The Government Budget


Review Questions

1. What are the major components of Federal government spending? How has each behaved over the last thirty years?

 

 Transfer payments have increased (from about 6% to 12% of GDP), defense spending has decreased (from more than 8% to less than 3.5% of GDP), real interest outlays have increased (from less than 0.5% to about 2% of GDP), and other expenditures have decreased (from about 3.5% to less than 2% of GDP).

 
2. Compare the behavior of Federal government spending and revenues over the last thirty years.

 

 Revenues have varied between 18% and 20% of GDP,  and this ratio has not displayed any long-run trend.   Expenditures are about 19% of GDP, about the same as thirty years ago, but this ratio has shown more variation.  Expenditures exceeded 22% of GDP for a few years in the mid-1980s.

 
3. What is the major difference between the real and conventional measures of the government budget deficit? How large is this difference?

 

 The real deficit recognizes revenue from money creation (reducing the deficit by about $25 billion) and uses real rather than nominal interest expense (reducing the deficit by about $80 billion, depending on the inflation rate). [See the relevant overhead for details of calculations.]

 
4. What is the primary budget deficit, and why is it a relevant number?

 

 The primary deficit is government purchases plus transfer payments less tax receipts.  Thus, it ignores interest outlays altogether.  It is relevant because governments cannot run primary deficits forever, so it puts an an easily calculated upper limit on the size of the sustainable deficit.  Governments that persistently run primary deficits will eventually either default on their debt or resort to excessive money growth as a source of revenue, which will lead to inflation.

 
5. Can the government run conventionally-measured budget deficits forever?

 

 Yes, as long as the debt does not forever grow faster than GDP.
6. What are the economic effects of government budget deficits according to the traditional view?

 

 Higher consumption and lower saving, leading to higher interest rates and lower investment in a closed economy (or, as will be seen in the next module, to a stronger currency and a smaller current account balance in an open economy).

 
7. What are the economic effects of government budget deficits according to the Ricardian view? No change in consumption or any other important variable.

 
8. What accounts for the difference between the predictions of the conventional and Ricardian views? The difference in consumption behavior.

 
9. Why is an unfunded social security system like government debt? The government promises to make future payments financed by taxes on future workers.

 
10. What determines the rate of return on worker contributions to funded and unfunded social security systems? The rate of return in an unfunded system is the rate of growth of aggregate wages, which is roughly equal to the rate of growth of GDP.  The rate of return in a funded system is the net rate of return on capital, which is higher than than the GDP growth rate in most if not all countries.

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Answers to Selected Textbook Problems

Mankiw, Macroeconomics, third edition, chapter 16, problems and applications. 

You should attempt to answer these problems only after studying the theory of consumtion, which is covered in the module on Business Cycles.

2. The crucial differences between the traditional and Ricardian views of government debt arise from differences in the assumed reaction of consumption to changes in the debt.  The Keynesian theory of consumption, particularly its focus on the reaction of consumption to current disposable income, is consistent with the traditional view of government debt and implies that changes in the debt can have large effects on the economy.  The permanent-income hypothesis (PIH) assumes that consumers have an infinite planning horizon, possibly because generations are altruistically linked.  This theory of consumption is consistent with the Ricardian view of government debt.  The life-cycle hypothesis (LCH) assumes that individuals base their consumption on their entire lifetime income, but the planning horizon does not extend beyond the individual's own life.  To the extent that an increase in the government debt today (and the accompanying reduction in current taxes) results in an increase in taxes only after current consumers are dead, the government borrowing raises the lifetime income of current consumers and causes them to increase their consumption.   Therefore, the LCH is consistent with the traditional view of government debt.   A one-time government deficit will have much smaller effects under the LCH than under the Keynesian theory of consumption, however, because a one-time deficit affects only current disposable income.

3.
This one-time change in Social Security benefits and taxes redistributes income from younger to older generations.  The economic effects of this redistribution depend on whether these generations are altruistically linked.  If they are so linked (as suggested by the PIH), then the redistribution will have no economic effects.   The older generations will simply undo the transfer by leaving more wealth to the younger generations.  If the generations are not altruistically linked, then the redistribution may or may not affect aggregate consumption.  Under the LCH, aggregate consumption would increase somewhat, because the older generations have a higher marginal propensity to consume (MPC) than the younger ones.  Under the Keynesian theory, aggregate consumption would not change, because the MPC does not vary with age according to that theory.

These results may seem puzzling at first glance, because the PIH and the Keynesian theory, which are generally diametrically opposed to each other, give the same prediction.  Furthermore, the LCH, which usually gives predictions somewhere between these polar extremes, in this case gives a totally different prediction.  Note, however, that the policy change described in the question does not change the government debt, either explicit or implicit, and does not shift resources from future generations to current ones.  The policy change merely redistributes income among living generations.

4.
The argument for generational accounting is that it gives a more accurate picture of government-induced, intergenerational wealth redistributions than do the common measures of the government budget surplus or deficit.  The proponents of generational accounting believe the LCH is the best model of consumption behavior.  According to the PIH, government-induced wealth redistributions have no aggregate economic effect, so there is little gain from measuring these redistributions more accurately. 

If consumers face binding borrowing constraints, then their consumption might be quite sensitive to current income, as suggested by the Keynesian theory.  In this case, generational accounting, which focuses on changes in lifetime resources, may fail to give good predictions about the effect of policy changes on consumption and other aggregate economic variables.  For example, suppose that the government today announces a policy that transfers wealth from future generations to today's 20-year-olds, but only when those 20-year-olds reach age 40.  Generational accounting would record the increase in the lifetime resources of today's 20-year-olds and would predict (via the LCH) that those 20-year-olds would increase their consumption immediately in anticipation of the future windfall.  But if the 20-year-olds are already consuming all of their income and face binding borrowing constraints, there is no way for them to increase their current consumption.