SESSION 7

Reading
1. This set of slides
2. From the text material :
Chapter-26 - page 553-563, and 565-567

Fiscal deficit and growth

Budget deficit
= G + TR + int. payment Tax collected disinvestment
(if any)
What happens to budget deficit if government
expenditure increases?

G BD
G AD Y direct Tax collection BD
Is it possible that increase in tax caused by the multiplier may
actually outweigh the increase in G?

Exercise
What happens to budget deficit if government expenditure
increases by Rs. 10 Cr.?
Given :
Proportional income tax of 20%
Marginal propensity to consume = .6

G BD
G AD Y Tax collection BD
Is it possible that increase in tax caused by the multiplier may
actually outweigh the increase in G?
Change in BD = G - T
T = t.y
T
= t. Y = t. G. [Y/ G] = t. G. [multiplier]
= t. G. [1]/ [1-c(1-t)]
Change in BD = G - T = G. [(1-t)(1-c)] / [1-c(1-t)] > 0
So BD will increase if there is an increase in G by a fraction of
increase in G.

Enhanced government expenditure increases output

Increased taxes cause decrease in output

Is it possible to affect output if budget is balanced,

that is if G and T increases equally?
Or is a budget deficit necessary to raise output?

In equilibrium
AD = AS
Y = a + c (Y T) + I + G

Y* = [a + I + G - cT]/[1 c]

Y / G = 1 / (1 c)
Y / T = -c/(1-c)

Therefore, change in Y when both G and T increases

= Y = [Y / G]G + [Y / T]T
= G /(1-c)
cT/ (1-c)
[When budget is balanced, G = T]
= G = T
Therefore [Y / G] = [Y / T] = 1
Balanced Budget multiplier = 1

Thus, even when budget is balanced, increased G increases

output.
But this increase is less than the case when only G increases
or G increases more than T.
Reason:

Only G AD more than in proportion

only T AD but only c frantion of the disposable
income is lost from the aggregate demand.
Therefore overall AD , when G and T increases equally.

This AD is less than the case when only G rises, without a

matching tax collection. Tax has a dampening effect on the
consumption expenditure.

Arguments against deficit budgets

1. Crowding out
When budget deficit is financed by borrowing from
domestic citizens,
saving left for lending to firms falls
G is offset by fall in private investment I, at least
partially
2. Automatic stabilizer
Fiscal Contraction (or expansion) policy is not as
contractionary (or expansionary) as is looks like.
G AD Y Tax revenue G-T rise Y rise

Fiscal deficit and the burden of debt

Fiscal Deficit
= G + TR Tax + interest payment on past debt
= G T + interest payment on past debt
As far as the deficit is concerned G and TR can both be treated as
expenditures. So we ignore the term TR. Disinvestment is not a
regular event, and hence assumed away for regular calculation of
fiscal deficit.
Fiscal deficit in year t :
D(t) = G(t) T(t) + r. B(t-1)
Where B(t-1) = debt accumulated till year (t-1)
r = interest rate on debt
Debt accumulated till now (year t) = B(t) =
B(t-1) + D(t)
Change in debt = B(t) B(t-1) = D(t) = G(t) T(t)
+ r. B(t-1)
Primary
deficit

Interest
paymen
t

Debt and the need for primary surplus

Three common ways of repayment

Debt repayment at a future date
Debt stabilization
Stabilization of debt-GDP ratio

Debt repayment at a future date

Year 1
Primary
Deficit

t-1

B1(1+r)

B1

Debt

B1

Repayme 0
nt

t
Bt < 0
=

Primary
Surplus
reqd.

Debt stabilization
Year 1
Primary
Deficit
Debt
Repayme
nt

B1
B1
0

2
-rB1
B1
rB1

t-1

-rB1

-rB1
B1

rB1

rB1

Primary Surplus reqd. every year

t
-rB1

rB1

Stabilization of Debt GDP ratio

The debt GDP ratio:

To
stabilize
debt
GDP
This
ratio is
the
required
primary
deficit or
primary
surplus

Exercise

The government intends to maintain the current debt-GDP ratio of

200% .
Interest rate on foreign borrowing is 10%
Current growth rate of GDP is 6%
Current GDP = Rs.2000 Trillion
Marginal propensity to consume = 0.8
Income tax rate = 50%
Last years primary deficit = Rs.150 Trillion

a) What is the maximum amount of primary deficit that the government can allow
itself ?
b) Given no significant change in collection of taxes, what is the maximum volume
of fiscal expansion possible?
c) How much increase in GDP an be expected from this fiscal expansion?

Dangers of very high public debt

0
That is if debt GDP
ratio has to be
maintained

If r is high
due to high
risk

Large primary
surplus required

Vicious circle leading to a debt crisis

Deficit budget
debt accumulated
higher perceived risk of debt default
rise in interest rates
need for primary surplus in the budget to
contain risk levels associated with borrowing
recession
need for a deficit budget