Question

1.) What are the public and private budget constraints? Use both to derive the national budget constraint

2.) Derive the alternative measures of the current account and show that they are equal

3.) assume that Xa=200 Ma=70 S^p=5 and I=120 what is the value of S^g

4.) Explain why there is no balance-of-payments problem if a country adopts a system of flexible exchange rates and its central bank allows clean floating of the foreign exchange rates.

Answer 1

Public:

government expenditure

• primary spending

• consumption (teachers, pharmaceuticals, soldiers)
• investment (schools, hospitals, tanks)

• interest payments on government debt

government revenue

• taxation

• direct (income tax, national insurance)
• indirect (corporation tax, VAT, excise duties)

government budget constraint

• government budget deficit = spending – revenue

• spending = primary spending + interest payments

• revenue = taxation – transfer payments = net taxation

• deficit = primary deficit + interest payments

• B = G – T + rD • government debt, D_t = D_t-1 + B_t

• how is the deficit financed?

• bond sales to the private sector or the central bank (money creation)

• government inter-temporal budget constraint

• G₁+G ₂/(1+r) = T₁ + T ₂/(1+r)

• PV spending = PV taxation

Private
Consumers’ inter-temporal budget constraint:

• C₁+C ₂/(1+r) = YD₁ + YD ₂/(1+r)

• but YD = Y – T, so

• C₁+C ₂/(1+r)=(Y₁-T₁)+(Y ₂-T ₂)/(1+r)

• C₁+C₂/(1+r)=Y₁+Y ₂/(1+r)-T₁-T ₂/(1+r)

This assumes that consumers are rational, not creditconstrained; are infinitely lived; and that consumers and government can borrow and lend at same interest rate.

national budget constraint

• We know that GNP = GDP + net external income

• GNP = GDP + rF + TP

• GNP = Y = C+I+G+CA = C+I+G+PCA+rF+TP

• present value of total domestic spending must equal the present value of GDP + value of initial foreign assets

• C₁+I₁+G₁+(C ₂+I ₂+G ₂)/(1+r)=GDP₁+GDP _2/(1+r)+F ₀

• no country can run a persistent deficit or surplus. A current deficit implies a surplus in future, and vice-versa.

2) Alternate measures of current account

The Current Account comprises the visibles account (trade in goods) and the invisibles account (trade in services plus net external investment income plus net transfer payments).

current account = primary current account + net external income (investments + employment) + net transfer payments

• CA = PCA + rF + TP

• primary current account = output – absorption

• PCA = GDP – (C+I+G) = X-M

• primary current account = trade in goods + services

• A current account deficit must be financed by a capital account surplus.

3) We know that  

But, S = S_p + S_g

and NX = X - M

So, 5 + S_g - 120 = 200 - 70

So, S_g = 245