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Unformatted text preview: Economics 154a Fall 2005 Bjorn Brugemann Problem Set 4 (posted Sep. 26, due Oct. 3 in class, discussed in section Oct. 5-6) Problem 1: Budget Deficits and Interest Rates The data and the plots discussed in the solution are contained in an Excel File posted on the class web site at http://www.econ.yale.edu/ bb338/econ154a05/ps 4 data.xls . 1. The data is in the columns Nominal i , Inflation pi , and Real r , respectively. The sheet i&r Plot contains a plot of the nominal and real interest rates. 2. The data is in the columns Net Government Saving SGOV , GDP Y , and Budget Deficit/GDP d , respectively. Using the ratio of the deficit to the GDP produces a nicer picture. 3. The sheet d&i&r Plot contains a plot of the budget deficit to GDP ratio d and the two interest rates i and r . It seems that up until the 1990s the nominal interest rate captures some of the year to year movements of the budget deficit. However, the decline in the deficit in the Clinton years and the recent return to large deficits do not appear to have a counterpart in the movements of the interest rates, which were going down over this time period. The article mentions concerns that a high budget deficit increases interest rates and this would adversely affect investment. According to our two period model the relevant interest rate for the investment decision of the firm (and the saving decision of the consumer) is the real interest rate. There appears to be no relationship between the year to year movements in the real interest rate and the budget deficit. The plot is not inconsistent with the idea that over the long term high budget deficits are associated with a high real interest rate, since both were low on average before 1980 and higher on average since then. However, it is more difficult to detect a relationship over the long run, because much more data is needed. Overall, we shouldnt be too surprised that we dont find unambiguous relationships, since more careful empirical studies also did not arrive at strong conclusions. 4. (a) A change that increases the deficit and the real interest rate goes as follows: increase G , leave T unchanged, i.e. finance the increase in current expenditures through an increase in borrowing and future taxation. Let G be the increase in current expenditures. Set T = 0, B = G . The required change in future taxation is more complicated, since it depends on the change in the interest rate and the size of the deficit before the change. (b) To create a change in fiscal policy that increases the deficit while leaving the real interest rate unchanged, we can rely on Ricardian Equivalence. Leave government expenditures unchanged, i.e. G = G f = 0, reduce current taxes T < 0 and increase borrowing B =- T ....
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