Fiscal Policy and the National Debt

Chapter 12

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Learning Objectives After this chapter, you should be able to:

1. Analyze the recessionary and inflationary gaps.

2. Calculate and apply the multiplier.

3. List and discuss automatic stabilizers.

4. Assess discretionary fiscal policy.

5. Distinguish between budget deficits and surpluses.

6. Discuss fiscal policy lags.

7. Define and differentiate between the crowding-out and crowding-in effects.

8. Assess the success of fiscal policy measures in ending the Great Recession.

9. Discuss and analyze the national debt.

10. Explain why the recovery from the Great Recession will be “jobless.”

11. Explain predictions for federal budget deficits in the future.

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Fiscal Policy Definition: the manipulation of the federal budget to

attain price stability, relatively full employment, and a satisfactory rate of economic growth.

Two sides to federal budget: Government spending (outlays) and federal tax revenue.

• Focus on level of Government spending (G), not how the funds are allocated.

• Focus on level of tax revenue (T), not using tax policy to reward certain behavior (e.g., home ownership).

• Both are responsibility of Congress and President.

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Three Options for Fiscal Policy Balanced Budget: G = T

• Government expenditures equal tax revenue for the fiscal year.

Budget Deficit: G > T• Government spending is greater than tax revenue for the

fiscal year.• Government borrows difference by issuing Treasury bonds.

Budget Surplus: G < T• Government spending is less than tax revenue for the fiscal

year. Before Keynes, economists argued government

should always balance its budget. No active fiscal policy.

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John Maynard Keynes invented fiscal policy. Problem in Depression was inadequate Aggregate Demand

for output (real GDP). Equilibrium stuck below full-employment level:

• C stays low because consumers are unemployed or cutting back. • I stays low because businesses have low profit expectations and no

incentive to expand inventories or production. • The only component of AD that the government can control is G.

Increase G to increase AD. • Or, by cutting taxes (T), government can hope consumers and

businesses will spend additional income.

Running a budget deficit could jump-start the economy.

Putting Fiscal Policy into Perspective

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Equilibrium GDP tells us the level of spending in the economy.

• Level of output at which everything produced is sold (Aggregate Demand equals Aggregate Supply).

Full-employment GDP tells us the level of spending necessary to reach full employment.

• If plant and equipment is operating at between 85 and 90% of capacity, that’s considered full employment.

• If approximately 5% of labor force is unemployed, that’s considered full employment.

Fiscal policy is used to push equilibrium GDP toward full-employment GDP.

Modeling Fiscal Policy Using Aggregate Expenditures

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Recessionary Gaps and Inflationary Gaps

Recessionary Gap occurs when equilibrium GDP is less than full-employment GDP.

• Inadequate Aggregate Demand (C + I + G + Xn)

• Fiscal Policy solution is to run a budget deficit (raise G or lower T).

Inflationary Gap occurs when equilibrium GDP is greater than full-employment GDP.

• Excess Aggregate Demand sparking inflation • “Too many dollars chasing too few goods.” • Fiscal Policy solution is to create a budget surplus (decrease

G or raise T).

Budget deficits are only appropriate during recessions.

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Questions for Thought and Discussion

Which do you think is easier politically for members of Congress and a President to do—raise taxes or lower taxes?

Which do you think is easier politically for members of Congress and a President to do—increase government spending or cut government programs?

Given your answers, which is easier politically to do—use fiscal policy to fight recessions or inflation?

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Graphing a Recessionary GapWhen the full-

employment GDP is greater than the

equilibrium GDP, there is a recessionary gap.

How much is it?

$7 trillion – $6 trillion = $1 trillion

Note that the recessionary gap is less than the gap in

output on the horizontal axis.

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Graphing an Inflationary GapWhen the full-

employment GDP is less than the

equilibrium GDP, there is an inflationary gap.

How much is it?

$200 billion

Note that the inflationary gap is less than the excess

output on the horizontal axis.

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Summary of Graphs

Recessionary Gap:• Difference between full-employment GDP and equilibrium

GDP is $2 trillion.• Recessionary gap (inadequate spending) is $1 trillion.

Inflationary Gap: • Difference between full-employment GDP and equilibrium

GDP is $500 trillion.• Inflationary gap (excess spending) is $200 trillion.

Why is gap in spending less than gap in output?• Multiplier effects

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The Multiplier and Its Applications

Any change in spending (C, I, or G) will set off a chain reaction, leading to a multiplied change in GDP.

C + I + G + Xn GDP

Size of multiplied change depends on MPC and MPS.

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Calculating the Multiplier

Remember: MPC + MPS = 1, therefore, MPS = 1 – MPC

Multiplier = 1

1 – MPC

Multiplier =1

MPS

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Calculating the Multiplier

Find the multiplier.

The MPC is 0.5.

1

1 - MPC

1

1 – .5

1

.5Multiplier = = =

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How Does the Multiplier Work? Suppose the government pays you $1,000 to write a

report as an economic consultant. The MPC in this economy is 0.5 (or 50%).

• You will spend $500 and save $500. Suppose you spend the $500 on a laptop.

• The seller of the laptop now has $500 in new income. The laptop seller spends $250 and saves $250. Suppose she spends the $250 on used text books.

• The used bookseller now has $250 in new income, so he spends $125 on concert tickets and saves $125.

• The concert promoter now has $125 in new income, so she spends $62.50 on a watch and saves $62.50.

• The watch seller now has $62.50 in new income, so he spends $31.25 buying gas and saves $31.25.

• And so on…

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Multiplier and MPC

If you add up all the rounds of spending ($1,000 + $500 + $250, etc.), you would get $2,000.

Using the formula is quicker. Question: As the MPC increases, what happens to the

multiplier? Answer: It gets bigger!

• Denominator is 1 – MPC. • If MPC increases, (1 – MPC) gets smaller.• Smaller denominator increases the number. (Hint: Compare ½

with 1/3.)

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Applications of the Multiplier The multiplier is used to calculate the impact of a

change in C, I, or G on GDP. Formula:

GDPNew = GDPInitial + (Change in spending X Multiplier)

Example: GDP = 2,500; C rises by 10; Multiplier = 3

What is the new level of GDP?

GDPNew = 2500 + (10 x 3)

GDPNew = 2500 + (30)

GDPNew = 2530Amount of increase in GDP

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Applications of the Multiplier

Formula: Change in GDP = (Change in spending X Multiplier)

Example: Multiplier = 7; G falls by $5 billion

How much will GDP decrease?

Change in GDP = 5 x 7

Change in GDP = $35 billion

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Removing the Recessionary Gap

To remove the deflationary gap, raise AD from

C+I+G+Xn

to

C1+I1+G1+Xn1

This pushes equilibrium GDP to $7 trillion (full-employment

GDP.

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Removing the Inflationary Gap

To remove the inflationary gap, lower

AD from

C+I+G+Xn

to

C1+I1+G1+Xn1

This pushes equilibrium GDP

down to 1,000 and removes the

inflationary gap.

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Automatic Stabilizers:(passively moderate business cycles)

Personal Income and Payroll Taxes• During recessions, tax receipts decline.• During inflations, tax receipts rise.

Personal Savings• During recessions, unemployed tend to use up their savings,

so we assume that saving declines. But sometimes saving increases because consumer confidence decreases, so those with jobs try to save more.

• During prosperity, we would expect that saving rises. But again, reality does not always follow the theory.

Credit Availability• Credit availability often helps get us through recessions,

enabling consumers to keep spending.• The Great Recession is different because one of its causes

was a credit crunch.

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Automatic Stabilizers:(passively moderate business cycles continued)

Unemployment Compensation• During recessions more people collect unemployment

benefits, putting a floor under purchasing power. • But only 40% of those out of work can quality for benefits in

the U.S., compared with 90% in Germany and 98% in France.

• The usual cap on US benefits is 26 weeks, much longer than in Europe. During recessions, Congress may extend the cap.

The Corporate Profits Tax• During economic boom, profits rise quickly but corporate

income taxes reduce the inflationary impact.

Other Transfer Payments• Welfare (or public assistance) payments, Medicaid

payments, and food stamps rise during recessions.

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Automatic Stabilizers reduce, but do not eliminate economic fluctuations.

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Discretionary Fiscal Policy:(under direction of Congress and President)

Making Automatic Stabilizers More Effective• Example: Extending unemployment benefits beyond 6

months.• Due to the Great Recession and the “jobless” recovery,

unemployment benefits were extended for as long as 79 weeks.

• Corporate incomes taxes can be raised during periods of inflation and lowered when recessions occur.

Public Works • New Deal programs built bridges, post offices, park trails, etc.

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Discretionary Fiscal Policy:(under direction of Congress and President continued)

Changes in Tax Rates• To fight inflation, the government can raise taxes.

This may generate a budget surplus, or at least reduce the deficit..

• To fight recession, the government can cut taxes. This may increase the budget deficit.

Changes in Government Spending• To fight recession, increase government spending.

This may increase the budget deficit.• To fight inflation, decrease government spending.

This may generate a budget surplus.

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U.S. Economic Growth Rate, 1871-2009

The U.S. economy has been more stable for most of the postwar period.

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Questions for Thought and Discussion

Are public works projects a bad idea? Cons:

• Public works projects are often labeled “pork barrel spending.”

• Members of Congress negotiate to bring spending projects to their local communities, even if it is wasteful. Some projects make headlines, like “Bridge to Nowhere in Alaska.”

Pros:• Our roads, bridges, and other public infrastructure are

crumbling. We need new public investment.• “Green-collar jobs” is the idea that government should create

jobs that improve the environment.

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Questions for Thought or Discussion

Is extending unemployment benefits a good idea? Cons:

• Unemployment benefits may be a disincentive to looking for a job.

Pros: • Extending benefits strengthens automatic stabilizers to maintain

Aggregate Demand.• People who are unemployed during a recession and jobless recovery

may not be able to find jobs through not fault of their own. • Monetary incentives are only one reason to work. Many unemployed

would rather have a job than benefits anyway, because jobs provide intrinsic rewards (like dignity, self-respect, identity, and purpose).

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Who Makes Fiscal Policy?

President submits budget to Congress.

Congress amends budget and passes individual

appropriation bills.• Both House and Senate have to reconcile differences between

their versions.

President can accept or veto.• If vetoed, Congress can try to override.

Fiscal Year begins October 1st.

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Fiscal Policy Lags Fiscal Policy takes time due to three types of lags (or

delays):• Recognition lag: Policy makers must identify that there is a

problem. (Recessions only declared after 6 months, at minimum.)

• Decision lag: President and Congress must agree on policy approach and pass legislation.

• Impact lag: It takes time for their actions to have effect.

Changing Aggregate Demand through fiscal policy is more like navigating a super-tanker than driving a car.

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Policy Lags and The Great Recession

President Bush used fiscal policy to stimulate the economy in response to The Great Recession:

• Recognition lag: Although there were strong signs of an economic slowdown during Fall 2007, the Bush administration and many members of Congress did not use the word “recession” until the unemployment rate rose to 5.0% in January 2008.

• Decision lag: The Bush administration and Congress took just a few weeks to agree to a $168 billion economic stimulus package that focused on taxpayer rebates (tax cuts).

• Impact lag: The IRS did not mail out the rebates until May 2008. And many people used the rebates to pay down det rather than increasing spending. It was too small to have much of an impact.

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The Economic Stimulus Package of 2009

President Obama passed a $787 billion stimulus package.• It included $287 billion in tax cuts and $500 in government spending.

$233 billion in tax cuts for individuals and families $106 billion for education and job training, including aid to states to

prevent cutbacks and layoffs $87 billion to states for increased Medicaid costs $78 billion for programs for jobless workers $48 billion for highway and bridge construction and mass transit $44 billion for energy programs, modernization of electric grid $41 billion for other infrastructure and environment projects $29 gillion for health, science, and research $21 billion for energy investments $20 billion to expand food stamp benefits

• By end of 2009, only 1/3 of funds had entered the economy.

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Questions for Thought or Discussion Was the 2009 Stimulus Package effective?

• Great Recession ended during the summer. But the unemployment rate is still high.

• It may have averted layoffs, especially by state and local governments. • Additional funds spent in 2010 and 2011 may support more job creation.

Was the deficit too big? • FY 2008 budget deficit was $459 billion.• FY 2009 budget deficit was $1.4 trillion.

But it was only 9.8 percent of GDP. In 1944, the budget deficit was 24.5 percent of GDP.

How was the Chinese stimulus plan different?

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The Deficit Dilemma

Discussion Question: How did the government get rid of deficits in the 1990s? What led to the return of deficits after 2000? In 2009?

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Why Are Large Deficits Bad?

Large deficits are problematic:1. Government borrowing pushes up interest rates.

2. Deficit is increasingly financed by foreign savers, giving U.S. less control over financial markets.

3. Money used to invest in government bonds is not being used to finance private sector investment.

Conclusion: We don’t need to balance the federal budget every year, but deficit spending has limits.

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Monetarists vs. Keynesians

Monetarists emphasize “crowding out”

Any expansionary impact of budget deficits will be offset by higher interest rates and crowding out private sector borrowing.

Go back to “Laissez-Faire” policy of Classical economics!

Keynesians emphasize “crowding in”

Stimulus of increased government spending or tax cuts will encourage consumption and investment.

Government “primes the pump” to get the private sector growing again.

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The Public Debt

Difference between Deficits and Debt• Deficits occurs when federal government spending is greater than

tax revenue in a single fiscal year. • Debt is the cumulative total of all the federal budget deficits less

any surpluses.

Example: • Suppose that our deficit declined one year from $200 billion to

$150 billion. The national debt would still go up by $150 billion. So every year that we have a deficit—even a declining one—

the national debt will go up.

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Percentage of National Debt Publically Held and Held by U.S. Government Agencies, 2010

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The National Debt: 1980—2010*Debt on January 1 of each year.

Portion held by USgovernment agencies

Portion held by public

Budget surpluses in 1990s led to decreases in public portion of debt.Source: Economic Report of the President, 2010.

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The U.S. National Debt as Percentage of GDP, 1980—2010

Since 1980, our debt has doubled as a percentage of GDP.

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When do we have to pay off the Public Debt?

We don’t. All we have to do is roll it over, or refinance it, as it falls due.

• Each year about $4 trillion dollars worth of federal securities fall due.

• By selling new ones, the Treasury keeps us going.

But even if we never pay back one penny of the debt, our children and our grandchildren will have to pay hundreds of billions of dollars in interest.

• At least to that degree, the public debt will be a burden to future generations.

• But it will also be income to Americans, since we owe much of it to ourselves.

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Questions for Thought and Discussion

Baby Boomer retirements will increase outlays for Social Security and Medicare. (Both programs now run surpluses each year.)

What are the options to avoid massive budget deficits when Boomers retire?

• Raise payroll taxes or eliminate the earnings cap on social security taxes to increase revenue (T).

• Raise retirement age or cut benefits to reduce spending (G).• Combine both approaches.• Which would you recommend?