Questions -- The Government Budget

The Government Budget

1.	What are the major components of Federal government spending? How has each behaved over the last thirty years?
2.	Compare the behavior of Federal government spending and revenues over the last thirty years.
3.	What is the major difference between the real and conventional measures of the government budget deficit? How large is this difference?
4.	What is the primary budget deficit, and why is it a relevant number.
5.	Can the government run conventionally-measured budget deficits forever?	Answers
6.	What are the economic effects of government budget deficits according to the traditional view?
7.	What are the economic effects of government budget deficits according to the Ricardian view?
8.	What accounts for the difference between the predictions of the conventional and Ricardian views?
9.	Why is an unfunded social security system like government debt?
10.	What determines the rate of return on worker contributions to funded and unfunded social security systems?

Old Exam Questions

The following table contains some macroeconomic data for the hypothetical country of Freedonia, which formerly had a Marxist economy but has recently converted to a market system. Except for the inflation, unemployment, and real growth rates, the numbers are in millions of local currency.

GDP	5,000 million
Public Debt	4,000 million
High-Powered Money	500 million
Government Purchases	500 million
Government Transfer Payments	600 million
Government Nominal Interest Payments	560 million
Tax Revenues	1,000 million
Unemployment Rate	5.5 percent
Growth Rate of Real GDP	3.5 percent/year
Inflation Rate	10.0 percent/year

Based on the experience of Russia and China over the past few years, Western businesses are concerned that the budget and the inflation rate in Freedonia will spiral out of control. Because of these fears, they have been hesitant to invest in Freedonia. In an attempt to reassure foreign investors, the Freedonian government has published an economic plan for the next several years.

The government thinks that real GDP can continue to grow at a rate of 3.5 percent for at least the next decade. All tax revenue is generated by a value-added tax that collects 20 percent of GDP. The government proposes to keep this tax rate constant far into the future, and also to let its purchases and transfer payments grow by 3.5 percent per year in real terms, so that they remain fixed as a fraction of GDP. The government promises to bring the inflation rate down to 2.5 percent per year within two years, and it has already adopted a money growth rate that is consistent with 2.5 percent inflation.

a.	What rate of money growth is consistent with 2.5 percent inflation? Why?
b.	Given this rate of money growth, how much revenue will the government generate from money growth this year?
c.	Calculate the conventional government budget deficit.
d.	Calculate the primary government budget deficit.
e.	Calculate the real government budget deficit.
f.	Do you think the government can keep all of the promises listed above? If yes, why? If no, why not, and how might the actual results differ from the promised results?

Answer:

a.	%DM + %DV = %DP + %DY Assuming no change in velocity, then %DM = 2.5 + 3.5 = 6 percent
b.	If the money multiplier is constant, then high-powered money grows at the same 6 percent rate as broader monetary aggregates. So DH = .06H = 30 million
c.	The conventional measure of the deficit is G + TR + iB_t-1 - T = 500 + 600 + 560 - 1000 = 660
d.	The primary deficit is G + TR - T = 500 + 600 - 1000 = 100
e.	The real deficit is equal to the conventional deficit with adjustments for (i) real vs. nominal interest rates, and (ii) revenue from money growth. Thus, the real deficit is 660 - pB_t-1 - DH = 660 - .10(4000) - 30 = 230
f.	This plan is not feasible. There are two ways of seeing this. The plan calls for each item in the definition of the primary deficit to remain constant as a fraction of GDP, so that the primary deficit is to remain a constant fraction of GDP. Because GDP is expected to grow at 3.5 percent per year, the primary deficit is projected to grow at the same rate. A government can run a primary deficit indefinitely only to the extent that it can be financed by money creation. Revenue from money creation (30) is much smaller than the primary deficit (100). If money growth were to increase by enough to cover the primary deficit, this would violate the government's inflation forecasts. So the plan is not feasible. Another way to see that the plan is infeasible is as follows. The real deficit is the change in the real government debt owned by the private sector. Current-year numbers imply that the growth rate of the real debt is 230/4000 = .0575, which is greater than the growth rate of real GDP. This implies that the debt/GDP ratio will increase from 0.8 (=4000/5000) to 0.8174 (=4230/5175) in the first year. The debt/GDP ratio would continue to increase under the proposed plan. Since this ratio cannot increase forever, the plan is not feasible.

The United States and some other countries currently have unfunded social security systems.

a.	What is an unfunded social security system?
b.	Why is such a system similar to government debt?
c.	What are the economic effects of an unfunded social security system?
d.	Describe some alternatives to an unfunded social security system.

Answer:

An unfunded social security system does not accumulate a significant trust fund. Instead, it uses taxes on current workers to finance payments to current retirees. The government's commitments under such a system are similar to government debt. Both unfunded social security and government debt are promises to make future payments that will be financed by taxing future workers.

Unfunded social security has similar effects to government debt. Under the traditional view, people alive today view these promises as net wealth. They consume more and save less for retirement. In a closed economy, this raises the interest rate and reduces investment. [As will be seen in the next module, in a small, open economy, it causes greater borrowing from (or less lending to) the rest of the world, raising the foreign-exchange value of domestic currency and lowering the current account balance.] Under the Ricardian view, people do not view social security promises as net wealth, so they do not increase their consumption. There is no change in the interest rate, investment, the exchange rate, the capital account balance, or the current account balance.

An alternative to unfunded social security is some fully funded system. This could be a fully funded government pension system, as in Singapore. It could also be a system of mandatory, privately administered, individual retirement accounts, as in Chile.