Chapter7 - Chapter 7 Ricardian Equivalence and Crowding Out...

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© Sanjay K. Chugh 93 Spring 2008 Chapter 7 Ricardian Equivalence and Crowding Out An issue that periodically receives much media attention is whether government spending and taxation decisions affect market interest rates. This issue was most recently in the news in the early 2000’s when the Bush administration was considering lowering taxes and raising government spending. The issue also received attention in the mid- and late- 1990’s, when large improvements in the government’s fiscal position under President Clinton were accompanied by a marked lowering of interest rates. 47 The relationship between the government’s fiscal position and market interest rates generates much debate among macroeconomists and politicians – some observers claim that there is a strong relationship between the two, while others claim there is no relationship at all. In this chapter, we will study the theory behind this link, using as our basis the two- period consumption-savings model. Until now we have neglected government in our two-period model, considering only consumers and firms. After defining some basic terms, we introduce a government into our two-period consumption-savings model. After working through the basic mechanics, we will consider under which circumstances there may be no relationship between the government’s fiscal position and interest rates as well as under which circumstances there may be. Basic Terminology You are probably familiar with terms such as a government budget deficit and budget surplus, but we briefly review the concepts. Items affecting the government’s budget are termed fiscal items, and there are two notions of budget deficits/surpluses: primary and secondary. A primary budget deficit (surplus) exists in any given period if the tax revenue collected by the government in that period are smaller than (are larger than) the expenditures of the government in that period. A bit more mathematically, for any given period t , we compute the difference tt Government tax revenue Government expenditure ± ( 4 0 ) and if this quantity is negative the primary budget is in deficit in period t , while if this quantity is positive the primary budget is in surplus in period t . Finally, just to be clear, the primary budget is said to balanced if this quantity is exactly zero. 47 Robert Rubin, President Clinton’s second Secretary of the Treasury, was a forceful advocate of the view that fiscal discipline on the part of the government dramatically lowers interest rates, hence promoting investment and, ultimately, economic growth.
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© Sanjay K. Chugh 94 Spring 2008 Another notion of the government’s budget also takes into account interest payments (or interest receipts) on government assets. A secondary budget deficit (surplus) exists in any given period if the sum of the tax revenue and interest income collected by the government in that period are smaller than (are larger than) the expenditures of the government in that period. Mathematically, if in period t tt t Government tax revenue
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Chapter7 - Chapter 7 Ricardian Equivalence and Crowding Out...

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