have decreased since the mid-1970s. • Convergence for much (not all) of the world.

  21. Aggregate Production • Output depends on capital and labor • Output per worker depends on capital per worker • Productivity Increase in capital – movement along the production function Increase in productivity – shift in the production function

  22. Determinants of Growth Savings • build capital through investment • needed for development • can the saving rate be too high? Productivity • technology and human capital • determines long run growth rate for GDP • What improves productivity?

  23. Long Run Policy • Improve savings/investment • Financial system • Savings • Safety • Return • Borrowing (firms) • Contracts • Available loans • Developing countries • International aid • FDI

  24. Long run policy • Improve productivity • R&D • Tax breaks • Patents • Education/Training • Property rights

  25. Summary LR • productivity matters • S/I/capital matters • particularly for developing countries SR • Productivity still matters • & other supply shocks • Demand shocks • Autonomous spending • I – “Animal Spirits” • C • Financial shocks

  26. Summary / Policy • Fiscal policy • Gov’t spends on public goods • Increase productivity • Monetary Policy • Target inflation • and output/unemployment? • LR balanced budget • stable debt/GDP ratio (30-50%) • SR implications - difficult • affect G & T changes on growth • liquidity trap • Laffer curve

  27. Review Problem • Show the effect of an increase in autonomous consumption on expenditure, IS-LM and AS-AD. Show the medium run adjustment on the AS-AD graph.

  28. Review Problem The Fed acts to raise interest rates. Starting from natural rates, show the short and medium run effect of this policy change on graphs of S&D for Money, IS-LM, AS-AD and the Phillips Curve.

  29. Final Review Questions

  30. Given the above information about a country’s output, find the following using 2007 as the base year. • Growth rate of nominal GDP. • Growth rate of real GDP. • Implied rate of inflation.

  31. Review Problem Show the effect of an increase in consumer confidence on an • Expenditure diagram • IS-LM graph • AS-AD • Start from the natural rate of output. • Show short and medium run effects. • What are the effects on equilibrium output and prices?

  32. Review Problem Show an inflationary gap on graphs of AS-AD and IS-LM. Show the result of passive policy on the graphs. How could monetary policy help to close the gap? How could fiscal policy help? Show the changes in the graphs in the case of active fiscal policy.

  33. Review Problem Show an inflationary gap on an AS-AD graph and the graph of the Phillips Curve. If the Fed wants to lower/avoid inflation what does it do? Show the resulting changes on graphs of money supply and demand, IS-LM as well as the AS-AD and PC graphs.

  34. Review Problem Starting from the natural rate of output, show how an increase in the markup affects the graphs of the wage and price setting equations, IS-LM, AS-AD and the Phillips Curve. Give two examples of reasons the markup might increase.

  35. Problem One analyst says a fall in GDP is due to a fall in productivity, while another says the cause is a decrease in investment spending. Show a separate AS-AD graph for each scenario. What are the implications for a policy response?

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