Chapter 15

The Eect of the National Debt on Capital and Savings

we can calculate a change in wealth for changes in endowments and taxes as: y2 2,t+1 wt = y1 1,t + , r In this problem, only 1,t has changed. Here, 1,t = 100 since there is a tax cut. We see, then that wt = +100. An increase in wealth causes c1,t and c2,t+1 to both increase if they are normal goods. Since there have been no changes in second-period taxes, for c2,t+1 to increase, savings must increase. Recall that st = kt + bt . Since the tax cut is completely nanced by bond issue, we know that bt = 100. Furthermore, since c1,t has increased, the change in savings must be less than the tax cut (some of the tax cut gets spent on rstperiod consumption). We see that kt + bt < 100 kt + 100 < 100 kt < 0.

There is crowding out of capital. This lower level of capital means there will be less output next period. Example 15.2 In this problem, the bonds will be retired in the following period by a tax increase. Since 100 units of bonds are issued in period t, the government must raise taxes by 100r units per old person next period

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(assuming the population is constant). The eect on wealth is: wt = y1 1,t + y2 2,t+1 r

= 0 (100) +

0 100r = 100 100 = 0. r

Since there is no change in wealth, there will be no change in c1,t or c2,t+1 . The entire tax cut will be saved (st = 100). Furthermore, st = kt + bt = 100 kt + 100 = 100 kt = 0.

There is no crowding out of capital. This scenario illustrates the Ricardian equivalence theorem. Equivalence occurs because the individuals enjoying the tax cut are also the ones who have to pay it back. Exercise 15.1 (a) To just pay o the government debt in the following period, xg must be such that 100xg 100r = 100x. If xg < x, then the capital project will not fully pay o the interest on the debt that was issued to nance the project. (b) We need to determine what eect this has on wealth. We can calculate a change in wealth for changes in endowments and taxes as: y2 2,t+1 wt = y1 1,t + , r In this case, one 2,t+1 changes. The tax cut will be equal to 100xg , so that the change in wealth is wt = (100xg ) 100xg = . r r

Here r = x. Since in this case, xg = x = r, we see that wt = 100. Since the wealth eect is positive, consumption in both periods increases. For consumption to increase in the rst period of life, savings must fall. We see then that st = kt + bt < 0 kt + 100 < 0 kt < 100.

The government project crowds out private capital. (c) When xg > x = r, the change in wealth is positive and larger than in part b. Hence, consumption increases in both periods of life and the increases are larger than in part b. For rst-period consumption to increase even more, savings must fall by an even larger amount than in part b. This implies that even more private capital is crowded out in this scenario.

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Exercise 15.2 (a) When young, the individual uses the endowment (y = 100) to consume or create capital, so that the budget constraint of a young person born in period 1 is: c1,1 + k1 y c1,1 + k1 100.

In this simple scenario, savings when young consists entirely of purchases of capital (s1 = k1 ). When old, the returns from savings (capital) are used to nance second-period consumption: c2,2 xk1 . Solving the second-period constraint for k1 and substituting into the rst period constraint yields the lifetime budget constraint of an individual born in period 1: c1,1 + c2,2 y. x

(b) The assumption on utility implies that one-half of the endowment is saved so that s1 = k1 = 100/2 = 50. From the rst-period constraint, we see that rst-period consumption is c1,1 = y k1 = 100 50 = 50. Second-period consumption is c2,2 = xk1 = 50x. (c) GNP is period 2 is the sum of the total endowment and the total returns from capital created in the previos period: GNP2 = N2 y + xN1 k1 = 100N2 + 50xN1 . (d) The government debt must oer the same rate of return as private capital for people to be willing to hold it. This implies te rate of return on government debt (r) must be such that r = x. The budget constraint of a young person in period 1 is modied to reect the holdings of government debt: c1,1 + k1 + b1 y. Now savings consists of capital holdings and bondholdings (s1 = k1 + b1 ). The budget constraint of an old person in period 2 becomes c2,2 xk1 + rb1 = x(k1 + b1 ) (since r = x).

Solving the second-period constraint for k1 + b1 and substituting into the rst-period constraint, we obtain the lifetime budget constraint c2,2 c1,1 + y, x which is identical to the lifetime budget constraint of part a. 87

(e) As before, the assumption on utility implies that one-half of the endowment is saved, so that s1 = k1 + b1 = 50. We also know that the government debt issue per young person is 10 goods, so that b1 = 10. This implies the capital holdings of a young person are k1 = s1 b1 = 50 10 = 40. The capital holdings of a young person have been reduced. Total savings of this generation have not changedmerely the mix of savings has changed, with less capital begin created. This lower capital, of course, aects output in the following period, as we see in the next part of this problem. (f) Total GNP in period 2 is now GNP2 = N2 y + xN1 k1 = 100N2 + 40xN1 . Comparing this to the expression for GNP in part c, we see that GNP in period 2 falls due to the lower capital stock. Since the debt is rolled over in period 2, each young person in period 2 must hold government debt equal to b2 = rb1 = xb1 = 10x. (g) Only if future generations can avoid an increase in their taxes to pay o the outstanding government debt can their consumption remain unaected. This is only possible if the government can roll over the debt perpetually. We know from Chapter 13 this can only occur if the economys growth rate exceeds the real interest rate on government debt (i.e., n > r = x). (h) Now debt is not issued, but the one-time government expenditure is nanced by a lump-sum tax (1 = 10 goods) on the current young. The budget constraint of a young person in period 1 is c1,1 + k1 y 1 . The budget constraint of an old person in period 2 becomes c2,2 xk1 . Solving the second-period constraint for k1 and substituting into the rst-period constraint yields the lifetime budget constraint c2,2 c1,1 + y 1 . x (i) We know that the tax imposed on each young person in period 1 is 1 = 10. The assumption on utility implies that one-half of the after-tax endowment is saved so that s1 = k1 = (100 10)/2 = 45. From the rst-period constraint, we see that rstperiod consumption is c1,1 = y 1 k1 = 100 10 45 = 45. Second-period consumption is c2,2 = xk1 = 45x. As we would expect, consumption falls in each period of life due to the decline in wealth. Capital holdings of this generation fall relative to those in part b. Output in the following period will also fall relative to part c. 88