lecture17 - Lecture 17 Economics W3213 Intermediate...

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Lecture 17 Economics W3213 Intermediate Macroeconomics Instructor: Mart´ ın Uribe Columbia University Spring 2016
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Announcements: What you should be reading this week: 1. These slides. 2. Textbook: Mankiw Chapter 16, (focus on 16.3 and 16.4) and Chapter 17.2. 3. Robert J. Barro, “The Ricardian Approach to Budget Deficits.” (available on courseworks) Homework 7 due today Midterm 2 one week from today
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Lecture 17 Fiscal Policy and Ricardian Equivalence (1/4) 1
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Motivating Questions How does a tax cut affect consumption, the real interest rate, and investment? Do tax-cut induced fiscal deficits drive up interest rates and crowd-out investment? 2
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View I: Tax-cuts generate fiscal deficits. More government bor- rowing drives up interest rates. This crowds out investment. And tax cuts by increasing households’ disposable income stimulate consumption spending. ( r , I , C .) View II: Because tax cuts lead to higher public debt, sooner or later, the government must increase taxes to repay that debt (including interest). Hence tax cuts today lead to tax increases in the future. Households understand this, so they do not spend the tax cut on consumption goods. Instead, they save the tax cut in the bank to be able to pay for the future expected increases in taxes. So current spending does not increase, the interest rate does not increase, and investment does not fall. r = Δ C = Δ I = 0). This result is known as Ricardian Equivalence. 3
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Goal To evaluate views I and II, we will build a model of the equilibrium determination of consumption, investment, and the real interest rate. 4
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A Two-Period Model of Consumption, Investment, Savings and the Interest Rate The economy lasts for only two periods, period 1 and period 2. Basic Units of the Model 1. The Government 2. Firms 3. Households 5
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1. The Government T 1 = taxes in period 1 T 2 = taxes in period 2 The government chooses T 1 and T 2 . Taxes are lump sum, in the sense that they do not depend on the household’s level of income, spending, or any other manifestation of wealth. G 1 = government spending in period 1 G 2 = government spending in period 2 G 1 , G 2 , are exogenously given. 6
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Government Debt, the Primary Deficit, and the Secondary Deficit Let B t denote government debt issued in period t and maturing in period t +1, for t = 1 , 2, r = denote the interest rate, The primary fiscal deficit is the difference between government spending and tax revene, Primary Fiscal Deficit = G t - T t and the secondary fiscal deficit is the primary deficit plus interest payments on the public debt Secondary Fiscal Deficit = rB t - 1 + G t - T t . The negative of the secondary fiscal deficit is known as the sec- ondary fiscal surplus or government savings. Thus, Government Savings = T t - rB t - 1 - G t .
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