EC1B3

Macroeconomics I
Winter Term
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Fiscal challenges in the
long run
Introduction
The government can borrow or lend.
• But the government’s budget must balance in PDV.
• Budget deficits today must be offset by budget
surpluses in the future.
Recent forecasts suggest current fiscal policies in
many countries are unsustainable.
• Shocks (Financial crisis, Covid, Russian invasion of
Ukraine, …)
• Demographics
• Healthcare
• Pension systems
The Government Budget Constraint
The flow version of the government budget constraint
holds in each period.
The sources of funds to the government must equal
the uses of funds.

𝐺! + 𝑇𝑟! + 𝑖! 𝐵!"# = 𝑇! + 𝐵! − 𝐵!"# + 𝑀! − 𝑀!"#

 Transfer
payments Interest
Government payments
purchases
on debts

𝐺! + 𝑇𝑟! + 𝑖! 𝐵!"# = 𝑇! + (𝐵! −𝐵!"#) + (𝑀! −𝑀!"#)

Change in
Taxes New the money
borrowing stock
The Government Budget Constraint
Assume for the moment
• The change in the stock of money is zero.
• Transfer payments are zero.
Therefore: 𝐵! = 1 + 𝑖! 𝐵!"# + 𝐺! − 𝑇!

The primary deficit: 𝐺! − 𝑇!

• It excludes spending on interest.
The total deficit: 𝑖! 𝐵!"# + 𝐺! − 𝑇!
Government Spending and Revenue
The budget balance
• The difference between tax revenues and spending
A budget surplus
• Tax revenues > Spending
A budget deficit
• Tax revenues < Spending
• The government must borrow by selling bonds.
A balanced budget
• Tax revenues = Spending
Spending and Revenue over Time
World War II
• Taxes and expenditures rose sharply.
For United States:
• After the war spending and revenues were an
approximately stable fraction of GDP.
• Budget deficits emerged starting around 1970.

Europe:
• Welfare state building increased deficits overtime
starting from 1970s
U.S. Federal Government Revenue and Spending
The Debt-GDP Ratio
A better indicator of the accumulation of debt compared with the income of the country
𝐵! = 1 + 𝑖! 𝐵!"# + 𝐺! − 𝑇!

Divide by 𝑌!
𝐵! 𝑌!"# 𝐵!"# 𝐺! − 𝑇!
= 1 + 𝑖! +
𝑌! 𝑌! 𝑌!"# 𝑌!

!
Notice that ! ! = 1 + 𝑔" where 𝑔! is the GDP growth rate. Use lower case letter for variable
!"#

divided by GDP

1 + 𝑖!
𝑏! = 𝑏 + 𝑝𝑏!
1 + 𝑔! !"#
The Debt-GDP Ratio—1
Government debt
• The outstanding stock of bonds that have been issued in
the past
In 2005
• The debt-GDP ratio (general government debt over GDP)
was just over 45 percent.
In 2018
• The debt-GDP ratio rose to nearly 91 percent.
In 2024:
• 129 percent!

More or less half of the debt is owed to foreigners.

Federal Debt and Deficits in the United States
International Evidence on Spending and Debt
Among the richer OECD countries, the United States
has a lower than average
• government spending-to-GDP ratio (38 percent).
• debt-GDP ratio.
Norway
• Negative debt-GDP ratio
• Saves its surpluses
Government Spending around the World, 2017
Debt-GDP Ratios around the World
How Much Can the Government Borrow?
When considering economic consequences of deficits
and debts, we must consider
• Economic growth
• The possibility of high inflation or default
• Intergenerational equity
• The extent to which deficits crowd out investment
Economic Growth and the Debt-GDP Ratio
The amount the government can borrow is limited by:
• The amount it can credibly be expected to pay back
• Partly on how large the economy’s GDP is
Stock of debt can grow over time if GDP is growing
even faster.
• The debt-GDP ratio will fall if this happens.
High Inflation and Default—1
If the debt-GDP ratio becomes too high:
• Lenders worry about the ability of the government
to repay.
• Investors demand higher interest rates.
If lenders stop:
• The government may print more money to satisfy
the budget.
• This generates inflation.
High Inflation and Default—2
Default:
• Government declares it will not repay certain debts.
• Or it will repay them at less than face value.
When the government borrows:
• The beneficiaries of borrowing may not be the same
people who repay the debt.
Example: World War II
• The generation that fought the war made large
sacrifices.
• Future generations benefited from the victory.
• Future generations paid for the war.
Generational Accounting
Generational accounting:
• Calculates the extent to which current policies pass
on tax burdens to future generations
High and rising debt-GDP ratios imply higher tax rates
on future generations.
Deficits and Investment
The national income identity
• Investment equals total saving:

Add and subtract tax revenues from the left side of the
equation:
Deficits and Investment—2
Investment can be financed through
• Saving from the private sector
• Government saving
• Saving by foreigners
Disposable income
• Difference between disposable income and
consumption
Crowding out
• Budget deficits may absorb some of the savings and
reduce investment.
Deficits and Investment—3
Ricardian equivalence implies:
• Holding the present value of government spending constant,
the timing of taxes does not affect consumption.
• Budget deficits need not crowd out investment.
Economists still debate the extent to which budget deficits crowd
out investment.
U.S. Investment and the Budget Deficit