Advanced Macroeconomics An Easy Guide Fiscal policy I Public debt and the effectiveness of fiscal policy

CHAPTER 17 Fiscal policy I Public debt and the effectiveness of policy We have now reached the point at which we can use our theoretical tools to study in depth the main policy instruments of , and eventually their and effects . We will start by considering policy , which means we will now address some of the most pressing policy questions in both developing and developed countries does an increase in government expenditure increase output , or does it reduce it ?

What are the of policy ?

What are the views ?

Fiscal policy can always be thought of under two lights . On one level , it is a component of aggregate demand and will interest us as a tool of stabilisation on the other hand , it also has a role in terms of determining the provision of public goods which brings in a whole host of other considerations associated with the quality of that spending . As a tool of stabilisation it is fundamentally different from monetary policy because policy requires resources , in other words , it needs to be . The result is that ever expansion is obtained by spending will be diluted by the negative effect produced by the fact that it needs to obtain resources from the economy to itself . As a result it will always ably put in motion a effect that must be taken into account . This chapter will deal with the role of policy , its role for demand management , which happens to be where we typically have our encounter with the topic at the undergraduate level . In fact , our treatment of policy illustrates how the things we learn in macro can be misleading . For instance , in the traditional rendition , policy helps stabilise output you may remember that an increase in moves the IS to the right ( see Figure 171 ) But this graduate level analysis is incomplete because it assumes that private consumption or investment are not affected by the increased expenditure , But how is the expenditure ?

Does this ing affect other components of aggregate demand ?

Imagine a permanent increase in expenditures with taxes . Our model of permanent income would anticipate a one to one decrease in consumption , quite the opposite of a consumption function that is a rigid function of income . In fact , if we ignore the side of the expenditure ( be it through taxes or debt ) it is evident that some budget constraint will be violated . Either the government is spending what it does not have , or consumers are spending what they can not afford . Once we include the complete picture we realise How to cite this book chapter , and , A . 2021 . Advanced An Easy Guide . 17 . Fiscal policy I Public debt and the effectiveness of policy , London Press . DOI License .

262 FISCAL POLICY I PUBLIC DEBT AND THE EFFECTIVENESS OF FISCAL POLICY Figure A expansion in the model that some variables need to adjust but when does this occur ?

And how ?

And by how much ?

It is these issues that make the analysis of policy so complex . We will thus start our analysis by considering the governments budget constraint . We have also explored the role of budget constraints in analysing consumption and current account dynamics , the same analytical tools we used then will come in handy here We will see the results that from this analysis in terms of the scope of policy and public debt dynamics . 17 The government budget constraint We must recognise that the government can not create resources out of nothing , so it must respect an budget constraint . This entails that the present value of government spending is limited by the present value of taxes ( minus initial debt ) Let us start by looking carefully at the government budget constraint . Let and , denote the ment real purchases and tax revenues at time , and do , its initial real debt outstanding The simplest of the budget is that it is the rate of change of the stock of debt . The rate of change in the stock of real debt equals the difference between the governments purchases and revenues , plus the real interest on its debt . That is , at ( where is the real interest rate . The term in parentheses on the side of ( is referred to as the primary . It is the excluding interest payments of debt , and it is often a better way of gauging how policy at a given time is contributing to the governments budget constraint , since it leaves aside the effects of what was inherited from previous policies The government is also constrained by the standard solvency ( game ) condition limp ,

FISCAL POLICY I PUBLIC DEBT AND THE EFFECTIVENESS OF FISCAL POLICY 263 The governments budget constraint does not prevent it from staying permanently in debt , or even from always increasing the amount of its debt . Recall that the households budget constraint in the Ramsey model implies that in the limit the present value of its wealth can not be negative . Similarly , the restriction the budget constraint places on the government is that in the limit of the present value of its debt can not be positive . In other words , the government can not run a Ponzi scheme in which it raises new debt to pay for the ballooning interest on debt . This condition is at the heart of the discussions on the solvency or sustainability of fiscal policy , and is the reason why sustainability exercises simply test that dynamics do not have government debt increase over time relative to . How do we impose this solvency condition on the government ?

We follow our standard procedure of solving the differential equation that captures the budget constraint . We can solve ( by applying our familiar method of multiplying it by the integrating factor ' and integrating between and ( do ( do ( Applying the solvency condition ( 172 ) and rearranging , this becomes , A household budget constraint is that the present value of its consumption must be less than or equal to its initial wealth plus the present value of its labour income . A government faces an analogous constraint the present value of its purchases of goods and services must be less than or equal to its initial wealth plus the present value of its tax receipts . Note that because do represents debt rather than wealth , it enters negatively into the budget constraint . An alternative way of writing this constraint is I ( do . Expressed this way , the budget constraint states that the government must run primary surpluses large enough in present value to offset its initial debt . equivalence We add households to our problem , and derive a very important result in the theory of policy , namely equivalence given a path for government spending , it doesn matter whether it is via taxes or debt . We discuss the conditions under which this result holds , and the to its application in practice . Let us now add households to the story , and ask questions about the effects of policy decisions on private actions and welfare . In particular , for a given path of spending , a government can choose

264 FISCAL POLICY I PUBLIC DEBT AND THE OF FISCAL POLICY to it with taxes or bonds . Does this choice make any difference ?

This question is actually at the heart of the issue of policy . If you remember the standard exercise , a stimulus is an increase in government spending that is not matched by an increase in current taxes . In other words , it is a increase in spending . Is this any different from a policy that would raise taxes to the increased spending ?

A natural starting point is the neoclassical growth model we have grown to know and love . To ideas , consider the case in which the economy is small and open , domestic agents have access to an international bond la which pays an interest rate ( the same as the interest rate on domestic government debt ) and in which all government debt is held by domestic residents . When there are taxes , the representative household budget constraint is that the present value of its consumption can not exceed its initial wealth plus the present value of its labour income no I , bo do ( Notice that initial wealth now apparently has two components international ho and domestic public debt holdings do . I The effects of debt tax Breaking the integral on the side of ( in two gives us co co , no I , bo do It is reasonable to assume that the government its budget constraint , with equality . If it did not , its wealth would be growing forever , which does not seem realistic . With that assumption , implies that the present value of taxes , equals initial debt do plus the present value of government purchases , Substituting this fact into ( 178 ) gives us as co co , 170 , Equation ( shows that we can express the households budget constraint in terms of the present value of government purchases without any reference to the division of the of those chases at any point in time between taxes and bonds . Since the path of taxes does not enter either households budget constraint or their preferences , it does not affect consumption . Thus , we have a key result only the quantity of government purchases , not the division of the of those chases between taxes and bonds , affects the economy . This was pointed out by British economist David Ricardo , back in the century , which is why it is called equivalence . 1974 ) revived this result , proving it in the context of the . To see the point more starkly , focus on the case in which the agent re ( where is the rate of time preference . Assume moreover that , as we have done in the past . This implies that the optimal consumption path is ,

FISCAL POLICY I PUBLIC DEBT AND THE EFFECTIVENESS OF FISCAL POLICY Applying this to ( 179 ) yields as oo , so that consumption is equal to permanent income . Again , since the path of taxes does not enter the of ( it does not affect consumption . What is the intuition for this remarkable result ?

If a certain amount of spending is by issuing debt , the solvency condition implies that this debt must be repaid at some point . In order to do so , the government will have to raise taxes in the exact present value of that spending . This means that government bonds are not net wealth for a given path of government expenditures , a higher stock of debt outstanding means a higher present value of taxes to be paid by households . In other words , the government can not create resources out of nothing , it can only transfer them over time rational , consumers recognise this , and do not change their behaviour from what it would have been had that spending been with taxes immediately I to equivalence This very strong result was obtained under rather stringent assumptions , which we now underscore . Consumers live forever , so that a change in taxes even very far away in time matters to them , But note , if consumers had lives but acted altruistically in regards their sons and daughters , the result would still hold , This was the insight of ( 1974 ) Taxes are and therefore . If the present value of private income Ow , for instance , fell if taxes increased ( due to effects on investment or labour supply ) then equivalence would not hold . Consumers face no borrowing constraints so that all they care about is the present value of taxes . Consider , by contrast , an agent who can not borrow and who has no initial wealth . Then , a tax increase today that was perfectly offset ( in present value terms ) by a tax break periods later would reduce his income today and therefore his consumption regardless of what happened in the future , Agents and the government can borrow at the same rate of interest , If government could borrow more cheaply than consumers , for instance , by cutting taxes and running a larger today , it would increase the wealth of consumers , enabling them to increase their consumption , Effects of changes in government spending We show that changes in government spending have real effects , and that they are very different depending on whether they are temporary or permanent . Permanent increases are matched one by decreases in consumption . Temporary increases are matched less than , with a current account emerging as a result . Now ask the opposite question , What is the effect of changes in government spending on consumption , savings , and the current account of the economy ?

To get started , notice that the private budget constraint is , 266 FISCAL POLICY I PUBLIC DEBT AND THE OF FISCAL POLICY Combining this with the government budget constraint ( we have 15 , Suppose now that income is constant throughout , but government consumption can vary . In , suppose that , can take two values and , with To gain further insights , we study the effects of permanent and temporary changes in government spending that take place at time . I The initial steady state Assume that just prior to the shock , spending is expected to remain constant forever that is , for all The economy is thus in a steady state in which consumption is given by . In the initial steady state , the current account is zero . I Permanent increase in government spending Suppose now that at time there is an unanticipated and permanent increase in spending from to . From ( it follows that consumption adjusts instantaneously to its new ( and lower ) value , Since consumption falls with government spending , the trade and current accounts do not change . Hence , an unanticipated and permanent increase in spending has no impact on the current account . I Temporary increase in spending Suppose that the economy is in the initial steady state described above , with consumption given by ( 1715 ) At time , there is an unanticipated and temporary increase in spending , ta ( for some . First compute the consumption path . From ( it follows that consumption falls immediately to the level given by ( Next compute the current account path . Plugging ( into ( we have ' og ( Notice that at time this implies ( The current account is negative ( from the start . It follows that 17 , be , and , from ( that , for all times between and The current account worsens over time and then jumps back

FISCAL POLICY I PUBLIC DEBT AND THE EFFECTIVENESS OF FISCAL POLICY 267 Figure Response to a transitory increase in government spending Bonds A Deficit to zero at time Figure 1712 shows the trajectory of the and foreign assets in response to this temporary shock . How do we know that the current account goes to at time ?

Recall the current account is given by 12 , Solving this for a constant path of income , spending , and consumption we have , be ( Plugging ( into this expression we have rho ( gI ) Evaluating ( at time we have . Finally , using ( and ( in ( we obtain ET ( 1726 ) That is , the current account is zero at time

268 FISCAL POLICY I PUBLIC DEBT AND THE OF FISCAL POLICY The key policy lesson of this discussion is that consumption does not fully offset the changes in government consumption when those changes are transitory So , if government expenditure aims at changing aggregate demand , it has a much higher chance of achieving that objective if it moves in a transitory fashion . Here the excess spending affects the current account which can easily be governed by temporary changes in policy . This is why you may often hear mentions of twin in policy debates , in reference to the idea that can be accompanied by current account . Fiscal policy in a world We go over how policy into the ( New ) framework . there is the possibility of increasing output via aggregate demand ( that is , in the short run ) policy can affect output . That depends , however , on the consumer and responses , which take into account the budget constraints . We have seen that , once we consider the governments budget constraint , and its interaction with the households budget constraint , the effects of policy are radically , compared to what you may have been used to in undergraduate discussions . As a starter , the effectiveness of policy as a tool for managing aggregate demand , in a full employment economy , is clearly dubious . For example , think about the in a closed economy . It should be immediately clear that government spending can not have an effect on output from the demand side the government can not through aggregate management increase the productive capacity of the economy , and this means its increased spending must crowd out something else . In a small open economy model , as we have seen , it crowds out mostly consumption in a closed or large open economy , it would also crowd out investment ) This has the of equivalence . Having said that , we are still left with the question where is the role for policy ?

Is the conclusion that such policy is impossible ?

Not quite . Recall that the models so far in this chapter had no room for aggregate demand policy by assumption the economies we ve seen were not demand constrained and output was exogenous , In other words , one might think of them as descriptions of effects . However , in a recession , the government can try to engage those that are sitting idle because of insufficient aggregate demand . This is the view that lies behind the thinking of proponents of stimulus . To think more systematically about this , let us look at the role of government in the context of the canonical ( New model we saw in Chapter 15 , The key change that we incorporate is to include government spending , which ( in a closed economy ) entails the following resource constraint , Expressing this in terms of ( percentage ) deviations from the steady state , it is easy to see that the resource constraint is ) where is the steady state share of government spending , and the hat above a variable represents log deviations from the steady state , Now take the equation coming from consumer . around the ( steady state of the economy ( and leaving aside the term in the discount rate , for

FISCAL POLICY I PUBLIC DEBT AND THE EFFECTIVENESS OF FISCAL POLICY notational simplicity ) yields our familiar , Now , we can simply substitute output for consumption , as we did back in Chapter 15 . Instead , the new resource constraint into ( yields , after some simple manipulation ?

EI 14 ( a ( where ( This term is the version of the natural interest rate that is to say , the rate that would keep output stable that we encountered in Chapter It is easy to see that a transitory increase in , corresponds to an increase in that natural interest rate . In other words , a transitory expansion increases aggregate demand , Here where you may ask but isn the resource constraint being violated ?

Well , no we have used ( explicitly in our derivation , after all . The trick is that the resource constraint embodies the possibility that output itself is not ( in the short run ) but can increase . That is the key distinction that allows for a potential effect of policy on aggregate demand . Does that mean that an increase in government spending will lead to an increase in output ?

Not necessarily First , consumption will change as well . Note that the equation that unc the in ( does not pin down the full consumption path for that we must incorporate the budget constraint . And we know that an increase in government spending must correspond to an increase in taxes at some point , and consumers will respond to that . In particular , in a world , that response will be a decrease in consumption if the increase is , thereby negating the impact of government spending on aggregate demand . That a permanent increase in no effect on aggregate demand can be seen by noticing that a permanent increase in not change ' in ( 1730 ) That permanent changes in no effect may come as a surprise , given what it typically portrayed in intermediate texts , but on a simple inspection is obvious . Countries radically in the amount of government expenditures , but there is no relation between aggregate demand , or performance between them . Permanent changes in government spending just crowd out other components of aggregate demand . More generally , the impact of government spending on aggregate demand is predicated on it being temporary , or on departures from assumptions , as we have discussed , On top of that , there is also a effect , via the behaviour of the New Phillips Curve ( will also be affected . You will recall that the looks ike this It , A shock to government spending will also have a effect via an increase in the output gap , thus affecting expectations , which will feed back into the . In short , he multiplier that is , the change in output in response to a change in government spending will depend on the and parameters of the model . Finally , the makes it clear that this will depend on the response of monetary policy and remember , the full of the canonical New model requires the tion of a monetary policy rule . For instance , if monetary policy responds by increasing the nominal interest rate , it undoes the impact of expansion ,

270 FISCAL POLICY I PUBLIC DEBT AND THE OF FISCAL POLICY Summing up , our point is that to assess the role of policy it important to keep in mind that people will react to policy , and will consider ( to a smaller or greater extent ) its dynamic effects . Part of a stimulus will end up being saved to face future taxes , and the extent to which they will crowd out other sources of demand will depend on how the economy is . It must also take into account its effects on the perceived sustainability of current policies , as well as the response of monetary policy . All of these are empirical debates that take place , at least to some extent , within the context of this framework we ve discussed . Let our discussion by considering what happens in practice . I The current ( empirical ) debate Fiscal stimulus and adjustment With all of these different effects in mind , we can look at some of the evidence regarding the of policy and , closely related , on the implications of the kind of adjustment that might be needed in the face of soaring debt ratios . The question on the effectiveness of policy as a tool for aggregate demand management is often subsumed in the discussion on the size of the multiplier if I increase government spending a given amount , by what multiple of this amount will it increase output ?

The undergraduate text provides an unambiguous answer to this question it goes up . But our model has led us to think of a number of things that might affect that multiplier whether the increase is permanent or temporary and how agents react to it , the context in which it takes place , and what it entails for the future path of spending . There is a wide range of beliefs about that in the policy debate as illustrated by the many countries in which proponents of expansion or austerity are pitched against one another . In practice , it is very hard to isolate that impact since there can obviously be reverse causality , and there are always lots of other things , besides the change in policy , that are going on at the same time and can also affect output . In sum , we have a classic challenge . There are two main approaches to overcome that challenge . First , some people ( and 2002 and et al . 2013 ) use what is called a structural vector ( econometric technique , which basically relies on the assumption that it takes time for policy to respond to news about the state of the economy . It uses VAR ( regressing a vector of variables on their lags , essentially ) to tease out predictable responses of policy to output and , and attributes any correlation between the unpredicted components to the impact of government spending on output . The problem , of course , is that what is unpredicted by the econometrician need not be so for the agents themselves , so we can never be sure we re estimating the true impact , The second approach is to use natural experiments where government spending increases due to some credibly exogenous factor . A popular example is wars and associated military ( and Shapiro 1999 , 2009 , and 2011 ) and , on a similar note , a recent paper by Nakamura and ( 2014 ) looks at the differential effect of military buildup shocks across US . regions . Another example , from ( 2013 ) uses variation induced by changes in state pension fund returns . The problem is that exercises rely on sources of spending that may not be typical . In other words , its hard to assess the external validity of these natural experiments . The variation in the estimates is enormous . In the natural experiment literature , they range from to , from military , and reach above in other approaches . The literature has wildly divergent numbers across time and countries and structural assumptions , ranging from to ! One attempt , et al . 2013 ) who use better ( quarterly ) data for a number of countries , also reached nuanced conclusions ( i ) multiplier is negative

FISCAL POLICY I PUBLIC DEBT AND THE EFFECTIVENESS OF FISCAL POLICY in developing countries ( ii ) Multiplier is zero or negative when debt level is high ( iii ) Multiplier is zero under exchange rates , but positive under exchange rates , and is higher in closed economies than in open economies . Note that ( i ) and ( ii ) are quite consistent with the effects we have been talking about if people believe that higher spending is unsustainable , they would expect higher taxes in the near future , dampening the effect of the expansion . By the same token , iii ) is consistent with a simple model , which we havent talked about in the book , but which you may recall from undergraduate macro under exchange rates , more government spending leads to a currency appreciation , which leads to a reduction in net exports that undoes the stimulus . These results share the with our previous discussion of equivalence when and debt levels become large , consumer behaviour seems to more clearly undo the effects of policy . Of course , in practice , have to act even with all this uncertainty . Here an example , Table , shows the estimates generated by the Congressional Budget Office ( for the impact of the 2009 stimulus in the One can see patterns that are broadly in line with our discussion ( temporary ) spending has a larger effect than tax cuts , tax cuts to people who are more likely to be have a larger effect . Note that this estimate keeps at a minimum the possible effects that might come from taxation . We will get to this in the next chapter . This discussion on the effectiveness of policy also colours the debate on the desirability and implications of adjustments aimed at putting the debt situation under control As discussed in et al . 2019 ) the conventional wisdom that these adjustments would necessarily be is too simplistic . The inherent nature of policy sees to that maybe a contraction , by convincing people that a previously unsustainable debt trajectory is now sustainable , will crowd in private spending , as people anticipate lower taxes ( or no tax hikes ) in the future It may also have the effects that will be the focus of our next chapter . et al . evidence suggests , that in practice , many contractions have indeed been ! It seems that this is particularly likely if the adjustment is about cutting spending rather than increasing taxes perhaps because the former are deemed to be more sustainable in the long run . While there is controversy about the evidence who would have thought ?

see Ball et al . 2013 ) particularly with respect to what is selected as an episode of major contraction ) the point remains that the practice is more complex than what the simple undergraduate textbook view would have suggested What have we learned ?

The key lesson from this chapter is that evaluating the impact of policy requires considering its dynamic implications and the existence of budget constraints . The fact that economic agents understand that means that any change in policy will meet with a response from the private sector , which in turn immediately affects the impact of that change . The expression of this logic is the equivalence result it does not matter whether a certain path of spending is via debt or taxes , because in the end it all has to come from taxes at some point . As a result , changes in government spending create a counteracting adjustment in private spending , because of future taxes . The size of the adjustment depends on whether the change is permanent or temporary in the later case , the adjustment by consumption is less than , and aggregate demand moves accordingly

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332 ii imam i Em smog i oU im onE i ism vi LE 855 25 25 . ma 95 80 32525 53 we vo EH we Bed . iu HEN vE 280 . 152 . 28 name FISCAL POLICY I PUBLIC DEBT AND THE EFFECTIVENESS OF FISCAL POLICY 273 Still , we saw that policy can affect output in the short run , in a world . But even in this case , understanding the impact of policy requires thinking about the private sector driven by the shadow of the budget constraints as well as the response of monetary policy . If you are interested in learning more about the debate on the impact of policy , a great starting point is the book Fiscal Policy After The Financial Crisis , edited by and ( 2013 ) It contains a thorough overview of different perspectives in that debate . Appendix I Debt sustainability Let us now turn to some practical issues when analysing policy from a dynamic perspective . Our discussion in this chapter has talked about how policy has to into an budget constraint . But that raises the question how do we know , in practice , whether a certain trajectory into the budget constraint ?

If it does not we say the debt level is unsustainable , and we must expect some sort of change . We deal with this issue . We then turn to some problems related to measurement , which are particularly important given the inherently dynamic nature of policy . I framework An important issue in analysis is to out if the debt dynamics are sustainable . Strictly speaking , sustainability means satisfying the condition the present discounted value of debt in the long run has to be zero . This restriction is relatively imprecise as to short term debt . Debt can grow , and grow very fast , and still satisfy the condition . There is an ample literature on this , but a very practical , though primitive , way of answering this question is by asking whether the ratio is increasing or not . According to this stark debt sustainability is achieved when the ratio is constant or declining over time . With this in mind a typical debt sustainability analysis would start with the dynamic equation for debt primary , 1732 ) Note that this is the equivalent of ( Divide this by , we also multiply and divide the term to the right of the equal sign by , to obtain , I )

274 FISCAL POLICY I PUBLIC DEBT AND THE OF FISCAL POLICY Denoting with lower cases the variables relative to , the above becomes ( 1734 ) I ?

I , or ( I ( I ' sag where and stand for primary and surplus ( again , the difference between government expenditure and income , and vice versa , respectively , prior to interest payments ) is the growth rate of . Assume that we are in a steady state such that everything is constant . In this case ( 1735 ) which can be solved for the primary surplus needed for debt to ratios to be stable i I Any surplus larger than that in ( will also do . In order to make this equation workable , typically try to estimate expected growth in the medium term ( growth has to be assessed in the same denomination of the debt , so if debt is , say , in dollars , you should use the growth rate of in current US , dollars ) the interest rate can be estimated from the average interest payments , and debt to ratios are typically available . Table 172 makes this computation for a series of values and given a ( in this table we use ) The table shows the primary surplus required to stabilise the debt to ratio . It can also be used to estimate restructuring scenarios , Imagine a country ( Greece ?

with a debt to ratio of 150 and an expected growth rate of . The table suggests it needs to run a budget surplus of of . If only a surplus is feasible debt , sustainability obtains ( at this interest rate ) if debt is 50 of . To obtain debt sustainability the country needs a haircut of 66 . Recent models have emphasized the stochastic nature of revenues and expenditures . these processes , rather than estimating a single number , they compute a distribution function for results thus allowing to compute the value at risk in public debt . The government budget constraint ( involves the present values of the entire paths of purchases and revenues , and not the at a point in time . As a result , conventional measures of either the primary or total can be misleading about the real evolution of accounts . We illustrate this with three examples .

FISCAL POLICY I PUBLIC DEBT AND THE EFFECTIVENESS OF FISCAL POLICY 275 Table Required primary surpluses Public debt growth rate ( to ( 35 40 45 50 55 60 65 70 75 80 85 90 95 100 110 120 130 140 150 160 I The role of The example is the effect of on the measured . The change in nominal debt standing that is , the conventionally measured budget equals the difference between nominal purchases and revenues , plus the nominal interest on the debt . If we let denote the nominal debt , the nominal is thus , i , where is the price level and i is the nominal interest rate . When rises , the nominal interest rate rises for a given real rate . Thus , interest payments and the increase . Yet the higher interest payments are just the fact that the higher is eroding the value of debt . The behaviour of the real stock of debt , and thus the government budget constraint is not affected . To see this formally , we use the fact that , by , the nominal interest rate equals the real rate plus . This allows us to rewrite our expression for the nominal as , Dividing through by , this yields ,

276 FISCAL POLICY I PUBLIC DEBT AND THE OF FISCAL POLICY Next real debt as at , I so that ( 1739 ) becomes ( dy . I But recall next from ( 171 ) that , Using this in ( 1741 ) we have . Higher raises the conventional ( nominal ) measure of the even when it is by the price level . This was Brazil problem for many years , I The second example is the sale of an asset , If the government sells an asset , it increases current revenue and thus reduces the current , But it also the revenue the asset would have generated in the future . In the natural case where the value of the asset equals the present value of the revenue it will produce , the sale has no effect on the present value of the governments revenue . Thus , the sale affects the current but does not affect the governments net worth . It follows that the effect of privatisation on the position of the government has to be analysed carefully , as it is not given by the bump in measured current revenue , If there is a positive impact it should be predicated on the idea that the present value of the revenues to the private sector is greater than what would be the case for the government ( say , because the government runs it inefficiently ) so that the buyer would be willing to pay more than the present value of the revenues the government would obtain from it . But this argument , not to speak of the computation , is seldom done . I Contingent liabilities The third example is a contingent liability . A contingent liability is a government commitment to incur expenses in the future that is made without provision for corresponding revenues . Did anyone say Social Security ?

In contrast to an asset sale , a contingent liability affects the budget constraint without affecting the current . If the government sells an asset , the set of policies that satisfy the budget constraint is unchanged . If it incurs a contingent liability , on the other hand , satisfying the budget straint requires higher future taxes or lower future purchases . In industrialised countries , the largest contingent or unfunded liabilities are entitlement programs , particularly social security and health insurance . These unfunded liabilities are typically larger than the conventionally measured stock of government debt they are the main reason that policies in these countries do not appear to be on sustainable paths . One way to compute these contingent liabilities is to do a debt decomposition exercise , ing the evolution of the ratio into its components the primary , economic growth , etc . The residual in this computation is the recognition of contingent liabilities over the years .

FISCAL POLICY I PUBLIC DEBT AND THE EFFECTIVENESS OF FISCAL POLICY 277 I The balance sheet approach Another alternative to look into accounts is to work out the whole balance sheet of the ment . This requires understanding that the main asset of the government is the of its taxes , and that the main liability is not explicit debt , but the of future wages and pensions . If so , the budget constraint can be written as Assets Liabilities of future taxes Explicit debt Liquid assets of future pensions and wages Other assets Contingent liabilities This balance sheet approach has been shown to qualify quite dramatically the role played by explicit liabilities in determining the vulnerability or currency exposure of governments . For example , for many countries that issue debt in foreign currency , it is believed that a real exchange rate ation compromises sustainability because it increases the real value of debt . However , this ment should consider what other liabilities it has in domestic currency ( say , wages ) and how a real depreciation may increase its tax base . If the government collects a sizable fraction of its income , say , from export taxes , then its net worth may actually increase with a devaluation . An example is in Figure , by looking at the histogram of the of government and its reaction to a real depreciation for Argentina and Chile . Argentina , for example , shows an improvement in the net worth of the government as a result of a devaluation , in contrast with the results from the literature that focuses on explicit debt . Figure Net worth Argentina Chile , from and ( 2007 ) Argentina Chile 20 initial shock normal simulation 20 initial shock normal simulation

278 FISCAL POLICY I PUBLIC DEBT AND THE OF FISCAL POLICY Notes I Is it really that easy ?

Let the steady state level of output , and , similarly , for and Now subtract if from both sides of the equation , and divide both sides by Recognising that , this gives you Now multiply and divide the term on the by , and the second term by , and you will get the result . Here how that one goes note from the resource constraint that , and plug this into ( Multiplying both sides by ( yields , Ag ( and collect terms , and the result follows . Recall that , for notational simplicity , we are leaving aside the terms in the discount rate and the productivity shock that shifts the natural rate of output , which is implicit within the log deviation term . References , 2019 ) Effects of austerity approaches . Journal Perspectives , 33 ( A . 2013 ) Fiscal policy after the crisis . University of Chicago Press . Leigh , 2013 ) The distributional austerity ( tech . DESA Working Paper No . 129 . I . 1974 ) Are government bonds net wealth ?

Journal Economy , 82 ( 2011 ) effects from government purchases and taxes . The Quarterly Journal , 126 ( 2002 ) An empirical characterization of the dynamic effects of changes in government spending and taxes on output . The Quarterly Journal , 117 ( Mendoza , Ve , A . 2013 ) How big ( small ?

are ?

Journal of Monetary Economics , 60 ( 2007 ) A approach to sustainability . CID ing Paper Series . Nakamura , I . 2014 ) Fiscal stimulus in a monetary union Evidence from US . regions . American Economic Review , 104 ( A . 2009 ) Defense news shocks , Estimates based on news sources . Unpublished paper , University of California , San Diego , A . Shapiro , 1999 ) Costly capital reallocation and the of government spending . National Bureau of Economic Research . 2013 ) Using state pension shocks to estimate since the Great Recession . American Economic Review , 103 (