Fiscal
Policy
Debt End This Year
 Debt End
Last Year
 DeficitThis Year
Deficitt =Outlayst  Receiptst
Deficitt   Surplust
Can you run a deficit every year?
Debtt
Deficitt
1
 dyt 
dyt 1 
GDP
GDPt
(1  g )
GDPt
dyt  dyt 1 
Deficitt
1
(1  g )
dyt 1 
dyt 1 
GDP
GDP
(1  g )
(1  g )
GDPt
GDP
GDP
Deficitt
g


dyt 1
GDP
GDPt
(1  g )
Sustainable Deficit

If
General Deficitt
g GDP

dyt 1
GDP
GDPt
(1  g )
then Debt-to-GDP ratio stays stable.

If
> then deficit is “unsustainable”
A growing economy allows the government to
borrow some money every year and still keep debt
in line with overall GDP
IMF Fiscal Indicators
Figure 2. Sovereign Bond Yield Spreads over German Bunds
(Basis points)
1800
1600
C ountries w ith Program s Supported by
EU /IMF
1400
1200
G reec e
1000
Crisis spreads to other countries
800
Irelan d
600
Po rtug al
400
Ro man ia
200
Latv ia
0
J an -10 Ap r-10 J ul-10 O c t-10 J an -11 Ap r-11 J ul-11
450
IMF Fiscal Monitor
Selected European C ountries
400
350
300
Sp ain
250
Background Reading
200
150
Italy
100
50
Belg ium
Neth erlands
Fin land
0
J an -10 Ap r-10 J ul-10 O c t-10 J an -11 Ap r-11 J ul-11
Sources: Bloomberg L.P.; Datastream.
Note: 10-year sovereign bond yields.
Primary Deficit

Simplified Government Budget
Primary Outlays (Total Expenditure less Interest Paid)
- Primary Receipts (Total Revenue less Interest Income)
Primary Budget Deficit
+ Net Interest Payments on Existing Debt
General Budget Deficit
Sustainable Primary Deficit
General Deficitt Primary Deficitt Net Interestt


GDPt
GDPt
GDPt
~
Net Interestt
i

dyt 1
GDPt
(1  g GDP )
Average Interest
• If
Primary Deficitt
g GDP  i

dyt 1
GDP
GDPt
(1  g )
then
Debt
GDP
stays stable.
Primary Balance
% of GDP

Consequences of Deficits
Austerity
 Inflation
 Default

Austerity and the Output Gap
YP
P
1
P*
1. Economy in
LT
equilibrium
SRAS
2
Y*
Recessionary Gap
2. Government
imposes
austerity
program –
cuts spending,
transfers,
AD
inceases taxes
AD′
3. AD Curve
shifts inward.
Y
Austerity has a negative effect on
business cycles.

IMF
Deficits and Inflation
Government generates revenues by printing
new money (referred to as seignorage).
 Government facing borrowing constraints
may be forced to rely on inflation tax for
deficit financing and real returns to owning
money.
 Explain the link between deficits and inflation.

19
70
19
71
19
72
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
Israel 1970-1990
Inflation
400
350
300
250
200
150
100
50
0
Israel 1970-1990
Surplus (% of GDP)
5.00%
-5.00%
-10.00%
-15.00%
-20.00%
-25.00%
-30.00%
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
0.00%
Default and Restructuring
Argentina 1999-2002
BBC Story
IMF Study
Argentina GDP
5.4E+11
5.2E+11
5E+11
4.8E+11
4.6E+11
4.4E+11
4.2E+11
4E+11
1997
1998
1999
2000
2001
2002
2003
2004
2005
Stabilization policy
In an economy subject to shocks to aggregate
demand (animal spirit shocks, external shocks,
asset market shocks), the economy will have a
self-correcting mechanism.
 However, if this self-correction mechanism
takes a long time to work, then government
may use policy to speed adjustment.

◦ Use expansionary policy to close a recessionary gap
◦ Use contractionary policy to close an inflationary
gap
Demand Driven Recession
Counter-cyclical fiscal policy
YP
P
P*
3
1
2
Y*
Recessionary Gap
SRAS
w/
1. Economy in LT
equilibrium
2. Demand shifts
in
3. Government
increases
AD spending to shift
the AD curve
back
AD′
Y
Demand Driven Expansion
Counter-cyclical fiscal policy
YP
P
SRAS
3. Government
cuts spending to
shift the AD
AD′ curve back
1
3
Y*
1. Economy in LT
equilibrium
2. Demand shifts
out
2
P*
w/
AD
Inflationary Gap
Y
Lags and Fiscal Policy
Administrative lags for fiscal policy may likely be
large.
 Except in absolute dictatorships, government will
have mechanisms for building a consensus for
expenditures. Adjusting this consensus will be time
consuming.
 If lags are too long, stabilizing government spending
or transfer payments may have a destabilizing effect,
shifting out demand after the economy has already
recovered.

Automatic Stabilization
Governments in most economies issue debt
to make up for shortfalls in revenues in
relation to spending.
Budget Deficit = Outlays – Revenues
 Tax collection is cyclical so the budget
deficit tends to be counter-cyclical.
 Maintaining a balanced budget over the cycle
means raising taxes in a recession an cutting
taxes in a boom which makes the business
cycle more extreme.

Counter-cyclical deficits
Learning Outcomes
Use growth rate of GDP, interest rates,
and the debt to GDP ratio to identify the
sustainable general and primary deficit
level.
 Use AS-AD model to identify the effects
of fiscal policy on the output gap and the
inflation rate.
