Economics 201

Introduction to Macroeconomics

Mark Witte

Northwestern University

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Government Borrowing: Debt & Deficits

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To summarize

• In the short run aggregate demand matters, but in the long run output is determined from the supply side.
• A better way of putting it is that supply adjusts to demand in the short run, but demand adjusts to supply in the long run.

Keynes: Try to get to full employment

• Government should use fiscal & monetary policy to move Aggregate Expenditure to where the economy is at full employment
• Fiscal Policy: Congress & Treasury Department
• ΔAE = 1/(1-MPC) * ΔG
• ΔAE = -MPC/(1-MPC) * ΔT
• Monetary Policy: Federal Reserve
• Money Supply↑ ⇒ Interest Rates↓ ⇒ I_D↑ 
• ΔAE = 1/(1-MPC) * ΔI_D

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But sometimes in recessions, monetary policy won’t work

How do we respond to Recessionary Gaps?

• Self correcting mechanism:  Wait for SRAS to shift
• Policy:  Use monetary or fiscal policy to move AD
• Problems:
• Sometimes monetary policy doesn't work
• Fiscal policy can run up deficits
• Raising G and cutting T means that the government must borrow money to fund what is doing

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Government Deficit = Taxes - Gov. Spending < 0

Government Surplus = Taxes - Gov. spending > 0

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Government Debt = Sum of all past government deficits and surpluses

Recessionary Gaps: 1930s, 1980s, 2010s, Covid….

1930s:  

• Russia had turned Communist
• Italy and Germany had turned Fascist
• England and the US had unemployment rates above 20%
• Would those governments fall next?

What did we do in the 1930s? The WPA!

• WPA = Work Progress Administration
• Part of Franklin Roosevelt's New Deal
• 1935-1943
• Lots of post offices, canals, parks were built
• Lots of adults went to school on this

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WPA in Evanston

• Evanston Duck Pond (south of campus)
• Post Office
• A lot of artwork

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Definitions

• Government Deficit:
• Government spending > Tax Collections
• Government sells some new bonds

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• Government Surplus
• Government spending < Tax Collections
• Government pays off some bonds

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• Government Debt
• Cumulative sum of all past deficits and surpluses

Should we balance the government budget every year?

• Government Balance = G - T
• Problem:  Tax revenues move with RGDP
• In a recession, RGDP goes down, and so do tax revenues
• In an economic boom, tax revenues go up
• If we try to balance the government budget every year, then:
• In a recession we would need to cut G and raise T
• In a boom we would need to raise G and cut T
• BUT THESE ARE EXACTLY THE WRONG POLICIES!  
• Destabilize the economy

Herbert Hoover

• This insight actually comes from David Ricardo
• He felt that it would be bad to raise taxes during an emergency, like a war, to fully cover the costs

Better government budget goal

• Government should run deficits during recessions and surpluses during booms
• We should aim to balance the budget for when the economy is at Full Employment, Potential GDP (Y_P)
• When the economy is strong, employment and profits are high, we get a lot of tax revenue, and are paying out relatively little in welfare
• When the economy is weak, employment and profits are low, we are getting little tax revenue and are paying a lot in welfare
• Balance the "cyclically adjusted budget" 
• Have a budget that would be in balance if they economy were at an unemployment rate of 4%
• Surplus when U<4%, deficit when U>4%

How much borrowing by the US gov is too much?

• US government borrows by selling bonds
• When these bonds come due, the US pays them off
• It usually pays them off by "rolling them over"
• This means, by borrowing from someone else
• Companies often to this, and I recently rolled over my mortgage
• How much can a person borrow?  It depends on that person's income and wealth
• How much can a country borrow?  It depends on that country's income or GDP
• Debt/GDP ratio is a useful comparison

This is how we run up the debt level

Fiscal Policy can run up the debt level

Government Debt/GDP ratio

• Debt/GDP ratio was 16% in 1929
• This is a low level of debt, but didn't save us from the Great Depression
• Debt/GDP ratio was 116% in 1946
• Driven up by WWII and the Great Depression
• This is a high level, but then we had 30 years of the greatest economic growth ever seen by a rich country
• The Debt/GDP ratio fell after WWII not because we balanced the budgets but because the economy grew faster than the debt

Japan is amazing

Note: The US, UK, and Japan all borrow (issue bonds) in their own currency.

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Many other countries borrow (issue bonds) denominated in other currencies, like dollars, euro, or yen.

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Debt is much less worrisome if a country can create what it needs to pay it back.

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Debt is harder to deal with when a country has to earn what it needs to pay it back.

Should the US pay off all of its debt?

• There must be some upper limit on how much any country can afford to borrow
• 200% of GDP maybe?   
• (My family borrowed four years of our salary to buy our house)
• If we paid off the US debt, we would need to raise taxes
• Most US debt held by Americans
• Such taxes would mainly be on the wealthy, because they have the income
• These taxes would pay off the bondholders
• These are foreigners, US banks, NU's endowment, and rich people
• To some extent, we would tax the rich to pay off the rich

Could we raise taxes that much?

“We’re the highest-taxed nation in the world.”

May 11, 2017

Just to throw some shade….

“My party is very interested in deficits when there is a Democrat in the White House. The worst thing in the whole world is deficits when Barack Obama was the president. Then Donald Trump became president, and we’re a lot less interested as a party.”

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- Mick Mulvaney

Head of the Office of Management & Budget

February 19, 2020

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People are willing to lend to the US at low rates

• This indicates confidence that the US will pay off each of its outstanding bonds.
• Granted, with $38T of debt and a 4% interest rate, that’s $1.5T/year in interest

So, why do people care about the US debt?

• The “Debt Ceiling?”
• No, that’s just a stupid, arbitrary number that no other financial entity uses
• Cynicism?
• I don’t want to publicly say that I am opposed to {feeding babies, saving Finland, going to Mars, paying the army}, so I say I oppose spending that would raise the deficit and debt.
• Crowding out!

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Government borrowing and “Crowding Out”

• From Leakages = Injections
• Savings = Investment + (G-T) + (X-Im)
• Government borrowing competes with private borrowing for a limited stock of saving
• High levels of government borrowing bid up interest rates, driving down investment demand
• Government borrowing can "crowd out" private investment
• Lower private investment leads to lower growth of the capital stock
• Lower growth of the capital stock leads to lower growth of the economy in the long run
• This is the real cost of government deficits
• But it's not a big deal in a depressed economy, but matters more when unemployment is low

Government borrowing and “Crowding Out”

• Total borrowing is private + Government
• At r_T, private borrowing is lower
• Q_T stands for Total Quantity of borrowing
• With more government borrowing, we get higher interest rates, and lower I_D
• Lower investment means slower growth of the capital stock
• Lower long run growth of incomes and the economy

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Or...if the government doesn’t want interest rates to get to high, or doesn’t want to raise taxes to pay the debt...it can always pay the debt by “printing money”...but that doesn’t end up going so well.

Clicker!

How does "Crowding Out" work?

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1. Government runs deficits, which raises interest rates and reduces investment demand.
2. Government runs deficits, which improves the economy, making investment more attractive.
3. Government runs deficits, lowering interest rates, making investment less profitable.
4. Government runs deficits, which increases leakages, bringing about a corresponding reduction in injections, like investment.

Finishing up finance!

This stuff will be on the final, but not this coming midterm.

Bonds versus Stocks

• Stocks pay share of profit
1. Pay out cash dividends
2. Or reinvest the earnings in the firm and have the share price rise for a “capital gain”
3. People can borrow against capital gains on their assets
• Bonds pay interest plus repay principal (hopefully!)
• "Payoff of Asset" versus "Success of Venture"

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Bond

Legal contract specifying future payments

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Face value = $200

Paid in two years

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Four coupons worth $12 each

Paid out every 6 months

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Bonds can vary by size, maturity, coupon rate, and many other factors

Bond prices

“One year, zero coupon bond”

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This bond will pay you $100 in one year.

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How much would you pay now to get that $100 next year?

Bond prices

“One year, zero coupon bond”

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This bond will pay you $100 in one year.

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How much would you pay now to get that $100 next year?

What about more complicated bonds?

• Same basic rule
• Bonds have a face value that pays off the end (“at maturity”)
• Bonds also have interest payments
• Called "coupon payments"
• Expressed as a percentage of the face value, usually paid every six months

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• Price of the bond = “Present Value” of [future coupon payments and face value]

How do you feel about these? Could it be a PPF?

• What’s the best possible outcome?

(Maybe infeasible)

• What’s the worst possible outcome?

Best

Worst

More ice cream

Lack of Nickelback

Risk versus Rate of Return: a PPF!

Higher rates of return come with more RISK! A tradeoff

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Just to be clear:

Nickelback = Risk

Both are bad

Best

Worst

Clicker!

For a given company, we generally see the stock for the company outperform the bonds for that company over the long term. Why?

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1) With stock, you own part of the company, and can vote on how it is run.

2) Stocks are riskier than bonds.

3) Bonds are riskier than stocks.

4) It's the law; stocks are required to pay a higher return than bonds.

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Does the financial system get us to equilibrium?

And...which equilibrium?

How do we make decisions about the future?

It involves interest rates

• How much is a given amount of money in the future worth to us today?
• Two super-useful formulas!
• Value today of some future amount of $$$ = “Present value”
• Present value of $X in T years at interest rate r

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• PV of $C per year forever (starting next year) at interest rate r

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How do these work?

Interest rates are how fast saved money grows

• $100 now = $100
• $100 deposited becomes $106 in a year at i=6%
• $100 in two years becomes $100*(1.06)² = $112.36
• Future value of $100 in three years = $100*(1.06)³

= $119.10

• In ten years = $179.08
• So, $100 now has greater value in the future because of compounding interest

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Interest rates are the “time value of money”

• If we put $100 in the bank at a 6% interest rate, in a year it will grow to be $100*(1 + 6%) = $106
• Therefore there is an equivalence between:

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$100 now ⇔ $106 in one year's time

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• Similarly, at 6% interest rates, you could sell something that will be worth $106 next year for $100 today.
• Present value today of $106 in a year at i=6%

= $106/(1.06) = $100

How much would I be willing to pay today….

• What is the most I would be willing to pay today to get $100 someday in the future?
• If I put $94.36 in the bank now at 6% interest, in a year it would grow to be $100
• Present Value of getting $100 one year from now at i=6%

= $100/(1.06)¹

= $94.36

• PV($100 in two years at i=6%) = $100/(1.06)² = $89
• PV($100 in 10 years at i=6%) = $100/(1.06)¹⁰ = $55.84

At i=5%, $100/year forever is worth $2,000

• If you put $2,000 in the bank at i = 5%, then you could take out $100 per year forever

$X = $100/5% = $2,000

• You wouldn't be willing to pay more than $2,000 to get $100 per year forever
• Opportunity cost, that's what you could get on your money at the bank
• Kind of amazing
• This sort of calculation gives us an idea of how much we should spend now to get future benefits
• Like how much a stock that’s expected to pay an annual $20 dividend is worth

Bubble: Price >> PV(Future payments)

• “P/E ratio”
• “Price/earnings ratio”
• Ratio of stock price over earnings per share.
• How much do you have to pay to get a dollar of earnings?

Robert Shiller, Nobel Prize 2013

• S&P Stock Index
• Stock prices should represent the PV of future earnings
• Are we in a bubble?

Housing bubble: Prices/rents

The price of a house should be proportional to the PV of future rents minus expenses

Interest Rates

• (I love this graph from the formation of the euro to the Financial Crisis)

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• Interest rates are the price of borrowed funds

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• The greater the expected inflation rate, the greater the nominal interest rate (Fisher Equation)

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• The greater the risk of default, the greater the interest rate (see what was going on with the interest rates on Greek government bonds)

So...consumption, savings, investment

How does all of this fit together?

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Y = SRAS = Production = Income

AE = C(Y) + I_D + G + X-Imports = Spending

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In equilibrium:

Production = Spending

Y = C(Y) + I_D + G + X-Imports

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So...consumption, savings, investment

In equilibrium: Production = Spending

Y = C(Y) + I_D + G + X-Imports

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And we can solve this for a unique, equilibrium level of Y.

That is, there is a level of Y where production = spending (AE).

And leakages = injections (at the right level of the interest rate)

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But that’s for later!

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But there needs to be a specific interest rate to make this true!

That turns this into a model with two equations and two unknowns (Y and r).

But we will leave this for Econ 311 Intermediate Macroeconomics.

Next up!

Money!