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1. 1
Chapter 3
Fiscal Deficits, Public Debt,
and The Current Account
© Pierre-Richard Agénor
The World Bank

2. 2
 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

3. 3
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).

4. 4
Structure of Public Finances
 Conventional Sources of Revenue and
Expenditure
 Seigniorage and Inflationary Finance
 Quasi-Fiscal Activities and Contingent Liabilities

5. 5
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.

6. 6
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8. 8
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.

9. 9
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11. 11
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14. 14
 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.

15. 15
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17. 17
 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.

18. 18
 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).

19. 19
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.

20. 20
 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 .

21. 21
 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.

22. 22
 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.

23. 23
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24. 24
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25. 25
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.

26. 26
 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.

27. 27
 Bailout of troubled commercial banks: central
bank provides an infusion of capital in troubled
banks, or directly takes control of some of the
nonperforming assets of problem banks.
 Sterilization operations : central bank pays
interest on its liabilities at a rate higher than the
one earned on the foreign exchange reserves that
it chose to accumulate.
Examples of the importance of quasi-fiscal
deficits: Chile and Argentina.
 Monetary authorities in both countries extended
emergency loans to financial institutions and
suffered large losses from exchange rate
guarantee programs.

28. 28
 Consolidated quasi-fiscal deficits averaged more
than 10% of GDP a year in Chile.
 In Argentina, quasi-fiscal deficits of the consolidated
public sector were roughly as large as
conventionally-measured deficits; together they
averaged 25% of GDP a year.
 Quasi-fiscal activities lead to the creation of
contingent implicit liabilities (obligations that the
government is expected to fulfill, although required
outlays are typically uncertain before a failure
occurs).

29. 29
 Contingent explicit fiscal liabilities: obligations
that the government is legally compelled to honor if
the entity that incurred them in the first place cannot
do.
 Because of severe distortionary effects of
contingent liabilities together with direct liabilities on
the allocation of resources, eliminating or reducing
the scope of quasi-fiscal activities is a key objective
of macroeconomic management.

30. 30
The Government Budget
Constraint

31. 31
 Budget constraint:
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.
G - (TT+TN) + iB-1+ i*EBg-1 = Lg + B +
EBg
*
*
(2)

32. 32
 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 .

33. 33
 Then (2):
D + iB-1 + i*EBg-1 = Lg + B + EBg (3)
* *
 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).

34. 34
 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).

35. 35
Difference between conventional balance
and operational balance:
 Assume B* = 0. Equation (3) becomes:
D + iB-1 = Lg + B.
 Divide both sides by P:
d + i(P-1/P)b-1 = (Lg/P) + (P-1/P)(B/P-1),
(4)
d: real primary deficit;
b: real stock of government bonds.

36. 36
 After some calculations:
d + rb-1 = (Lg/P) + b, (5)
r = [(1+i)/(1+)] - 1: real interest rate.
 Left hand side of (4): nominal deficit deflated by the
price level P.
 Left hand side of (5): total deficit in real terms.
 Comparing these two: simply deflating the
conventional fiscal balance by current prices leads
to an overestimation of the real deficit by the
amount:
[/(1+)]b-1.

37. 37
 This represents the compensation to creditors for
the falling real value of their claims on government
caused by inflation.
 To see the difference: In Brazil, for example,
conventional deficit 27.3%, operational deficit 4.5%,
primary deficit -0.5% in 1988.
 Figure 3.7: sharp differences between operational
and primary balance.
 Operational deficit becomes problematic when
inflation is highly variable, because of difficulties in
measuring and interpreting real interest payments.
 Inflation may also affect noninterest expenditure
and revenue, thus all three measures of fiscal
deficits.

38. 38
F
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39. 39
 It can reduce real revenue in the presence of
collection lags (Olivera-Tanzi effect).
 Lag between the time tax payments are assessed
and the time they are collected by the fiscal
authorities.
 If n is collection lag (in months),  monthly inflation
rate, the amount by which real revenue drops is:
(1+ )-n-1.
 If n = 1 and  = 10%, drop in revenue = 9.1%.
 In a high-inflation environment, the effect of inflation
on the interest bill tends to exceed its effect on
spending and revenue.

40. 40
Assessing the Stance of
Fiscal Policy

41. 41
 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.

42. 42
 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.

43. 43
 Structural budget deficit:
DS = GS - TS = G(1 - GGAP)
- T(1 - TGAP),
G and T : elasticities of expenditure and revenue.

44. 44
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.

45. 45
 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.

46. 46
 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.

47. 47
 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.

48. 48
 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.

49. 49
 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:

50. 50
 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.

51. 51
Fiscal Imbalances and
External Deficit

52. 52
 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.

53. 53
 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.

54. 54
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55. 55
Consistency and
Sustainability
 The Consistency Framework
 Fiscal and External Sustainability

56. 56
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.

57. 57
 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.

58. 58
 Government budget constraint:
D + iB-1 + i*EBg-1 = Lg + B + EBg (8)
* *
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.

59. 59
 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)

60. 60
 Balance sheet of central bank:
Assets Liabilities
Lg
ER*
CU
RR
NWcb
} M
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.

61. 61
 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

62. 62
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.
 After rearrangements:
D + iB-1 + i*EB-1 = B + EB* + M (12)
*

63. 63
 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.

64. 64
 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.

65. 65
 r and r* are defined such that
1 + r = (1 + i)/(1 + );
1 + r* = (1 + i*)/(1 + *).

66. 66
 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
= b + (z/z-1)(zb*) + m + (/(1+ ))m-1.
*
^
(17)

67. 67
 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;
~
 value of , that is consistent with a given total
debt-to-output ratio and a target for the primary
fiscal deficit.

68. 68
 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).
* *

69. 69
 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
+ (/(1+ ))m-1/y.
*
(18)
*
~
~

70. 70
 For given values of r and r*, z, g, , and a properly
specified money demand function equation (18)
determines the financeable primary deficit:
^ ~
 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:
^
= - (r - g)b-1/y - (r* + z - g)zb-1/y
+ m/y + (/(1+ ))m-1/y.
*
~
~
f
d
y

d
y f
d
y
a
d
y
= -

71. 71
 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;

72. 72
 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.

73. 73
 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.

74. 74
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.

75. 75
 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.

76. 76
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).
 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.
 Assume b* = 0, g = 0.02,  = 0.63, r = r* = 0.04, d/y
= 0.04 and targeted debt-to-output ratio = 0.1.
~

77. 77
 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.

78. 78
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.

79. 79
 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.

80. 80
 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.

81. 81
Sustainability
and the Solvency Constraint

82. 82
 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.

83. 83
 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.

84. 84
 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.

85. 85
b0= [(1+g)/(1+r)]h(sh-dh)
+[(1+g)/(1+r)]NbN.

h=1
N
 Assume constant r and g and solve (20)
recursively forward from period 0 to N:
 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.

86. 86
b0  [(1+g)/(1+r)]h(sh - dh) . (23)

h=1
N
 Suppose N is the relevant terminal date.
Solvency constraint requires:
bN  0.
 Solvency constraint:
 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.

87. 87
 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.

88. 88
 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);

89. 89
 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.

90. 90
 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.

91. 91
Commodity Price Shocks
and Fiscal Deficits

92. 92
 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.

93. 93
 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).

94. 94
 Designing contingency mechanisms and
institutional structures that are capable of ensuring
that governments engage more in expenditure
smoothing.

95. 95
Public Debt and Fiscal
Austerity

96. 96
 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.

97. 97
 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.