Chapter 3

Fiscal Deficits, Public Debt,

and The Current Account

© Pierre-Richard Agénor
The World Bank
1
 Structure of Public Finances
 The Government Budget Constraint
 Assessing the Stance of Fiscal Policy
 Fiscal Imbalances and External Deficits
 Consistency and Sustainability
 Sustainability and the Solvency Constraint
 Commodity Price Shocks and Fiscal Deficits
 Public Debt and Fiscal Austerity

2
 Constraints on fiscal policy and macroeconomic
management:
 inadequate tax base and limited ability to collect
taxes (result in tax evasion and a growing informal
sector);
 reliance on money financing (result in
macroeconomic instability, capital flight, and
currency crises);
 high levels of public debt (cause a pressure on real
interest rates and financial volatility and
macroeconomic instability).

3
Structure of Public Finances
 Conventional Sources of Revenue and
Expenditure
 Seigniorage and Inflationary Finance
 Quasi-Fiscal Activities and Contingent Liabilities

4
Conventional Sources of Revenue and
Expenditure
 Figure 3.1: Public revenue and expenditure patterns
vary across developing countries.
 Structure of conventional sources of revenue and
expenditure differs significantly between industrial
and developing countries.

5
 Figure 3.1a
Central Government: Revenue and Expenditure
(In percent of GDP, average over 1990-95)

Revenue Expenditure

Asia
Africa

India
Burkina Faso

Cameroon Indonesia

Ethiopia
Korea

Gabon
Malaysia
Ghana
Nepal
Guinea

Kenya Pakistan

Madagascar Philippines

Malawi
Singapore
Mauritius
Sri Lanka
Zambia
Thailand
Zimbabwe

0 5 10 15 20 25 30
0 5 10 15 20 25 30 35

Source: World Bank.

6
 Figure 3.1b
Central Government: Revenue and Expenditure
(In percent of GDP, average over 1990-95)

Revenue Expenditure

Latin America Middle East and North Africa

Argentina Egypt

Bolivia
Jordan
Brazil

Chile Morocco

Colombia
Oman
Costa Rica

Ecuador Syria

Mexico
Tunisia
Nicaragua

Peru Turkey

Uruguay
Yemen
Venezuela

0 10 20 30 40 0 15 30 45

Source: World Bank. 7

 Main differences (Burgess and Stern (1993)):
 Shares of total tax revenue and total central
government expenditure in output are larger in
industrial countries (Figure 3.2 and Figure 3.3).
 Explanation: increased need for risk insurance as
the degree of openness and exposure to large
external shocks increase. (Rodrik, 1998b).
 Composition of spending: Developing countries
devote a substantially larger fraction of
expenditures to general public services, defense,
education, and other economic services. Industrial
countries spend more on health and social
security.
8
 Figure 3.2a
Tax Revenue and Per Capita Real GDP 1/
(Average over 1980-95)

50 Tax Revenue (in percent of GDP)

40

30

20

10

0
0 5000 10000 15000 20000
Per capita real GDP in 1987 US dollars

Source: World Bank.

1/ 44 developing countries and 17 industrialized countries are included. A dark circle refers to
developing countries and a lighter circle to industrial countries.
9
 Figure 3.2b
Government Expenditure and Per Capita Real GDP 1/
(Average over 1980-95)

Government Expenditure (in percent of GDP)

60

50

40

30

20

10

0
0 5000 10000 15000 20000
Per capita real GDP in 1987 US dollars

Source: World Bank.

1/ 44 developing countries and 17 industrialized countries are included. A dark circle refers to
developing countries and a lighter circle to industrial countries.
10
 Figure 3.3a
Industrial Countries: Government Spending, 1870-1996
(In percent of GDP)

France Germany

1870 1870

1913 1913

1920 1920

1937 1937

1960 1960

1980 1980

1990 1990

1996 1996

0 20 40 60 0 20 40 60

Source: International Monetary Fund.

11
 Figure 3.3b
Industrial Countries: Government Spending, 1870-1996
(In percent of GDP)

Italy Japan

1870 1870

1913 1913

1920 1920

1937 1937

1960 1960

1980 1980

1990 1990

1996 1996

0 10 20 30 40 50 60 0 10 20 30 40 50 60

Source: International Monetary Fund.

12
 Figure 3.3c
Industrial Countries: Government Spending, 1870-1996
(In percent of GDP)

United Kingdom United States

1870 1870

1913 1913

1920 1920

1937 1937

1960 1960

1980 1980

1990 1990

1996 1996

0 10 20 30 40 50 60 0 10 20 30 40 50 60

Source: International Monetary Fund.

13
 Main source of central government revenue: in both
groups is taxation; however, the share of nontax
revenue in total revenue is much higher in developing
countries.
 Within total tax revenue, the relative shares of direct
taxes, taxes on domestic goods and services, and
taxes on foreign trade vary across developing
countries and over time (Figure 3.4). In industrial
countries, income taxes account for the largest share
of tax revenue.
 There has been a gradual move away from trade taxes
to taxes on domestic sales as economies develop and
their domestic production and consumption bases
expand.
14
 Figure 3.4a
Direct Taxes
(In percent of total tax revenue)

1980 1995

Taxes on income, profits, and capital gains

Colombia Kuwait

Costa Rica Malaysia

Ecuador Mexico

Egypt Pakistan

Ethiopia Philippines

Ghana Sri Lanka

Indonesia Syria

Jordan Thailand

Kenya Turkey

Korea Venezuela

0 20 40 60 80 0 20 40 60 80

Source: World Bank.

15
 Figure 3.4b
Indirect Taxes
(In percent of total tax revenue)

1980 1995

Domestic taxes on goods and services

Colombia Kuwait

Costa Rica Malaysia

Ecuador Mexico

Egypt Pakistan

Ethiopia Philippines

Ghana Sri Lanka

Indonesia Syria

Jordan Thailand

Kenya Turkey

Korea Venezuela

0 5 10 15 20 0 5 10 15 20

Source: World Bank. 16

 Within direct taxes, the share of tax revenue
raised from individual incomes is much larger
than that from corporations in developing
countries, while the reverse is true in industrial
countries.
 Need for revenue in developing countries is large.
Reasons:
 Need for the government to invest in
infrastructure, foster the development of market
institutions, and encourage employment creation
in order to reduce poverty.

17
 Deficit bias: due to the fact that although fiscal
policy is decided collectively, the parties involved
do not fully recognize the full social cost of the
programs they support (commons problem).
 Taxation systems in many developing countries
remain highly inefficient.
 Key reason: severe administrative and political
constraints on the ability of tax authorities to
collect revenue.
 Consequences: direct taxation plays a much
more limited role in developing countries and high
tax rates tend to be levied on a narrow base
(encourage tax evasion and lead to a high degree
of reliance on monetary financing). 18
Seigniorage and Inflationary Finance
 Developing countries tend to rely more on
seigniorage than industrial countries.
Reasons:
 limited administrative capacity and political
constraints hinder the collection of tax revenue in
developing countries;
 limited scope for issuing of domestic debt.
 Seigniorage consists of the amount of real
resources extracted by the government by means of
base money creation.

19
 Seigniorage revenue (conventional measure):

(M/P) = (M/P) -(P-1/P)(M-1/P-1)

= (M/P) + [(P - P-1)/P-1](M-1/P)

= m + [/(1+ )]m-1 (1)

M : nominal base money stock;

P : price level;
m  M/P;   P/P-1 .
20
 Equation (1): seigniorage is the sum of the
increase in the real stock of money, m, and
the change in the real money stock that would
have occurred with a constant nominal stock
because of inflation, /(1+)]m-1.
 Second term represents the inflation tax, with
[/(1+)] denoting the tax rate and m-1, tax base.
 When m = 0 (stationary state), seigniorage is
equal to the inflation tax.
 If monetary base is bearing any interest, Equation
(1) overstate seigniorage revenue and a
correction must be made to obtain an
appropriate measure.
21
 Alternative seigniorage definition: interest burden
foregone by the government through its ability to
issue non-interest-bearing liabilities.
 This is private sector's revenue loss from foregone
interest earnings (opportunity cost of money)
corresponds to an equivalent revenue gain for the
government from issuing money, iM/P, where i is
the nominal short-term interest rate.
 Figure 3.5: differences across countries in the use
of seigniorage---from almost 12% in Yemen to less
than 1% in Tunisia.
 Figure 3.6: reliance on seigniorage tends to be
associated with large fiscal deficits.
22
 Figure 3.5
Seigniorage
(In percent of GDP, average 1993-95)

Argentina Lebanon
Bolivia Malaysia
Brazil Mexico

Chile Pakistan

Colombia Peru
Philippines
Costa Rica
Singapore
Ecuador
Sri Lanka
Egypt
Sudan
Ethiopia
Thailand
Ghana
Tunisia
India
Turkey
Jordan Uruguay
Kenya Venezuela
Korea Yemen
0 2 4 6 8 10 12 0 2 4 6 8 10 12

Source: World Bank.

Note: Seigniorage is measured as the change in the base money stock divided by nominal GDP.
23
 Figure 3.6
Fiscal Deficits and Seigniorage
(In percent of GDP, average 1993-95)

Venezuela Algeria

Morocco
3 India
Bolivia
Turkey Ecuador
Seigniorage 1/

Pakistan Uruguay
Zambia Egypt

2 Kenya
Tunisia Indonesia
Sri Lanka Philippines
Peru
Chile
Korea Thailand
Sierra Leone
Costa Rica Dominican Rep.
1
Nicaragua
Mexico
Argentina
Jordan

0
-8 -6 -4 -2 0 2 4
Fiscal balance, including grants 2/

Source: World Bank.

1/ Seigniorage is the change in the base money stock divided by nominal GDP.
2/ Central government only.
24
Quasi_Fiscal Activities and
Contingent Liabilities
 Quasi-fiscal activities: operations whose effect can in
principle be duplicated by budgetary measures in the
form of an explicit tax, subsidy, or direct expenditure.
 Carried out by the country's central bank, by public
sector banks and other public financial institutions, such
as development banks.
Main examples of quasi-fiscal activities:
 Subsidized credit: lending at preferential rates by the
central bank to the government or other public entities,
or subsidized lending by specialized public sector
financial institutions to the private sector.

25
 Manipulation of reserve and statutory liquidity
requirements, through, for instance, central bank
regulations requiring commercial banks to hold large
reserves.
 Multiple exchange rate practices: it may be a
surrender requirement on export proceeds at a rate
that is more appreciated than the market rate. This
implicit tax on exports may have potentially large
distortionary effects on trade flows and production
patterns.
 Exchange rate guarantees: given by the central bank
on the repayment of principal and interest on foreign-
currency denominated debt of other public sector or
private sector entities.
26
The Government Budget
Constraint

27
 Budget constraint:

G - (TT+TN) + iB-1+ i*EBg-1 = *Lg + B + EBg

*
(2)
G: public spending on goods and services;
TT: tax revenue ; TN: non-tax revenue;
B: end-of-period stock of domestic public debt (bears interest at the
market-determined rate i);

Bg*: end-of-period stock of foreign-currency-denominated

public debt (bears interest at i*);
E: nominal exchange rate;
Lg: nominal stock of credit allocated by the
central bank. 28
 Left-hand side of Equation (2): components of the
budget deficit; spending on goods and services
and debt service, net of taxes (conventional
fiscal balance).
 Right-hand side: government finances its budget
deficit by either issuing domestic bonds,
borrowing abroad, or borrowing from the central
bank.
 Primary fiscal balance:

D=G-T
where T = TN + TT .
29
 Then (2):

* = Lg + B + EB*g (3)

D + iB-1 + i*EBg-1
 Conventional fiscal deficit can be sensitive to
inflation.
 Key reason: effect of inflation on nominal interest
payments on the public debt.
Limitations of conventional deficit under
inflation:
 No longer a reliable indicator of sustainability of
fiscal stance (issuance of public debt occurs at a
rate in excess of the growth rate of the resources
available for eventual debt service). 30
 No longer provide an adequate measure of fiscal
effort by policymakers.
 Primary balance is a more reliable measure.
 Economists often use an alternative to conventional
balance, operational balance (defined in real
terms).

31
 Figure 3.7
Brazil: Alternative Measures of the Fiscal Balance 1/
(In percent of GDP)

Interest payments
Primary balance
4

-2
Operational Balance

-4

-6
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

Source: Bevilaqua and Werneck (1997).

1/ General government only (Federal government and states and municipalities). 32

Assessing the Stance of
Fiscal Policy

33
 Tools for assessing the medium-term stance of
fiscal policy are structural budget deficit and
fiscal impulse measure.
 Key idea to assess medium-term fiscal strategies
properly: determine which changes in actual budget
balances reflect structural factors, (discretionary
fiscal policy action), rather than cyclical
movements.
 Changes in deficit attributable to the business cycle
(or short-term fluctuations in aggregate demand) is
self-correcting.
 Changes in deficits attributable to structural factors
can be offset only through discretionary measures.
34
 Removing cyclical component from the observed
budget balance provides a more accurate indication
of medium-term fiscal positions : structural budget
balance.
First approach to calculate structural budget
balances:
 Budget elasticities are used to adjust revenues, TS ,
and total expenditures, GS , for movements in the
cyclical output gap, GAP.
 GAP: difference between actual and potential (or
capacity) output, in proportion of potential output.

35
 Structural budget deficit:

DS = GS - TS = G(1 - GGAP)
- T(1 - TGAP),

G and T : elasticities of expenditure and revenue.

36
 Second approach to calculate structural budget
balances:
 Used by IMF.
 Cyclical revenue and expenditure components are
expressed as ratios to GDP and estimated using
parameters that describe the cyclical response of
revenue and expenditure to movements in the cyclical
output gap.
 Budget deficit as a percentage of GDP:

d = g - ,
g: observed total expenditure-to-GDP ratio;
: observed total revenue-to-GDP ratio.
37
 Decomposing the revenue and expenditure ratios into
structural components (S and gS)and cyclical
components (C and gC) :

d = (gS + gC) - (S + C).

 Impact of cyclical component on budget deficit:

dC = gC - C = GGAP - TGAP,

G and T: cyclical response of expenditure and

revenue ratios to an increase of 1 percentage point in
cyclical output gap.
38
 Overall effect of the business cycle on the budget:

(G - T).
 Structural budget deficit:

dS = d - dC.

 Two approaches are basically equivalent:

T  (T -1)(T/Y); G  (G -1)(G/Y)

T/Y, G/Y: revenue-to-GDP and expenditure-to-GDP ratios.

39
 Presenting the estimates as ratios to GDP makes it
easier to evaluate the sensitivity of estimates of
structural budget balances to changes in
assumptions about cyclical output gap and cyclical
responsiveness of the budget.
 Key aspect of the cyclical adjustment is the
estimation of potential output.
 Industrial countries: a common approach is first to
estimate a production function linking output to
capital, labor, and total factor productivity. Potential
output is then estimated as the level of output that is
consistent with normal capital utilization, and
natural rate of unemployment.
40
 Developing countries: Potential output is
approximated by trend output, which can be
estimated for instance by Hodrick-Prescott filter.
Fiscal impulse measure:
 First step: decomposition of the actual budget deficit

into a cyclically neutral component and a fiscal

stance component.
 Cyclically neutral component: calculated by

assuming that government expenditures increase

proportionately to potential output and that
revenues increase proportionately to actual output.
 Fiscal stance: residual between the cyclically

neutral and the actual budget deficits.

41
 Second step: calculate the fiscal impulse as the
annual change in the fiscal stance measure.
 Negative value: contractionary demand impulse.
 Positive value: expansionary demand impulse.
 Fiscal stance was significantly more expansionary
than what conventional indicators (such as the
primary deficit) indicated.
Limitations:
 Beside to discretionary fiscal policy measures and
business cycle, other factors can be important for
movements in the structural components of
revenues and expenditures:

42
  Revenue side: changes in natural resource
revenues, nonneutralities of the tax system with
respect to inflation.
 Expenditure side: changes in interest rates,

changes in the demographic composition of the

population.
 Chand (1993): fiscal impulse measures do not
include the effect of automatic stabilizers on
aggregate demand.
 Effects of fiscal policy on long-term interest rates
and the distortions associated with tax and transfer
programs on the supply side of the economy are
not included.
43
Fiscal Imbalances and
External Deficit

44
 Key issue for policymakers in developing countries:
correlation between fiscal and external deficits.
 Link between fiscal accounts and external balance:

(Ip - Sp) + (G - T) = J - X - NT ,

Ip: private investment; Sp: private saving;

G: current government spending;
T: current government revenue;
J (X): imports (exports) of goods and services;
NT: net current transfers from abroad.

45
 Counterpart to the current account balance is the
government fiscal deficit and the investment-saving
balance of the private sector.
 As long as (Ip - Sp) is stable, changes in fiscal deficits
will be closely associated with movements in current
account deficits.
 Figure 3.8: correlation between budget deficits and
current account deficits not suggest any clear pattern.
 Correlation between fiscal and external deficits
depends on the effect of fiscal policy on the private
sector's investment and saving decisions.
 Fiscal deficits may respond to, rather than cause,
changes in the current account.
46
 Figure 3.8
Budget Deficits and Current Account Deficits
(In percent of GDP, average over 1980-95)

2
Venezuela
1 Algeria

Panama Korea
Current account balance

0
Brazil Turkey
-1 Uruguay
Kenya
-2 Mexico Malaysia Argentina Colombia
India Burundi Indonesia
-3
Philippines
Zimbabwe Pakistan Ghana Chile
-4
Peru Thailand
Morocco Egypt
-5
Cameroon
Jamaica Tunisia
-6 Sri Lanka Ecuador Bangladesh
Nepal
Bolivia
-7 Costa Rica
Paraguay
-8 Côte d'Ivoire Senegal
Honduras
-9
-14 -13 -12 -11 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1

Overall budget deficit, including grants

Source: World Bank. 47

 Consistency and
Sustainability
 The Consistency Framework
 Fiscal and External Sustainability

48
A Consistency Framework
 Anand and van Wijnbergen (1989) model.
The framework can be operated in two modes:
 deficit mode: allows the analyst to calculate a
financeable deficit, given targets for inflation and
other macroeconomic variables;
 inflation mode: allows the calculation of the rate of
inflation consistent with given targets for the fiscal
deficit and other macroeconomic variables.
 In the presence of various macroeconomic targets,
sources of fiscal deficit financing become
interdependent and determine the level of the primary
deficit that can be financed from below the line.
49
 If actual deficit exceeds the level that can be
financed (given the other policy targets),
policymakers must adjust their fiscal stance or
revise their other objectives.

50
 Government budget constraint:

* = Lg + B + EB*g (8)

D + iB-1 + i*EBg-1
G: public spending on goods and services;
TT: tax revenue ; TN: non-tax revenue;
B: end-of-period stock of domestic public debt (bears interest at the
market-determined rate i;

*
Bg:end-of-period stock of foreign-currency-denominated public debt (bears interest at
the rate i*;

E: nominal exchange rate;

Lg: nominal stock of credit allocated by the
central bank. 51
 First step: consolidate the balance sheets of the government and the
central bank.
 Add and subtract ER*:

*
D + iB-1 + i*EBg-1 = (Lg + ER*) + B
+ E(Bg - R*) (9)
*

52
 Balance sheet of central bank:

Assets Liabilities
Lg CU
ER* RR} M
NWcb

CU: currency in circulation;

RR: reserves held at the central bank by commercial
banks against their deposit liabilities;
NWcb: central bank's accumulated profits or net worth.

53
 Monetary base:

M = CU + RR.
 Change in monetary base:

M = Lg + ER* - NWcb.

 Net profits of central bank is interest earnings on official reserves :

i*ER-1* = NWcb

54
 After rearrangements:

D + iB-1 + i*EB*-1 = B + EB* + M (12)

Two observations are useful at this stage:
 Because base money is considered a liability of the
public sector, net foreign assets held by the central
bank must be subtracted from the government's
foreign debt to calculate the net external liabilities
of the public sector.

55
 The above derivations remain almost identical if the
central bank lends to commercial banks and to the
private sector.
 Definition of the base money stock needs to be

adjusted to correspond to the central bank's net

liabilities to the private sector.
 This is done by defining the adjusted monetary

base as the sum of

 currency in circulation minus central bank

credit to the private sector;

 required reserves minus central bank loans to

commercial banks.

56
 Dividing by P (in real terms):

d + rb-1 + r*zb-1* = b + zb* + M/P,

d = D/P: real primary deficit;
b = B/P: real value of the stock of domestic debt in terms
of domestic goods;
b* = B*/P*: real value of the stock of foreign debt in
terms of foreign goods, with P* denoting the foreign
price level;
z = EP*/P: real exchange rate,
r and r*: real interest rates in terms of domestic and
foreign goods.
57
 r and r* are defined such that

1 + r = (1 + i)/(1 + );

1 + r* = (1 + i*)/(1 + *).

58
 After rearranging:

d + rb-1 + (r* + z)^zb-1 *

= b + (z/z-1)(zb*) + M/P,

z = z/z-1: rate of depreciation of the real exchange rate.

 After substitution of seigniorage revenue from equation (1):

d + rb-1 + (r* + z)^zb-1 *

(17)
= b + (z/z-1)(zb*) + m + (/(1+ ))m-1.
59
 This equation can be used in various ways to ensure
the consistency between fiscal policy and
macroeconomic targets.
 It can generate two types of values for a given
money demand function:
 value of the primary fiscal deficit that is

consistent with a given total debt-to-output ratio

and an inflation target;
 ~ is consistent with a given total debt-to-
value of , that
output ratio and a target for the primary fiscal deficit.

60
 First mode: simple possibility is to assume that both domestic
and foreign debt ratios grow at the constant rate of growth of
output, g:

b/b-1 = g , (zb*)/z-1b-1 = g.
*
 Measuring all variables in proportion of output yields:
b/y = g(b-1/y),

(zb*)/y = g(z-1b-1/y) = g(zb-1/y)(z-1/z).

* *

61
 Dividing each term in Equation (17) by output, and
using the preceding results to substitute for
(zb*)/y:
d/y + rb-1/y + (r* + z)zb-1^/y *
= g(b-1/y) + g(zb-1/y) + m/y
* (18)
+ (/(1+ ))m /y.
-1

~ ~

62
 ^ g, ~, and a properly
For given values of r and r*, z,
specified money demand function equation (18)
determines the financeable primary deficit:

d = - (r - g)b-1/y - (r* + z^- g)zb-1*/y

y f
~ ~
+ m/y + (/(1+ ))m-1/y.
 Given the value of the financeable primary deficit the
reduction in the actual deficit-to-output ratio, d/y|a,
required to achieve consistency can be calculated:

d d d
y  = y a
- y f 63
 For a given target value of d/y|f , Equation (18)
allows one to calculate the consistent (or
sustainable) rate of inflation.
 In this case, however, multiple solutions for the
sustainable inflation rate may arise if the money
demand function is nonlinearly related to inflation
and/or nominal interest rates.
 In practice, estimates of base money demand are
derived by using a complete model of portfolio
choice that includes:
 demand for currency;

 demand for sight deposits, time deposits;

64
  foreign-currency deposits
all as a function of income, inflation and interest
rates.
 Demand for reserves by commercial banks may be
estimated by using a simple portfolio model, taking
into account existing legislation on reserve
requirements.
 Major advantage of this extended approach: it
allows the investigator to assess the effects of
changes in financial regulations on the
financeable fiscal deficit or the sustainable rate of
inflation.

65
 In practical applications, it is common to use a two-
or three-year moving average of actual real output
growth rates and interest rates, and a constant real
exchange rate (z = 0), to generate an ex ante
measure of sustainability.

66
 Two other considerations:
 Assessing the magnitude and likelihood of
realization of contingent liabilities, such as
foreign exchange guarantees, may be critical to
assess the fiscal stance and its sustainability.
 See Towe (1990).

 Measures of the primary balance should include

quasi-fiscal losses.
 Degree of concessionality of foreign debt must
be accounted for in assessing sustainability.
 See Cuddington (1997).

 For many developing countries, foreign financing

contains a sizable grant element.

67
 The larger that element is, the higher will be the
level of foreign indebtedness consistent with
fiscal sustainability.
 In effect, concessionality reduces the effective
real interest rate on foreign borrowing.

68
 Functioning of the consistency framework:
 Assume RR = 0. So M = CU.
 Demand for currency:

ln(CU /y)=0.1 - 1.5 ln(1+) - 2.1 ln(1+i).

 Assume b* = 0, g = 0.02, ~ = 0.63, r = r* = 0.04, d/y

= 0.04 and targeted debt-to-output ratio = 0.1.
 Then from (18):

d/y = 0.027, for t = 1

d/y = 0.028, for t = 2,…,9
d/y = 0.030, for t = 10. 69
 Suppose: policymaker’s objective is to find the
inflation rate that is consistent with a primary deficit-
output ratio constant at 0.03.
 Sustainable inflation rate:
 = 73%, for t = 1
 = 71%, for t = 2
 = 58%, for t = 10.
Limitations:
 It lacks a simultaneous determination of the
primary deficit, output growth rates, and the real
interest rate.
 Lenders play no role.
70
Fiscal and External Sustainability
 Fiscal sustainability is neither necessary nor
sufficient for external sustainability.
 The behavior of the private sector is a crucial link in
explaining any divergences between fiscal and
external sustainability.
 Any increase in government dissavings, given
private savings and national investment behavior,
will translate automatically into an increase in the
current account deficit.
 However, a sustainable fiscal stance need not be
sufficient for external sustainability if private sector
behavior is such that its net savings are highly
negative and/or falling. 71
 Extension by Parker and Kastner(1993).
 Key feature: net private savings are added to net public
savings to determine the current account balance.
 Real interest rates are determined endogenously, and
are specified as depending in part on the debt-output
ratio.
 This captures the existence of a risk premium: the
higher the level of public debt, the lower the probability
that debt will be sustainable, the higher the risk of
default, and the higher the real interest rate.
 Taxes are exogenous.

72
 For given targets for output growth, inflation, and
domestic and foreign borrowing, the model generates
consistent estimates of public spending.
 The difference between financeable expenditure and
actual expenditure provides the fiscal adjustment
required to meet both fiscal and external targets.
 Model: attempt to capture explicitly the role of the
private sector in assessing external sustainability.
 It shows the need to account for general equilibrium
interactions among macroeconomic variables.
 Lenders play an active role.

73
 Sustainability
and the Solvency Constraint

74
 Consistency framework is static and focuses on
flow budget constraint.
 Budget constraint has also intertemporal
dimension.
 Intertemporal solvency condition: central to an
evaluation of the medium- and long-run
sustainability of fiscal deficits and public debt.

75
 Assume no foreign financing of the deficit. Then
budget constraint:

d + rb-1 = b + M/P,

d: real primary deficit; b: real value of the stock of

domestic debt in terms of domestic goods; r: real
interest rates.

76
 Rewrite:

b = [(r - g)/(1+g)]b-1 + d - s, (20)

d = d/y:ratio of primary deficit to GDP;

b = b/y:ratio of government debt to GDP;
s = M/Py: ratio of seigniorage revenue to GDP;
g: rate of growth of real GDP.
 If r > g, b will increase explosively, unless s
exceeds d by sufficiently large amount.

77
 Assume constant r and g and solve (20)
recursively forward from period 0 to N:
N


b0 = [(1+g)/(1+r)]h(sh-dh)

+[(1+g)/(1+r)]NbN.
h=1

 Outstanding stock of domestic debt must be equal in

value to the present discounted value of the future
stream of seigniorage revenue, sh, adjusted for the
primary fiscal deficit, dh, between the current date and
some terminal date N, plus the present discounted
value of the debt held at that terminal future date.
78
 Suppose N is the relevant terminal date. Solvency constraint requires:

bN  0.
 Solvency constraint:

N
b0   [(1+g)/(1+r)]h(sh - dh) . (23)
h=1

 For a solvent government b0 cannot exceed, the present

discounted value of future seigniorage revenue, adjusted
for the primary fiscal deficit.
 Policy is sustainable if this constraint holds.
79
 This framework can be used for various policy
exercises:
 It can be used to calculate the magnitude of the
primary deficit-output ratio that would be needed to
get from an initial debt-output ratio b0, to a target
future value of that ratio H periods later, bH.
 This quantity can be called required primary deficit-
output ratio.
 By comparing the required ratio to the actual ratio
the primary fiscal gap can be obtained (Blanchard,
1993).
 Solvency is not sufficient to identify a unique fiscal
stance.
80
 Lack of uniqueness: governments possess some
degrees of freedom in the selection of fiscal policy
instruments that they can manipulate to ensure
solvency, as well as the timing of use of these
instruments.
 If solvency constraint is violated, the following main
policy options may be considered to close the
solvency gap:
 either by cutting spending or by raising tax and

nontax revenues;
 increase current and future seigniorage

revenues (limited);

81
  declare an outright default or impose a unilateral
moratorium on debt payments (may increase risk
premium).
 In practice, solvency analysis is fraught with difficulties.
 Solvency constraint imposes only weak restrictions
on fiscal policy.
 If r < g, a primary surplus is not necessary to achieve
solvency. The government can run a primary deficit of
any size.
 Size of the debt-to-output ratio: influence on the private
sector's perception of the government's commitment
to meet its intertemporal budget constraint, and its
ability to do so.

82
 As the debt ratio continues to grow, private agents
may become skeptical about the government's
ability to meet its budget constraint.
 This loss of credibility may translate into higher
interest rates.
 The larger the outstanding debt-to-output ratio is, and
the longer appropriate policy actions are postponed,
the greater will be the magnitude of the primary
surplus needed to satisfy the solvency constraint.
 Because governments typically face a limit to the tax
burden that they can impose on their citizens, they
face a feasibility constraint on the amount of
revenue that they can raise.
83
Commodity Price Shocks
and Fiscal Deficits

84
 In the short run, commodity price shocks may
also play a role on fiscal deficit.
 Since many developing economies depend heavily
on primary commodities for the bulk of their export
receipts, tax revenues are strongly affected by
movements in commodity prices.
 When commodity prices rise, government revenues
are boosted both
 directly, in countries where commodity-

producing sectors are state owned, and

 indirectly, through increased revenues from

trade and income taxes.

85
 Collier and Gunning (1996): These windfall gains
are used to finance procyclical expenditures.
 Result: when prices have declined, these countries
have been left with large and unsustainable fiscal
deficits.
 Reason as noted by Cooper (1991): governments
typically behave as if positive shocks are
permanent, and negative shocks are temporary.
 Expansion of government spending induced by a
transitory improvement in the terms of trade was
accompanied also by a sustained real exchange
rate appreciation (Dutch disease).

86
 Designing contingency mechanisms and
institutional structures that are capable of ensuring
that governments engage more in expenditure
smoothing.

87
Public Debt and Fiscal
Austerity

88
 Fiscal austerity may be expansionary (oppose to the
Keynesian view).
 Bertola and Drazen (1993): negative fiscal multiplier.
 Expectations about future policy actions may have
a major effect on interest rates, depending on their
degree of credibility.
 If the policy measures are fully credible, when
austerity program begins, interest rates may fall
immediately.
 Reason: credible policy announcement may be
viewed as reducing the risk of higher inflation,
currency overvaluation, and possibly future financial
instability.

89
 As a result, the risk premium in interest rates is
likely to decline.
Expansionary effects of reduction in
interest rates on output:
 demand side: by lowering the cost of capital and
thereby increasing investment, and by stimulating
consumption of durables;
 supply side: by reducing the cost of financing
working capital needs for credit-dependent firms.
 Even though there is virtually no evidence on the
importance of negative fiscal multiplier effects in
developing countries, it has important implications
for the design of adjustment programs.
90