ECON 314 - Government Sector - Lecture 1 of 2

ECON 314:
MACROECONOMICS II
THE GOVERNMENT SECTOR
Main Texts
•Dornbusch, R., S. Fischer and R. Startz (2011).

th
Macroeconomics, 11 Edition, Irwin McGraw-Hill.
•Mankiw, N.G. (2013). Macroeconomics, 8th Edition,

Worth Publishers
ECON 314 Lecture Material Prepared by Dr. Emmanuel Codjoe 3

Essential Background Reading
•Government Budget.
•The Measurement of the Budget Deficit
•The Problems with the Measurement of the

Budget Deficit
Motivation
•Why do we have government?
•What does government do?
•What is the impact of government?
What Government Does!
•If altruistic, then motivated to produce public

goods.
•Related to that is ensuring fairness
•Addressing inequality through redistribution

FISCAL POLICY
•The important aspects of government
actions can be represented under fiscal
policy.
•Fiscal Policy can be seen in many respects

and can have important consequences.
FISCAL POLICY
•A few things to know about fiscal policy.
•Countries (governments) are in for the long-

term.
•Need not balance their books (𝐺𝑡𝑜𝑑𝑎𝑦 ≠

𝑇𝑡𝑜𝑑𝑎𝑦 ).
FISCAL POLICY
•Fiscal policy therefore has intertemporal
dimensions too.
•Thus, to understand fiscal policy, we
incorporate the present value of income
stream into the analysis.
•The consumption function as we now know,
goes beyond the simple Keynesian version.
•We think of the consumption function as:

𝑫
𝑪 = 𝒄(𝒀 , 𝑾)
𝒇𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝒑𝒓𝒐𝒑𝒆𝒓𝒕𝒚
𝑾= 𝑾 +𝑾
𝑻
𝑫 𝑫
𝒀𝒕+𝒊 − 𝑻𝒕+𝒊
𝒀 = 𝑷𝑽 𝒀 =෍ 𝒊
(𝟏 + 𝒓)
𝒊=𝟎
•What about the Government Sector?
•We can think of the government undertaking
an exogenous amount of expenditure, 𝑮𝑻
and 𝑮𝑻+𝟏 .
•The government (like the household) faces
two flow budget constraints:
𝑮𝑻 ≤ 𝑻𝑻 + 𝑩𝑻
𝑮𝑻+𝟏 + 𝒓𝑩𝑻 ≤ 𝑻𝑻+𝟏 + 𝑩𝑻+𝟏 − 𝑩𝑻
•𝑩𝑻 is the stock of debt issued by the government
in T carried into T+1.

•Government can finance its current spending by
raising taxes (𝑻𝑻 ) or issuing debt (𝑩𝑻 ), with initial
debt (𝑩𝑻−𝟏 = 𝟎).
•This is the same in the next period, except

government is faced with interest expense on
debt (𝒓𝑩𝑻 ).
•Intertemporal Budget Constraint is given by:
𝑻𝑻+𝟏 𝑮𝑻+𝟏
𝑻𝑻 + = 𝑮𝑻 +
(𝟏 + 𝒓) (𝟏 + 𝒓)
•Conceptually, same as the household’s; that of the
Government must balance in an intertemporal
present value sense, not period-by-period.
•The Household again; preferences are modelled as:
𝑼 = 𝒖 𝑪𝑻 + 𝜷𝒖 𝑪𝑻+𝟏 + 𝒉 𝑮𝑻 + 𝜷𝒉(𝑮𝑻+𝟏 )
•Household obtains utility from government
spending, although we can ignore this part without
loss of understanding.
•Households budget constraint is given by:

𝑪𝑻 + 𝑺𝑻 ≤ 𝒀𝑻 − 𝑻𝑻
𝑪𝑻+𝟏 + 𝑺𝑻+𝟏 − 𝑺𝑻 ≤ 𝒀𝑻+𝟏 − 𝑻𝑻+𝟏 +𝒓𝑺𝑻
•Household takes 𝑻𝑻 and 𝑻𝑻+𝟏 as given, and

with 𝑺𝑻+𝟏 = 0, the household’s IBC is given
by:
𝑪𝑻+𝟏 𝒀𝑻+𝟏 − 𝑻𝑻+𝟏
𝑪𝑻 + = 𝒀𝑻 − 𝑻𝑻 +
(𝟏 + 𝒓) (𝟏 + 𝒓)
•This can be re-written as:
𝑪𝑻+𝟏 𝒀𝑻+𝟏 𝑻𝑻+𝟏
𝑪𝑻 + = 𝒀𝑻 + − 𝑻𝑻 +
(𝟏 + 𝒓) (𝟏 + 𝒓) (𝟏 + 𝒓)

•But since PV(Tt) must equal PV(Gt) then:
𝑪𝑻+𝟏 𝒀𝑻+𝟏 𝑮𝑻+𝟏
𝑪𝑻 + = 𝒀𝑻 + − 𝑮𝑻 +
(𝟏 + 𝒓) (𝟏 + 𝒓) (𝟏 + 𝒓)
•From the household’s perspective, knowing that

the government’s IBC must hold, we can get:
𝑪𝑻+𝟏 𝒀𝑻+𝟏 − 𝑮𝑻+𝟏
𝑪𝑻 + = 𝒀𝑻 − 𝑮𝑻 +
(𝟏 + 𝒓) (𝟏 + 𝒓)
• From the household’s perspective, it is as though 𝑻𝑻 = 𝑮𝑻
and 𝑻𝑻+𝟏 = 𝑮𝑻+𝟏
• This means that the consumption function (derived

qualitatively via indifference curves and budget lines) does
not depend on Tt or Tt +1.
•The consumption function now becomes:
𝒅
𝑪𝑻 = 𝑪 (𝒀𝑻 − 𝑮𝑻 , 𝒀𝑻+𝟏 − 𝑮𝑻+𝟏 , 𝒓𝑻 )
•All the household cares about when making
its consumption/saving decision is the
present discounted value of the stream of
income
•Therefore, a cut in taxes, not met by a
change in spending, means that future taxes
must go up by an amount equal in present
value.

• How does fiscal policy affect consumption?
• The link is between consumption and wealth.
• Consumption depends on wealth, and this helps us

understand how fiscal policy affects consumption and thus
output.
• To see how, recall the Intertemporal Budget Constraints

and how the government finances its spending.
The Irrelevance of Fiscal Policy
•We limit ourselves to only two periods:
•For the government:
𝑻𝟐 𝑮𝟐
𝑻𝟏 + = 𝑮𝟏 +
(𝟏 + 𝒓) (𝟏 + 𝒓)

•For the household (assuming W = 0):
𝑪𝟐 (𝒀𝟐 − 𝑻𝟐 )
𝑪𝟏 + = (𝒀𝟏 −𝑻𝟏 ) +
(𝟏 + 𝒓) (𝟏 + 𝒓)
•Suppose that households realize that the
government is subject to an intertemporal
budget constraint.
•We can consider two cases of financing G:
1. The government budget is balanced in
each period: 𝑇1 = 𝐺1 𝑇2 = 𝐺2 then;
𝑪𝟐 (𝒀𝟐 − 𝑻𝟐 )
𝑪𝟏 + = (𝒀𝟏 −𝑻𝟏 ) +
(𝟏 + 𝒓) (𝟏 + 𝒓)
𝑪𝟐 (𝒀𝟐 − 𝑻𝟐 )
𝑪𝟏 + = (𝒀𝟏 −𝑻𝟏 ) +
(𝟏 + 𝒓) (𝟏 + 𝒓)
(𝒀𝟐 − 𝑮𝟐 )
= 𝒀𝟏 − 𝑮 𝟏 +
(𝟏 + 𝒓)
•Now consider the second scenario:
• 𝑇1 = 0 , 𝐺1 = 𝐵 𝑇2 = 𝐺2 + 𝐵(1 + 𝑟)
•By substituting, we still get:
𝑪𝟐 (𝒀𝟐 − 𝑮𝟐 )
𝑪𝟏 + = (𝒀𝟏 −𝑮𝟏 ) +
(𝟏 + 𝒓) (𝟏 + 𝒓)
𝑪𝟐 (𝒀𝟐 − 𝑻𝟐 )
𝑪𝟏 + = (𝒀𝟏 −𝑻𝟏 ) +
(𝟏 + 𝒓) (𝟏 + 𝒓)
(𝒀𝟐 − 𝑮𝟐 )
= 𝒀𝟏 − 𝑮 𝟏 +
(𝟏 + 𝒓)
•From the first and second scenarios, we see
that they way the government finances a
given level of spending makes no difference.
𝐺2
•All that matters is 𝑃𝑉 𝐺 = 𝐺1 +
(1+𝑟)

•This result is known as Ricardian Equivalence,
named after its first proponent, David Ricardo.
•In its modern rendition, this idea is attributed to

Robert Barro.
•Hence, the term Barro-Ricardo Equivalence is

used in more advanced analysis.
•This result is known as Ricardian Equivalence.
•According to Ricardo it makes no differences
whether government finances its expenditure
through current taxes or to issue government
bonds with infinite maturity and annual
interest payment in all following years
financed by future taxes
•In other words, a tax cut financed by
government debt does not reduce the tax
burden; it merely reschedules it.
•This should therefore not encourage

consumers to spend more.

•The implication of Ricardian equivalence is
that a debt-financed tax cut leaves
consumption unaffected.
•Households save the extra disposable income

to pay the future tax liability that the tax cut
implies.
•This increase in private saving exactly offsets
the decrease in public saving.
•National saving—the sum of private and
public saving—remains the same.
•The tax cut therefore has none of the effects
that the traditional analysis predicts.
•Why the Ricardian view might not hold?
•Myopia
•Borrowing constraints
•Future generations

GOVERNMENT BUDGET DEFICIT
AND DEBT
•The next part of the lecture looks at the
relationship between the government budget
deficit and the debt, as well as the implications
of mounting debt.

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ECON 314:

•Dornbusch, R., S. Fischer and R. Startz (2011).

•Mankiw, N.G. (2013). Macroeconomics, 8th Edition,

ECON 314 Lecture Material Prepared by Dr. Emmanuel Codjoe 3

•The Measurement of the Budget Deficit

•The Problems with the Measurement of the

•If altruistic, then motivated to produce public

•Addressing inequality through redistribution

•Fiscal Policy can be seen in many respects

•Countries (governments) are in for the long-

•Need not balance their books (𝐺𝑡𝑜𝑑𝑎𝑦 ≠

•We think of the consumption function as:

ECON 314 Lecture Material Prepared by Dr. Emmanuel Codjoe 13

•This is the same in the next period, except

•Households budget constraint is given by:

•Household takes 𝑻𝑻 and 𝑻𝑻+𝟏 as given, and

ECON 314 Lecture Material Prepared by Dr. Emmanuel Codjoe 18

•From the household’s perspective, knowing that

• This means that the consumption function (derived

ECON 314 Lecture Material Prepared by Dr. Emmanuel Codjoe 22

• Consumption depends on wealth, and this helps us

• To see how, recall the Intertemporal Budget Constraints

ECON 314 Lecture Material Prepared by Dr. Emmanuel Codjoe 24

ECON 314 Lecture Material Prepared by Dr. Emmanuel Codjoe 30

•In its modern rendition, this idea is attributed to

•Hence, the term Barro-Ricardo Equivalence is

•This should therefore not encourage

ECON 314 Lecture Material Prepared by Dr. Emmanuel Codjoe 33

•Households save the extra disposable income

ECON 314 Lecture Material Prepared by Dr. Emmanuel Codjoe 36

ECON 314 Lecture Material Prepared by Dr. Emmanuel Codjoe 37

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