IE University

Problem Set 4

Fiscal Policy
1. Review the answer key to PS3. Which were your most important mistakes?
2. i) Explain an argument from the economists that do support active fiscal policies (i.e. doing
something. ii) Explain the two arguments from the economists that do NOT support active
economic policies. iii) Why some economist believe that monetary policy is a better policy tool
than fiscal policy?
ANSWER - i) The economy in the LONG run will always return to potential level
of GDP, but the long run might take a long time (several years). Because of this,
in order to avoid unnecessary suffering, some economist (activists) are advocates of
using expansionary policies (fiscal or monetary) in order to speed up the process
towards full employment of resources. Additionally, since there is not guarantee
that the economy might return to full employment by itself.
ii) Policies should not active for two reasons: FIRST reason: fiscal Policy presents
THREE types of delays: delay in recognising the problem, implementation delay
and impact delay, and because of these lags, fiscal policy could make the economy
more unstable. SECOND reason: expansionary polices always increase the public
deficit in the short run.
iii) Monetary Policy besides not presenting one of the delays (implementation), the
impact channel is thru investment, which is very responsive to changes in interest
rates. Additionally, since it is easier to fine tune monetary policy, policy makers
can take more risks when deciding to change interest rates, even if it is not that
clear if the economy is heading to a recession or to an inflationary period. Another
advantage of Monetary Policy is that the changing interest does not have a direct
impact on the budget deficit (i.e. monetary policy is for free, you dont have to spend
money (besides the salaries payed to the central bank employees).
3. The Public sector data for an economy in 2018 were: government expenditure (G) 20, revenue
from taxes (T) 20, transfers (Z) 10, interest rate 20%, public debt at the beginning of 2018 was
zero. In 2019 the transfers and the interest rate did not change but the public expense (G)
increased to 25. By how much should T change so that at end of 2019 the public debt in the
economy is 20?
ANSWER - The government must satisfy the identity: G+Z+INT = T−DEF. From
the 2018 data we know interest payments are equal to IN T = .20 × 0 = 0. Substitute
the data (G=20, Z=10, T=20) together with INT= 0 to the government budget
constraint then it must be the case that DEF=10. Because of this, the public debt
at the beginning of 2019 will be equal to 0 + 10 = 10 units. We want the PUBLIC
DEBT at the end of 2019 to be equal to 20, therefore the deficit in 2019 must be
equal to 10. Substitute the data (IN T = .20 × 10 = 2, G=25, Z=10, DEFICIT=10)
and we we see that T=27, that is taxes must increase in 7 units.
4. (Extra Question just for practice) At the beginning of 2012 the public debt of Santa Clara is 10
units. During the year the public sector spent 3 units for paying its employees; it transferred 1.5
units to the private sector, it did not make any other payment and its revenue from taxes was
2 units. If the interest rate was 5%. Compute the amount of Santa Clara’s public debt at the
beginning of 2013. (Hint: use the government budget constraint equation).

1
 ANSWER - The government must satisfy the identity: G+Z+INT = T−DEF. From
the data we know interest payments are equal to IN T = .05 × 10 = 0.5. Substitute
the data (G=3, Z=1.5, T=2) together with INT= 0.5 to the government budget
constraint then it must be the case that 3 + 1,5 + 0,5 = 2 + DEF. Therefore the
deficit in 2012 is equal to 3 units. Because of this the public debt at the beginning
of 2013 will be equal to 10 + 3 = 13 units.
5. The public debt of Gerardovian is zero and they plan to keep at this level. If the public sector
wants to keep the same level of government spending, can the disposable income of households
increase by raising government transfers? (Hint: remember that in an economy with transfer
payments, disposable income is equal to income plus transfer minus taxes).
ANSWER - If public debt of Gerardovian is zero and they plan to keep at this level
then it must be the case that G + Z + 0 = T − 0, in order words, it must be the case
that ∆G + ∆Z = ∆T . If G stays constant (i.e. δG = 0) then it must be the case that
∆Z = ∆T . That is, any increased in transfers (Z) will be followed by an increase in
Taxes (T) by the same amount, therefore Disposable Income (Yd = Y − T + Z) can
never change with an increase in Z.
6. i) If the tax rates drops then it could be the case that government revenue increases. Is this
statement true or false? ii) An increase in government spending generates an increase in y* and
because of this and increase in government revenue —households pay more taxes—. Could it be
the case that the increase in government revenue is bigger than the increase in G thus reducing
the budget deficit?
ANSWER - i) A tax rate drop could increase government revenue only if the economy
is at the right hand side of the LAFFER curve. Unfortunately, most countries live
in the left hand side (why?) . Therefore, even though theoretically is possible, in
reality is not feasible.
ii) In the last exercise we will prove that this can never be the case: and increase in
G will never generate enough economic activity where the increase in government
revenue is enough to finance the increase in G. This result is independent of the
value of the multiplier (this will also be proved in the last exercise

7. i) ) Why it could be the case that after an initial sharp increase, the budget deficit could drop
thru time (as it did in the USA after the 2008 financial crisis)? ii) What do economist mean
when they say that policy makers should jump-start the economy ?
ANSWER - i) Because if the expansionary fiscal policy manages to have an impact in
consumers and firms expectations about the economy, there will be further increases
in aggregate demand that will have an impact in equilibrium GDP, thus government
revenue will increase, reducing the budget deficit. Alternatively, the government
could gradually start reducing government spending , with any fear of reducing GDP
since this reductions are compensated with an increase in autonomous consumption
and investment.
ii) The fiscal policy effort should be big enough to change the expectations about
the future of the economy, since if they fail to do so, the increase in government
spending will have to be permanent in order to close the gap between equilibrium
GDP and potential GDP, thus generating a continuous increase in the government
public debt.
8. i) Do countries with a big public debt are more likely to have eventually an unsustainable public
debt? ii)What do we mean by sustainable public debt? iii) Under which conditions the debt
is sustainable? iv) Under which conditions the public debt can turn UNsustainable? v) Why
the public DEBT of the PIIGS turned unsustainable? vi) Why the public debt of Japan is
sustainable?

2
 ANSWER - i) Empirical data shows that country defaults are more likely to occur
in countries with a low debt to GDP ratio. More than 1/3 of the defaults ocurre in
countries with a debt to GDP ratio between o,2 and o,4.
ii) If the public debt to GDP ratio is constant, then the public debt is sustainable,
also if it grows at a very low grow rate.
iii) If the debt to GDP ratio starts to grow at faster rand faster rates, then it is
turning into an unsustainable public debt that might lead to a country default.
iv) if it is the case that (g-r) x (public debt/Y )= ( Deficit/Y) then the public debt
to GDP ratio is constant. Notice that if r > g, then a country must run a (primary)
budget surplus in order to have a constant public debt to GDP ratio, if this is not
feasible then the ratio will increase and the public debt could start turning into
unsustainable.
v) Because in 2011 they faced a sharp increase on interest rates and the difference
between r and g was very big ( r > g !), then the debt to GDP ratio started to
increase a faster rates.
vi) Because even with a low growth rate of GDP, if interest rates are even lower,
then they can run a budget deficit and still have a constant debt to GDP ratio.
9. Is the public debt of your home country sustainable? (Hint: use the equation for sustainability
of public debt, and the collect data for your home country. When looking for interest rates, do
not look to the interest rates from the Central Bank, look for the return on public debt. Every
country has a name for its public (treasury bonds, treasury bills, etc.) just find their return. The
risk premium is calculated using the interest rate of the 10 year treasury bond, then probably
is good idea to use this rate. They are many pages that publishes this data, Datosmacro.com is
one of them, actually this page has the data for most European countries.
ANSWER - Below you can find the yield of the 10 year government bond —
usually used to calculate the risk premium)— of several countries. The public debt
of my home country is at 8.36%, and the average annual growth rate (before the
pandemia) was 2.2%. I decided not to use the Covid years data since. they special
years and maybe misleading for our type of analysis since it does reflects the real
long term growth of the economy. I also found that he debt to GDP ratio is 52%.
Then replacing this data to the formula: (r - g) puiblic debt /Y = deficit/Y we get
(2.2 − 8.36)52 = 3.2, which means that Mexico must run a 3.2% budget SURPLUS (as
percentage of GDP) in order to have a constant public debt to GDP ratio, otherwise
it will start growing with the threat turning into unsustainable. Bad news, Mexico
is not running a SURPLUS they are running a DEFICIT of 4.6%. Which means
that the public debt to GDP ratio will continue growing.

3
10. When the public debt of a country is running the risk of turning into unsustainable, a common
practice in the past has been to reduce the budget deficit. i) Explain the logic behind this
strategy. ii) Under which circumstances this strategy might fail to work?
ANSWER - i) There was the common believe that market interest on public debt
will drop if the budget deficit drops.
ii) Unfortunately, in order to drop the budget deficit, countries must reduce G and
increase T which, as any contractionary policy, produces a drop in GDP, but if the
drop in GDP is very big, the government will face a sharp drop in revenue, which in
some case manages to generate an increase rather than drop in the budget deficit.
11. In Sufrolandia the consumption function is C = 180 + 0.8(Y − T ). The government collects direct
and indirect taxes according to T = 100 + 0.5 ∗ Y . Unfortunately, the tax revenue is not enough
to cover the public expenditure.MadreMı́a, a firm formed by prominent IE graduates, has been
hired to design a policy that reduces the deficit. However, they recommend to increase public
spending by 300 million, rather than cutting spending and raising taxes. They argue that the
since c0 = 0.8 the multiplier is very high. This policy, with the combination of a high tax rate
on income (50% !!) will make the tax collection from taxes more than sufficient to finance the
increase in spending, so that the government budget deficit will be reduced.

(a) Should the IE graduates be thrown to jail because the recommended policy failed to decrease
the budget deficit? (Hint: Incorporating the recommendation of your colleagues, calculate
the INCREASE in GDP, but probably you have already noticed that you do not have
sufficient data to calculate the level of GDP, but you have sufficient data to calculate the
government spending multiplier (remember that you should use the multiplier for the T =
to +t0 y case, where the multiplier is ∆Y ∗ = 1/(1−c0 +c0 t0 )∆G), therefore is easy to calculate

4
 the INCREASE in Y even if you can not calculate the level of Y. ii) Calculate now by how
much government revenue increases. iii) Does the government deficit increases or decreases?
That is, should Mr. Trump (dictator of Sufrolandia) send to jail to your buddies or regard
them as national heroes?

SOLUTION - First we see that the change in income is:

1
∆Y ∗ = ∆G
1 − c0 + c0 t0
∆G = 300 million
c0 = 4/5
t0 = 1/2

Therefore
5
∆Y ∗ =
300 million = 500 million
3
Then we can see that the increase in tax revenue (T ) will be:

∆T = 1/2 ∗ 500 million = 250 million

This means that the government deficit increases by 50 million, when G in-
creases by 300 and T only increases by 250. Therefore we should fire them.

(b) For this policy to be successful, do you recommend to raise the tax rate in order to increase
revenue? (HINT: find the tax rate such that an increase in government spending could cre-
ate enough income in order not produce an increase in the budget deficit —a little surprise
is waiting for you!—). Try to use algebra, not a numerical example, the math is very simple.

SOLUTION - If want the tax revenue T increase to be higher than the increase
in government spending G, it must be the case that ∆T > ∆G. We also know
that ∆T = t0 ∆Y ∗ (i.e. tax revenues increase when income increases). We also
know that ∆Y ∗ = 1/(1 − c0 + c0 t0 )∆G. Putting all this data we know that, since we
need that ∆T > ∆G, then

1
∆T = t0 ∆Y ∗ = t0 × × ∆G > ∆G
1 − c0 + c0 t0
With a little bit of algebra we can see that this implies that t0 > 1 − c0 + c0 t0 , which
implies that t0 − t0 c0 = t0 (1 − c0 ) > 1 − c0 which can only be true if t0 > 1 (a tax rate
higher than 100 percent!!).