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NK Debt Deficit Dynamics 2

The document discusses the New Keynesian budgetary arithmetic, focusing on the relationship between government spending, taxes, and debt. It establishes a fundamental dynamic equation for the growth of the debt-to-GDP ratio, emphasizing the importance of the real interest rate compared to GDP growth for debt sustainability. The analysis also hints at the political implications of fiscal policies and presents various scenarios regarding debt dynamics based on different economic conditions.

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89 views3 pages

NK Debt Deficit Dynamics 2

The document discusses the New Keynesian budgetary arithmetic, focusing on the relationship between government spending, taxes, and debt. It establishes a fundamental dynamic equation for the growth of the debt-to-GDP ratio, emphasizing the importance of the real interest rate compared to GDP growth for debt sustainability. The analysis also hints at the political implications of fiscal policies and presents various scenarios regarding debt dynamics based on different economic conditions.

Uploaded by

bhavya.moduboina
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd

The New Keynesian budgetary arithmetic: 2

Start with the budget identity:

⏟t +
G i⏟
t B t−1
Govt exp ∫ ¿≡ T⏟t + ⏟
ΔB ⏟
+ Δ M (1)¿
Taxes new bonds new money

Abstracting from money financing (printing money),

⏟t +
G i⏟
t B t−1
Govt exp ∫ ¿≡ T⏟t + ⏟
ΔB (2)¿
Taxes new bonds

Change in
debt
Or
⏟ t −1+ Gt−T t ( 3)
Δ B =i B
B t −Bt−1

In other words, change in debt equal budget deficit, including interest payments on the
debt, minus taxes net of transfers.

If government runs a deficit, its debt increases as the government borrows to fund the part
of spending in excess of revenues,

Bt −B t−1=i Bt −1+ Gt−T t (3a)

Change in Interest Primary


the debt payments deficit

or Bt −B t−1 ≡ Δ Bt =i Bt −1 +Gt −T t

Removing time subscripts for notational simplicity and dividing by GDP, since interested
growth of the debt-gdp ratio

Δ B iB G−T
= + (4 )
py py py

B G−T
Letting b= ; d= .
pY pY

And since B=bpy and total differentiating,

Δ B=py Δ B+by Δ p+ bp Δ y (5)


And dividing by py on both sides yields,

ΔB Δp Δy
=Δ b +b +b (6)
pY p y

ΔB
=Δ b +bπ +bg .( 6 a)
pY

ṗ Ẏ
where π= (inflation rate) and g= (growth of GDP).
p Y

Equating (6a) and (4) yields,

Δ b=d+ (i−π −g ) b

Since, r =i−π , i.e., real interest rate is equal to nominal interest rate minus the rate of
inflation (This is called the Fisher equation),

The fundamental dynamic equation for the growth of debt-gdp ratio is given by the
following differential equation

Δ b=d+ ( r−g ) b(5)

Now solve this first-order linear difference equation, find the equilibrium debt-gdp ratio and
its stability property, which will give you the condition for debt sustenance.

Intuitively, you can see the stability condition is simply ( r −g ) <0. i.e., growth rate has to be
greater than interest payment for the reduction of the debt i.e., for ḃ< 0. On the contrary,
when r > g , debt-gdp will grow ḃ> 0.

There is where the government’s primary balance, d , comes into play (and political
ideologies enter in Economics)

Till now, we have seen the economy quite objectively, starting from the government’s
budget identity – pure accounting, no politics so far, and we derived (5) from that identity.

Analyse (5) and the analysis will reveal to you the positions taken by people on the right or
the left, or conservatives or democrats, or Keynesians or Neoliberals etc, or whatever.

Graphically visualise various scenarios in the phase space, i.e., (b , Δ b) plane. There are four
different scenarios,

What happens to debt-gdp ratio when r > g


when govt has a primary deficit (d >0 ¿ and primary surplus ¿ ),

&

What happens to debt-gdp when r < g ,


when govt has a primary deficit d >0 and primary surplus d< 0.

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