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Question 3: Fiscal policy and long-run sustainability (20 points) a. Explain the concept of an automatic stabilizer in the context of fiscal policy. (2 points) b. Explain what is meant by deficit bias and state at least three reasons for why it may arise. (4 points) Derive an expression for how the primary budget balance as a share of GDP and the existing debt-to-GDP ratio affect the change in the current debt-to-GDP ratio. (6 points) d. Use the equation derived in question c to discuss what is required to stabilize the debt ratio. Explain the trade-off that governments face when contemplating debt stabilization. (4 points)

Answer 1

a.

Automatic Stabilizers are used in the fiscal policy to stabilize the economy from positive or negative demand and supply shocks. They are used mainly to avoid the fluctuations caused by the business cycles. There is no direct intervention by the government in the economy. Tax, transfer systems, unemployment insurance are some examples of automatic stabilizers that stimulates the economy during recession time.

b.

Deficit bias refers to the tendency of the government to increase the deficit through the increase in public debt rather than curing it.

Below are the reasons which can lead to deficit bias:

- Lack of knowledge to understand long run constraints: The government may have insufficient knowledge/understanding about the intertemporal budget constraints over several future periods. Overconfidence might also be the reason for not correctly understanding such constraints.

- Rent-Seeking: The government can try to manipulate public policy and the economic conditions in order to increase the profits. They would fetch more profit at the expense of increased public debt.

- Short-sightedness or Myopic Behaviour

- Time inconsistencies: The government may only consider the short run profit and not include the long-run impact of current changes in public policies. This trade-off between the short and long-run increases the debt burden and favors deficit bias.

c.

Below images show the derivation:

Government Budget Constraint: Page 1 B4 -84-=7B1-, +94- Tt - 0 where Bt = Debt in year t (current years t) Bt-, - Debt in year t-1. Tt = Taxes in year t Now, Let Yt = In come in year t. t = Debt Ratio or Debt-to-4DP ratio. from equation 0, we have B4 = 7B4 + Bt-, + 9+ - Tt = (+0)87-1+9+ - Tt We divide both sides of equation by income Yt. ne no (+5) 6 1 4 ) + STATE (+1) * C*") + 9 = Tt — @ Now, let g be the % chang in y ie. g = Yt – Yt -1 VE YE- + g- Yt - 1 na ito → eye and its equation ③ we get Put Yt - in

- We know, ** ~ 1+x-y Son X (1+8+9) Betty + lei – o = 66-93 hit =+ ' Rove D Equation ® is the evolutionary equation for Debt-to-4DP Ratio. where Gt - Te = Primary Deficit → 94T Primary Deficit Ratio Deficit, higher will be the next year debt-to-GDP Higher the Primary Ratio (0)

(G - T / Y) in equation 4 shows primary budget balance as share of GDP (Y).

Current Debt-to-GDP ratio = B_t / Y_t

Existing Debt-to-GDP ratio = B_t-1 / Y_t-1

d.

To stabilize the debt ratio it is required that the primary deficit should be negligible. That is, the interest payments should not be postponed for future and be paid on time. Delay in the interest payments will increase the primary deficit of current year and increase the debt to GDP ratio of next year.

While contemplating on debt stabilization, the government faces a trade-off between minimizing the debt service cost and reducing the budgetary risk. Budgetary risk refers to the fluctuations in the budget that can impact the final tax burden.

So, there is always a trade-off between debt service cost and budgetary risk.

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