copyright © 2006 by the mcgraw-hill companies, inc. all rights reserved. 14-1 national debt and...

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.14-1

National Debt and Economic Growth

See: DeLong/Olney: Macroeconomics; McGraw-Hill; 2006; Chapter 14, section 14.3


Questions• What are the reasons that we should

worry about a rising national debt?• What are the reasons that we

shouldn’t worry too much about a rising national debt?


Debt & Deficits• The national debt (D) is the amount

of money that the government owes those from whom it has borrowed– when government spending < tax

revenues, the difference is the government surplus (-d)• the national debt falls by d

– when government spending > tax collections, the difference is the government deficit (d)• the national debt rises by d


Measuring the Budget Balance• The government budget balance

reported in the news is generally the unified cash balance– the difference between the money the

government actually spends in a year and the money it takes in

– unifies all of the government’s accounts and trust funds

– doesn’t take account of changes in the value of government-owned assets or future liabilities


Inflation

• A good measure of the deficit should be a measure of whether the government is spending more in the way of resources than it is taking in– we should correct the officially-reported

cash budget balance for inflation– the real deficit (dr) is related to the cash

deficit (dc) by

r cd d - D


Liabilities & Generational Accounting

• The correct way to count the government’s debt is to look at all of its promises to pay money out in the future– this system is called generational

accounting• it would examine the lifetime impact of taxes

and spending programs on individuals born in specific years and would come up with a balance that could be used for long-term planning


The Equilibrium Debt-to-GDP Ratio

• Fiscal policy is sustainable if the debt-to-GDP ratio (D/Y) is heading for a steady state– D and Y must be growing at the same

proportional rate• Y grows at a proportional rate equal to the

sum of the annual rate of growth of the labor force (n) and the annual rate of growth of labor efficiency (g)

gn Yof rate growth



• The debt next year will be equal to

t 1 t tD (1- )D d

• Since tax revenues and spending grow with real GDP, it makes sense to focus on the deficit as a share of GDP



• The proportional growth rate of the debt is

t 1 t

t

D - D d Y-

D Y D



• The debt-to-GDP ratio will be stable when the proportional growth rates of the debt and GDP are equal

d Yn g -

Y D

D (d/Y)

Y n + g +



• Example– growth rate of labor force (n) = 2%– growth rate of output/worker (g) = 1%– inflation rate () = 5%

D d/Y 4% 1

Y n g 2% 1% 5% 2

– if the current debt-to-GDP ratio<1/2, the debt-to-GDP ratio will

rise– if the current debt-to-GDP ratio>1/2, the debt-to-GDP ratio will

fall


Sustainability• The higher the debt-to-GDP ratio, the

riskier an investment financiers judge the debt of a country to be– if the government changes hands, the

new government must decide whether to honor the debt issued by previous governments

– the government can lower the real value of its debt by increasing the rate of inflation


Sustainability• A deficit is sustainable only if the

associated steady-state debt-to-GDP ratio is low enough that investors judge the debt safe enough to be willing to hold it

• If a government has too much debt to be considered safe, the interest rates it must pay will rise dramatically– the government will then be faced with a

larger deficit (because of interest costs)


Deficits and Long-Run Economic Growth

• If the deficits continue for long, they will affect the economy’s capital intensity

• A lower balanced growth capital-output ratio implies a lower level of output per worker for any given level of the efficiency of labor


Debt Service, Taxation, and Real GDP

• A higher deficit also implies a higher debt, which means that the government owes more in the way of interest payments to bondholders– over time, the increase in interest

payments will require tax increases– these tax increases may discourage

entrepreneurship and economic activity


Deficits and long-run growth

• Persistent deficits a rising national debt threaten to diminish national savings, reduce the level of output per worker along the economy’s balanced growth path, and retard economic growth

copyright © 2006 by the mcgraw-hill companies, inc. all rights reserved. 14-1 national debt and...

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