SETASIGNThis e-book
B) Second hypothesis
3. The long term adjustment
5.3 The government budget constraints and debt dynamics
Advanced Macroeconomics
151
Modern Macroeconomics Here, Xt is the wage contract settlement signed in period t. Sometimes, firms pay the average wage in the next contract period, depending on the labor market. If the workers want high wages then they should negotiate for the t+1 period. There is also a possibility that the economy will experience a downturn and a rise in unemployment, which would reduce the chances of a wage increase.
Wage adjustment
Prices cannot be controlled and they are always on a rise. It is the firm which decides the amount of increment in wages. If the firm is competitive then they will increase the wages. But if the firm is less competitive, then wages are adjusted slowly. There comes a time when all firms adjust their wages and prices. A natural equilibrium is then achieved in the economy. The decline in prices forces firms to reduce the nominal wages and consequently, the temporary real wage increases. But if real wages are less, then fewer workers will agree to work. If real wages are higher than the efficiency wage, then more workers will not work. If the efficiency wage is higher than the market wage then workers will not shirk as doing so proves to be more costly.
Advanced Macroeconomics
152
Modern Macroeconomics
Another way of writing the budget constraints is:
1 1
( )
t t t
B B B
−rB
−G T
∆ = − = + −
(5.10)The fiscal deficit is the government expenditures that are not related to the repayment of debt, G plus repayment of the debt, rB less government revenues T. The difference between the fiscal deficit and interest payments is the primary deficit.
The above equation can be rewritten as:
(1 )
1t t t
B = + r B
−+ D
(5.11)D
tis the primary deficit. If we divide the above equation by Yt, then the equation becomes:1 1
1 1 1
(1 )
t t t t
t t t t
B r B Y D
Y = + Y Y−− −− +Y− (5.12)
Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more
“The perfect start of a successful,
international career.”
CLICK HERE
to discover why both socially and academically the University
of Groningen is one of the best places for a student to be
www.rug.nl/feb/education
Excellent Economics and Business programmes at:
Advanced Macroeconomics
153
Modern Macroeconomics
If
b B Y
t=
t/
t, the debt/GDP ratio isd D Y
t=
t/
t. The primary deficit/GDP ratio and the one period rate of GDP will be1 1 1
1
( / ) 1
1
t t
t
t t
t t
g Y Y Y Y Y or
g Y Y
−
−
−
−
= −
= −
+ =
We can rewrite the above equation as:
1
1
t 1 r t t
b b d
g −
= + +
+
The debt/GDP ratio increases because firstly, a government issues debts to cover a primary deficit.
Secondly, the government must pay interest on existing debt. It is expressed as 1+r/1+g. If the primary deficit is zero, then
1 1
1
t r t
b b
g −
= +
+ (5.13)
If the government increases the interest rate on existing debt, then the debt/GDP ratio increases. But if GDP increases at the rate (1+g) with an increase in tax revenues, GDP will also increase, helping the debt/GDP ratio to be reduced somewhat.
The net effect on the increase in GDP and interest is the debt/GDP ratio. If g r, the debt/GDP ratio will not increase; it is sustainable. This can be presented in the following:
%W EW 'HEW*'3UDWLR
6ORSHUJ
GW
E U G
J
EW
Figure 5.3 Debt and the gross domestic product (GDP) with effects of interest and growth
Advanced Macroeconomics
154
Modern Macroeconomics Figure 5.3 shows that the debt/GDP ratio in period t is bt. The first is the primary deficit/GDP ratio is dt. The second is the ratio of one plus interest rate to growth rate of GDP. The debt /GDP ratio of the previous period is t-1. The steady state of debt/GDP, which does not change with time, is given by b−.
EW 6ORSH
U J !
E EW
'HEW*'3UDWLRLQSHULRGW
8QVWDEOHVWHDG\VWDWH
Figure 5.4 Unstable steady state conditions in debt-to-GDP ratio
Figure 5.4 illustrates that a debt/GDP value other than b− will gravitate towards b−. If the interest rate is higher than the growth rate of GDP then the debt is considered to be unstable.
A steady state b bt = t−1 =b− is a condition. It is given as:
1 1
b rb d g
− = + −+ + 1
b g r d g
−= − =
+ 1 g
b d
g r
− +
= − (5.14)
5.3.1 Primary deficits and stability
The first part of the figure shows [(1+r)/(1+g)] < 1 or r > g, a stable steady state. The debt/GDP ratio at any time t, bt moves closer to the steady state valueb−. The second part of the figure displays [(1+r) +(1+g)] > 1 or r > g, and depicts an unstable steady state. The debt /GDP ratio moves towards bt. The value is b− over time for any starting value of bt other than b− the steady state value itself. It is [(1+r) + (1+g)] > 0 if r > -1 and g > -1.
Advanced Macroeconomics
155
Modern Macroeconomics The second part of the figure indicates that the economy could settle at a debt/GDP ratio which is constant at b−.The constant debt/GDP ratio is not a problem for economists. But the constant value of debt/GDP leads to non-repayment of debt. The debt/GDP ratio will tend towards b−, bt-b−. It means that the government is not paying back the principal of its debt. The figure also shows that r > g, which means the debt/GDP ratio increases. The debt will be larger than GDP and when the debt is larger, the entire GDP will be insufficient to pay the interest on the debt. The government becomes bankrupt in this case. Further loans are denied by all other government and international institutions. The result is in conformity with the recent trend in Indian public finance where the high interest rate fuelled the accumulation of more debt, an increase in interest payments and the consequent debt-deficit spiral (Chakraborty 2002). From the above discussion, it can be concluded that the government increases taxes and collects above its expenditures, then uses this revenue to first pay off the existing government debt or to purchase financial assets from the private sector.
For the primary deficit to be positive, the government must accumulate enough assets. This can be done by running the average value of b−. But the government should find alternatives and raise enough revenues to service the interest on the debt.
Under a balanced budget, the government has a close to zero fiscal deficit. If (G-T) + rB = 0, the rate of interest on debt is rB > 0. To be positive, we must have (G-T) < 0, then the government will have a primary surplus.
Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more Click on the ad to read more
89,000 km
In the past four years we have drilled
That’s more than twice around the world.
careers.slb.com
What will you be?
1 Based on Fortune 500 ranking 2011. Copyright © 2015 Schlumberger. All rights reserved.
Who are we?
We are the world’s largest oilfield services company1. Working globally—often in remote and challenging locations—
we invent, design, engineer, and apply technology to help our customers find and produce oil and gas safely.
Who are we looking for?
Every year, we need thousands of graduates to begin dynamic careers in the following domains:
n Engineering, Research and Operations n Geoscience and Petrotechnical n Commercial and Business
Advanced Macroeconomics
156
Modern Macroeconomics Figure 5.5 shows that if the government continues to have a primary surplus, the debt/GDP ratio is b*.
It can repay its debt eventually. It can also accumulate a stock of positive assets /GDP as b−.
Figure 5.6 shows that the government has a primary surplus. The debt /GDP ratio of b* diverges from the steady state debt/GDP ratio of b−. If b− is positive, the government manages debt/GDP ratio to its steady state value. Government will never pay the debt b− raised. It is not solved here. At b*<b−, the government gets out of debt. It accumulates more assets while increasing debt.
EW
%W EW 'HEW*'3
VORSH U
J
E EEW GW
Figure 5.5 Repayment of government debt over time
Advanced Macroeconomics
157
Modern Macroeconomics
EW
%W EW 'HEW*'3
VORSH U
J
E EEW GW
Figure 5.6 Government assets with rising debt
A government’s debt management policy should ensure that the states can borrow on terms comparable to those of the central government, so that the spread of interest rates between the debt of the central government and the states is reduced (Chakraborty 2005). Another study shows that India’s public deficit bias and indebtedness cannot be sustained much longer especially with stepped-up external liberalization.
Thus, there is a strong case for adopting fiscal responsibility legislation that involves a high degree of transparency, for well designed fiscal policy rules at the national and sub-national levels of government, for short-run contingency measures and a multi-year macro budgetary process, an institutional framework for implementation of rules and appropriate preparation and sequencing including the phasing in of supporting structural reforms (Kopits 2001).