Government Debt And Macroeconomic Effects: Analysis

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Government debt and macroeconomic effects:Analysis with real-financial CGE modelTahar ABDESSALEM 1Imen BENNOUR SMIDA 2AbstractThe aim of this paper is to show how choosing modalities to finance public deficit, such as,financing by bonds or monetary financing, affects the real economy and income distribution.General equilibrium analysis is most appropriate to simulate the medium and long termeffects of different funding policies of government debt and to identify the differenttransmission channels on the real economy.This work lies indeed among recent attempts of modelling financial aspects in a computablegeneral equilibrium model (CGEM). "Standard" walrasien model was extended by taking intoaccount monetary and financial dimension.So, our contribution consists in proposing a recursive dynamic general equilibrium model,whose real part is Walrasian type. The real part of the model allows generating savings ofeach agent. Allocation of savings among different assets determines the money marketequilibrium.Thus, the closure rule between savings and investment is not neoclassical since investmentdoes not automatically adjust to savings. Moreover, investment of firms and of thegovernment will be financed by domestic and foreign borrowing. For this reason, allocation ofhousehold savings and borrowings of firms and government will be treated in the financialpart of the model.Keywords: computable general equilibrium model, government debt, financialassets, macroeconomic policies.JEL Classification : D58, C68, E621Professor in Quantitative Methods, Faculté des Sciences Economiques et de Gestion de Tunis (FSEG) andHead of Economics and Industrial Management Laboratory (LEGI-EPT). E-mail: [email protected] student at Tunisia Polytechnic School, a member of Economics and Industrial ManagementLaboratory (LEGI-EPT). E-mail: [email protected]( contact person).1

1. IntroductionTheories about the economic role of the state have always been subject to economic andpolitical controversies. The need of state intervention in the regulation of economic activityhas been justified by the fact that market economy can not spontaneously solve someeconomic and social problems.This idea argued for the first time by Keynes (1936), following the overproduction 1929’scrisis, gives the state a stabilizing role during the recession period. This goal is achieved byexpansionary policies which affect the effective demand and subsequently determine the levelof output and employment.Thus, Keynes suggests a short-term increase of public expenditures to stimulate economicgrowth and to contribute to of unemployment’s reduction, through the multiplier effect.If the state finances additional expenditures by higher taxes, the stimulating effect on demandcan be cancelled; that’s why Keynes proposes a counter-cyclical variation of budget deficit.According to him, the budget deficit is chronic or temporary (short-term analysis).The crisis of the 1970s, characterized by the growing indebtedness of the government as wellas by high unemployment and inflation (stagflation), resists to Keynesian stimulus policieswhich are unable to pull the economy out of durable crisis.This situation favours a return to liberal principles, mainly with the permanent income theoryof M. Friedman who demonstrated that interventionist policies are ineffective anddestabilising. Furthermore, financing budget deficit by borrowing leads to an eviction effecton the private investment.Starting from the same liberal logic, the Ricardien equivalence theory3 asserts that the budgetdeficit is neutral without any multiplier effect on the demand, and the effect of the budget deficitincrease is independent from the way it is financed.According to this approach, financing deficit by loans brings rational individuals to anticipate thefuture taxes increase, in order to save more. Also, if the financing is monetary, the individuals willrationally anticipate the erosion of their cash money.3Barro, R.J.(1974). Are government bonds net wealth?, Journal of Political Economy2

During the 1980s, the International Monetary Fund (IMF) has established sets of policiesto reduce macroeconomic imbalances through the public sector reduction in favour of privatesector.In this context, developing countries, such as Tunisia, have adopted structural adjustmentprogrammes so as to improve the competitiveness of the economy in order to it’s progressiveintegration within the global economy.As a consequence, the government budget has not ceased to be modified following theprogressive abolition of tariffs and hence the decrease of an important part of the fiscalrevenues.The paper is organised as follows. Section 2 below discusses the issue, methodology andgives an overview of theoretical literature. Section 3 presents the model characteristics.Section 4 discusses macroeconomic closure rule of the model and, finally, some conclusionsin the last section.2. Research problem and MethodologyGeneral equilibrium analysis is the most appropriate to simulate medium and long termeffects of different funding policies of government debt and to identify the differenttransmission channels on the real economy.To develop our model, we relied on the theoretical literature of financial computable generalequilibrium models (FCGEM). There are two approaches to modelling. The first isneoclassical4, developed by researchers at the World Bank. It is based on a combination ofmicroeconomic modelling, with a Walrasian foundation , and a macroeconomic modellingbased on the IS-LM model for endogenous determination of asset prices. In line with thismodel, there are models developed by Bourguignon, Branson and de Melo (1989), Fargeixand Sadoulet (1990) to analyze the structural adjustment effects on income distribution, andthe work of Lewis (1992) to study the impact of financial liberalization.The second is the structuralist approach, inspired by the work of Rosensweig and Taylor(1984.1990), which considers the structural characteristics of economies and theirspecificities. Thus, the CGE structuralist type views that markets do not work perfectly andassumes the possibility of disequilibrium in one or more markets. Yeldman (1997) introducesin his model the portfolio choice of agents and shows that savings generated from the real4Bourguignon, F., Bransonb, W. et De Melo, J.(1989):" Macroeconomic adjustment and incomedistribution: a macro- micro simulation model". For these models the emphasis is on money: the intersectionbetween money supply and money demand determine the general level of prices.3

side is the deposits of banks that will finance investment, which connects the real andfinancial economies.From their side, Nasstepad (2002), Easterly (1990) and Vos (1998)5 focus on the impact ofbudget deficit on the availability of credits, output and prices. They introduce creditconstraints considering that the rate of interest is administered by the State, reflecting asituation of financial repression. In these models, the link between real and financial submodels lies in demand and supply of credits that depend on production and investmentpolicies. If the supply of credit is sufficient, investment is exogenous. Otherwise, theinvestment is endogenous and the excess of demand is absorbed by credit rationing.These theoretical lessons will help us build a financial computable general equilibrium modelfor Tunisia which should answer questions about the effect of alternative budget deficitfinancing policies.3. Specification of the theoretical model3.1 The real side of the modelIt is a computing general equilibrium model with financial assets whose real part is based onthe walrasien spirit and financial part inspired from Rosensweig and Taylor’s (1990) model.Specificities of the behaviour of both financial institutions and economic agents form themain difference from the latter. Additionally, our model is dynamic recursive without anyanticipation mechanism, which means that it is solved for static equilibrium sequence of oneperiod, linked by dynamic equations of capital and assets.The model includes six agents: households (including individual enterprises), private firms,government, commercial banks, Central Bank and the rest of the world.3.1. Production and EmploymentThe economy consists of three sectors of production indexed by i: agriculture, industry andpublic services. For each sector if, production technology is nested, characterized by aninput-output production function, à la Leontief, and a CES function for production factors:capital (K) and labor (L), which satisfies the standard conditions of constant returns to scaleneoclassical production functions with.5In these models the credit channel links the real and financial side of the economy.4

3t equationsThe total production per sector i is the ratio of the added value and the respective fixedtechnical coefficient ai.3t equations0 ai 1WithIntermediate consumption by production sector i:3t equationsTotal intermediate consumption demand per sector i:CI i ,t9t equationsCI j ,tjProducers are assumed to maximize profits given their technology and the prices ofinputs and outputs. In The short-term the capital is supposed to be fixed and productiondepends only on labor.Labor market is competitive; labour supply is assumed to be exogenous and the demand forlabor is given by the first order conditions of profit maximization, where the wage rate equalsthe marginal productivity of labor.rw 1LDi ,t11K i ,t3t equationsis the elasticity of substitution between capital and labor; r and w are respectively thecapital and labor prices.The gross operating surplus (returns to capital by producing sector i):RK i ,t PVAi ,tVAi ,twLDi ,t3t equations5

3.1.2 Foreign tradeOn the demand side, imports and domestic outputs are treated as imperfect substitutes, by thespecification of Armington (1969), using CES functions.2t equationsWith Q being the composite good, M the imported and D the produced locally,the share1of imports in demand of good i and mthe elasticity of substitution (or elasticity1maggregate) of the CES function.Optimal mixes between imports and domestic outputs are achieved through expenditureminimization, given prices of imports and of domestic sales and subject to the CES function.The first order solution determines the import function of relative prices of foreign goods andgoods produced in the domestic market:mPnD,tM n,tPnM,tm(1)Dn,t2t equationsThe price of the composite is a weighted average of domestic prices and prices of importedgoods:Mcn ,tPPn M n ,tDPn Dn ,t2t equationsQn ,twith2t equationsThe domestic currency price of imported goods is obtained by adjusting the world price bythe exchange rate ,the import tariff rate,and indirect taxation .6

On the offer side, tradable goods are allocated either to exports or to domestic sales, andimperfect transformability between these two, are reflected through Constant Elasticity ofTransformation (CET) functions that assume the following form:2t equationsDomestic production is totally divided with imperfect substitution among products sold in thedomestic market and products intended to the foreign market. Thus, it is assumed that theproducers do not specialize in only one market. Optimal mixes between exports and domesticsales are achieved through the profit maximization of firms which behave as perfectcompetitors in the goods markets, taking prices of exports and of domestic sales as given andsubject to the CET functions.The export volume is given by the first order condition:eDPtEPtEX n,tWith1XDn,t2t equations1the CET elasticity of transformation.1eWe assume that the country is price-taker on the international market, thus the world prices ofeimported and exported goods are exogenous . The domestic currency prices of these goods areobtained by adjusting the world prices with the exchange rate and export tariffs:1t equationTrade balance is written as:1t equationTherefore, the current account balance is:BOC tBCOM t TRG ,t T RM ,t i EE ,t CE E ,t i EG ,t CE G ,t3.1.3 Income and savings71t equation

Household receives income from labour, capital, transfers and its portfolio YPm .tYmtwtDLtdivRKtNTgm ,teTrm,tTmr ,ti D D M ,ti B BTM ,t1t equationThe model assumes that the household is a net lender, and that his decision to savings isindependent of its consumption decision. This representative household first determines theshare of disposable income (YDM) to be allocated to savings. Then he assigns the remainingincome to consumption:1t equationSmtpmst YDmtCmtYDmt1t equationSmt1t equationThe marginal propensity to save (pms) is endogenous, related to average yield of householdportfolio.Private firms’ income consists of capital income and capital transfers. What remains fromtheir income after paying taxes and interest payments on loans for investment purposes,constitutes firms’ saving.YetRK t1t equationTGE ,tSe t Ye t - (t RK,t div t ) RK t - i C,t CD E, t - TER,tN- ei EE, t CE E ,t1t equation3.1.4 Public BudgetThe review of financing modalities of the public deficit requires beforehand a description ofTunisian public finance .The state revenues consist in direct taxes on labor income, corporate profits taxes and indirecttaxes on consumption; another part of its income consists of non-tax revenue mainly fromprivatization (transfers from private companies) and foreign grants (transfers incoming).8

YGtNt m ,tYmtTAXM tNt rk ,tNTAXE tRK tetITrg ,tTAXX tTeg ,t1t equationWe assume a balanced public budget in the basic situation. Therefore, the State financesthese expenditures Gt (these are all purchases of durable goods and unsustainable nature ofcurrent record without public investment) and transfers through the tax revenue.Thus, public investment is a decision variable in the model which will be financed by the useof debt; this means that the budgetary savings at time t must take into account the interestpayments of the debt:SG , tYG, t - G t