m

m






V
m  V

 m 

   V
 


m
Ô       !" #$! 
m$%# (as seen).
Ô In addition, during a recession , #&# # 
   & $%$ & (as unemployment benefits
are linked to output), which further reduces the
Multiplier.
Ô „he Impact of this is that the  !$#  !"
%#, which "%  "%! & '
($ !).
Ô „his is what is meant by the ¶Automatic stabilisers· in
the economy; O
O




O
 
 O


O

Ô A consequence of the Automatic Stabilisers is that the
budget deficit rises when output falls and vice-versa.
Ô In practice, Auto-stabilisers account for a very small
percentage of the reaction.
V
m  V

 m 

   V
 


m
Ô „hus we can write the budget deficit as:


O a  O
O a  £
a  O
a  


O 

„O  
O 

   O O




O  O
 
O O 






O.
Discretionary
spending.
Ô „he Cyclically Adj. Budget Def. is calculated by
considering what the budget deficit would be at
equilibrium output
V
 

 

Ô   #" $( '

u u
      
uO uO
Ô ën the LHS are the outgoings: Government
expenditure and interest on Bonds (i.e., DEB„).
Ô ën the RHS are inflows: „axation, the rate of
new Bonds being issued, the rate of Money
creation.
Ô Expansionary Fiscal policy can be financed by
any of the items on the RHS.
V
 

 
 V

 
V *
r
Ô rhen a deficit is financed by
bonds, there may be a wealth LM·
effect if bonds are considered
to be a form of net wealth („he
Ricardian equivalence debate). IS IS· IS·
Ô „hus, after the initial · LM
expansion (A-B), the IS curve D
will further shift due to higher
wealth creating higher C
consumption (B-C). B
Ô However, if the money supply is
assumed constant, a bond A
financed deficit will # 
%#%# &  
"'   !"'+
Ô „herefore there will be a RISE
IN „HE DEMAND ëF MëNEY
to restore that proportion. Y
Ô „he rise in money demand will
shift LM back (C-D).
V
 

 
 V

 
V *
Ô „he Ricardian Equivalence debate concerns 
O



O


O 


  
  

O
O 
Ô Ricardo argues that they O be perceived as such
because „axes MUS„ rise later on in order to service the
debt (thus, a bond-financed expansion will have the same
effect as a tax-financed one).
Ô Assumptions:
Ô Households are able to borrow against expected future
income at the current interest rate (i.e.,  ,$'
!#).
Ô # #  " #- #  " for
Governments and Households.
Ô $ !  & '  &# #.
Ô #  "%#!  ! $(((  !
& .,$ !, thus making the previous analysis
(with wealth effects) more realistic.
V
 

 
  /

 
V *
Ô „his is the case with a fully-tax r
financed programme, hence
Ô è 0 è(
Ô If we assume tax is exogenous IS·
(not a necessary condition), IS IS·
then: · LM
Ô Ʀy = Ʀg + cyƦg+ cy(cyƦg) + ... (1)
Ô Ʀy = - cyƦt - cy(cyƦt) - ... (2) B
Ô It is therefore evident that: C
Ô è' 0 è 0 è(
Ô è /è
= 1 [Balanced Bud
et A
Multiplier]
Ô $1  ' "%! 
$%$ 2  &#" 
 "$$. (A-B).
Ô HërEVER, the multiplier will
be pulled down when the Y
interest rate/impact of
increased income on the
demand for money are
reintroduced (A-C).
V
 

 
  /

 
V *
Ô If we assume that there is a proportional tax, such
that t = tyy, a tax financed programme will only be
balanced if:
Ô Ʀg = Ʀt
Ô Ʀg = tyƦy
Ô è(3è' 0 43'
Ô However, we know that the Multiplier is actually:
Ô è(3è' 0 43 ' 5
''* 6 43'
Ô „his is because Në„ ALL of the rise in incomes will
be recouped via taxation, 

O
O


 
as well.
Ô „he implication is that there will need to be a degree
of bond-financing in addition.
V
 

 

m
 
V
r
Ô A programme financed by
the printing of new money
will lead to not only an IS· LM
outward shift of the IS IS
curve but also an outward LM·
shift of the LM curve
(Money supply will rise).
Ô Hence, it is very effective
at raising output. A B
Ô BU„, will also raise
inflation by a large amount
² '%#&s are
usually caused by
Monetarising the deficit. Y
Ô „herefore, it is not treated
as a viable option, unless
as a last resort.
V  m
m V
V
Ô Start with the static Government Budget identity and divide through
by +' in order to get all the terms in their relative to V #.
Ô G-„ + iB = dB/dt
Ô ( 7  5 0 8393 +'*
Ô B/P.y = b; B = b.P.y
Ô „hus,  '*3 0 3 0 3*+' 5 3*+' 5 '3*+
Ô Divide through Py:
Ô [dB/dt]/(P.y) = (db/dt).(Py/Py) + (dP/dt).(by/Py) + (dy/dt).(bP/Py)
Ô =OO  O 
Ô Noting that 8 3*39 0 8è39 0 :  "# &# '*
Ô [dB/dt]/(P.y) = db/dt + Ǒb + DŽb
Ô „hus:
Ô g ² t + ib = db/dt + Ǒb + DŽb
Ô db/dt = (g-t) + b(i ² Ǒ ² DŽ)

Ô 3 0 (.* 5  # 7 ;* mm +

  V  m
Ô „he previous equation can be shown in a
—
PHASE diagram, which deals with rate
of change equations. —O
Ô „he gradient is determined by the term
(r-DŽ) which can be described as:
Ô „he cost of servicin
the debt ² the # 6 ;
abilit to service it.
Ô If r > Y, then the line will be positively Primary
sloped (the red line).  " 
! & # !(   !  deficit E
'  #%' +
Ô If r < Y, then the line will be negatively
Primary b
sloped (blue).  "  '  surplus
%'   !  ! & +
Ô „he intersection is determined as to
whether there is a 
 


O  # = ;

    (the [g-t] term).
Ô If r < Y, then points to the right of E will
have db/dt > 0, thus increasing ¶b· and
moving along the x-axis back to E (and
vice versa for points to the right).
Ô „his is  V  
<m.
Ô If # 6 1 2 #1  # 2  
V 
 from E.
Ô E could also occur to the left of the ¶y·-
axis; this would suggest a negative level
of Government debt.
m    V
Ô It is possible for the gradient of the slope to change
over the course of time, and can catch out
Governments.
Ô For example, in the 60·s and 70·s post war economies
were largely in the position where their rate of income
growth was higher than the real rate of interest (blue
line).
Ô „hus, they borrowed beyond the sustainable level of
debt (E) as they would converge back to it anyway.
Ô However, in the 80·s the real rate of interest exceeded
than their rate of income growth (red line).
Ô „hey were then faced with the problem of having to
actively cut the level of debt via Fiscal Consolidation.



V 
Ô Suppose the economy is currently at
— # 6 ;
A and wishes to move to D as it has
a lower b. —O
Ô „he Government can control the
economy·s path by #( 
(.#$ %#"#' ! (in A
this case, a surplus).
By INCREASING the surplus
Ô
initially (from S ² S·), the economy D
moves onto the black phase line, to
point B. b
Ô Because the economy will  #( S·· B
from the sustainable debt/GDP
ratio, it will move south-west along
the line, until point C.
Ô At point C (at the debt/GDP ratio S
desired), the Government can
REDUCE the surplus to S··, moving
the economy onto the yellow phase C
line and sustainable (but not stable) S·
equilibrium D.
Ô Alternatively, it could go with a
more gradual approach and do the
above, but in smaller steps and
more frequently and use the blue
phase lines and follow the blue
arrow to D.


  V




Ô Re-arrange the dynamic Government budget identity [ Ʀb = (G/y ² „/y) + b(r ²
Y)] in terms of b: the PFPR starts with the point that the debt ratio must not
rise, i.e., Ʀb • 0.
Ô b ” [(tP ² gP)/(rP ² DŽP)]
Ô  0  > ( 5  # 7 U*  

Ô „his states that the tax level is a fixed proportion of GDP in the long run and
that it should be greater than or equal to Government spending per GDP in the
long run plus the second term, which can either be positive or negative,
depending on the factors.
Ô A rise in PERMANEN„ Gov. Spending must be matched with a rise in
taxation.
Ô „his ensures solvency.
Ô Substitute the rule into the dynamic identity:
Ô è ? ( 7 (* 5 8 #.#* 7 ; 7 ;*9
Ô „hus, the PFPR allows for a O
 divergence from the long-run trend,
financed by borrowing, and that the deficit can widen if the real rate of interest
is temporarily above it·s permanent level or output below it·s permanent level
(recession) the deficit can be safely allowed to rise.
Ô „he Rule has promising implications for stability: it allows for automatic
stabilisers, however, any deficit racked up must be cancelled out in the boom
years for the average to hold ² hence, discretionary fiscal policy is frowned
upon as there is no way to reverse it/recoup the losses.
Ô A constant share of taxation allows for consumption smoothing.


  V @A
BV A
Ô „he Golden Rule states that the cyclically
adjusted deficit [g(ye) ² t(ye)] must be no greater
than that required to fund Government
investment spending (as a share of GDP):
Ô ( '* 7  '* ? ±( 3' ^ >( ±gI is the cyclically
adjusted Government Investment)}
Ô A "#    
, as it 


OO

   O



O 
and

O O  

O
O (which
would have to be financed by a rise in taxation
under the PFPR).
Ô It is not good at keeping the debt to GDP ratio
low as it   %!&'   ! #$#
is needed for the investment projects.


    V
@ 

Ô „he SGP states that the budget deficit/GDP ratio
should be less than 3% and that the cyclically
adjusted budget deficit ratio should be balanced
or in surplus:
Ô V&!3V ? C+CD
Ô
'!!' E$ $( &!3V ? C
Ô Both rules are harsher than PFPR and
potentially harmful (although their intent is to
reduce b).
Ô „he first rule puts an arbitrary limit on b; in a
deep recession,   #"A  #
, whilst they wouldn·t necessarily be in a
PFPR.
Ô „he second rule imposes a strict limit on what
projects can be pursued for #$!$#