OUTLINE

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Fiscal Policy, Budget Deficits and Government Debt
Week 9 SF Intermediate Economics Professor
Dermot McAleese
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OUTLINE

• ? Counter-cyclical fiscal policy
• ? Crowding-out
• ? The limits of fiscal activism
• ? Public debt ageing of population

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COUNTER-CYCLICAL FISCAL POLICY

• The Keynesian aggregate supply curve and fiscal
  policy

Price level
KAS
E1
AD1
E2
E
AD
AD2
Output
Y
Y2
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CROWDING OUT

• ? Crowding out refers to the various ways by
  which changes in public spending impact
  negatively on private sector spending.
• ()G ? () Budget Deficit ? borrowing
• ? () r ? (-) I, (-) C
• ?BD matched by () LM offsets crowding out effect

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r
LM
IS
IS
Y
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RICARDIAN EQUIVALENCE

• (-) T today ?() Budget Deficit today
• ?() Govt borrowing ? () T tomorrow
• ? (-) C today
• ? The stimulus to AD by budget deficit will be
  offset by a rise in private sector saving
• ? Financing by borrowing increase in taxation
• ? Rational expectations

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FISCAL ACTIVISM THE LIMITS

• ? Knowledge gaps and time lags
• ? Political interference
• ? Inefficiencies of the public sector
• ? Deterrent effects of public debt overhang
• ? Private sector response
• ? Empirical experience

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The Debt Penalty - Limits to Public Borrowing

• ?Public debt is sustainable when it remains
  constant proportion of GDP over time (see
  formula in Appendix)
• ?Effect on financial markets expectations
• ? inflation to erode real value of fixed
  interest debt
• ?debt default, rescheduling or moratorium on
  interest payments
• ?New measures of indebtedness (public debt
  adjusted for net pensions liabilities)
• ?Openness of the financial markets ? fiscal
  conservatism
• ?Further reinforced by ageing

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EMPIRICAL EXPERIENCE

• ? Fiscal policy often pro-cyclical instead of
  counter-cyclical
• ? Private sector response not always positive
• Extreme Cases
• expansionary fiscal contraction (Ireland?)
• extreme incipient indebtedness (Japan)
• surplus for an ageing population (Norway)

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CONCLUSION

• ? Coarse-tuning instead of fine-tuning
• ? Effectiveness of fiscal policy depends on
• ?initial position (public debt, size of public
  sector)
• ? political institutions (credibility)

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Table. 1 Industrial countries fiscal balances (
GDP)

• Source IMF, World Economic Outlook (May 1996 and
  May 2000)

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Table. 1a Industrial countries fiscal balances
( GDP)

• Source IMF, World Economic Outlook (May 1996 and
  May 2000)

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Table. 2 Fiscal policy stance, 1999-2000
Source IMF, World Economic Outlook (May 1996 and
May 2000)
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Table. 3 Government spending (GDP)
Source European Economy, Annual Report No 59,
1995 European Economy, special Supplement,
Spring 1995 OECD pre-Second World War figures
taken from Vito Tanzi and Ludger Schuknecht, The
Growth of Government and the Reform of the State
in Industrial Countries, IMF Working Paper,
December 1995 European Economy No. 68, 1999.
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Table. 4 General government net debt (GDP)
Source European Monetary Institute, First Annual
Report, April 1995 OECD Economic Outlook,,
various issues.
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Table. 5 Elderly dependency ratios
Source Eurostat
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Table. 6 Public sector debt and net public
pensions liabilities, 1990 ( GDP)
Source Van Noord and Herd (1994)