Fiscal Policy, Deficits, and Debt

30

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

AGENDA Thurs 3/10

• Team Teaching: CH 30

– P3: Amanda, Jeyla, Joseph, Vanessa

– P5: Ms. K (yep, once again)

• On Deck: CH 31-32 (Tues)

– P3: Allan, Ezra, George

– P5: Ms. K (surprised??) • QOD #21 : Crowding Out

• Fiscal Policy & Stabilizers

• HW: Read pp 636-650 Q#2,3,4, 7, 8 (DUE Tues 3/15)

– Read pp 655-667 Q#4,5,6 (Due Thurs 3/17)

LO1 29-2

QOD #21 :Crowding Out

• Suppose that the investment demand curve in a

certain economy is such that investment declines by

$100 billion for every 1 percentage point increase in

the real interest rate.

• Also, suppose that the investment demand curve

shifts rightward by $150 billion at each real interest

rate for every 1 percentage point increase in the

expected rate of return from investment.

• If stimulus spending (an expansionary fiscal policy)

by government increases the real interest rate by 2

percentage points, but also raises the expected rate

of return on investment by 1 percentage point, how

much investment, if any, will be crowded out? LO1 30-3

QOD #21 :Crowding Out Solution

• The increase in the interest rate would reduce

investment by $200 billion (= 2 x $100 billion), but the

increased rate of return would increase investment by

$150 billion (= 1 x $150 billion), so the combined

effect of the stimulus spending would be $50 billion of

crowding out (= $200 billion – $150 billion).

LO1 30-4

Fiscal Policy

• Deliberate changes in:

•Government spending

• Taxes

• Designed to:

•Achieve full-employment

•Control inflation

•Encourage economic growth

LO1 30-5

Expansionary Fiscal Policy

• Use during a recession

• Increase government spending

•Decrease taxes

•Combination of both

•Create a deficit

LO1 30-6

Expansionary Fiscal Policy

Real GDP (billions)

Pri

ce level

AD2

AD1

$5 billion increase in spending

Full $20 billion increase in aggregate demand

AS

$490 $510

P1

LO1

Recessions

Decrease AD

30-7

Contractionary Fiscal Policy

• Use during demand-pull inflation

•Decrease government spending

• Increase taxes

•Combination of both

•Create a surplus

LO1 30-8

Contractionary Fiscal Policy

Real GDP (billions)

Pri

ce level

AD3

AD4

$3 billion initial decrease in spending

Full $12 billion decrease in aggregate demand

AS

$502 $522

P2

AD5

$510

d b

a P1

c

LO1 30-9

Policy Options: G or T?

• To expand the size of government

• If recession, then increase

government spending

• If inflation, then increase taxes

• To reduce the size of government

• If recession, then decrease taxes

• If inflation, then decrease

government spending

LO1 30-10

Built-In Stability

• Automatic stabilizers

• Taxes vary directly with GDP

• Transfers vary inversely with GDP

• Reduces severity of business

fluctuations

• Tax progressivity

•Progressive tax system

•Proportional tax system

•Regressive tax system LO2 30-11

Built-In Stability

G

T

Deficit

Surplus

GDP1 GDP2 GDP3

Real domestic output, GDP

Go

vern

men

t exp

en

dit

ure

s, G

, an

d t

ax r

even

ues,

T

LO2 30-12

Fiscal Policy: The Great Recession

• Financial market problems began in

2007

• Credit market freeze

• Pessimism spreads to the overall

economy

• Recession officially began December

2007 and lasted 18 months

LO4 30-13

Problems, Criticisms, & Complications

• Problems of Timing

•Recognition lag

•Administrative lag

•Operational lag

• Political business cycles

• Future policy reversals

• Off-setting state and local finance

• Crowding-out effect

LO4 30-14

Current Thinking on Fiscal Policy

• Let the Federal Reserve handle short-

term fluctuations

• Fiscal policy should be evaluated in

terms of long-term effects

• Use tax cuts to enhance work effort,

investment, and innovation

• Use government spending on public

capital projects

LO4 30-15

The U.S. Public Debt

• $11.9 trillion in 2009

• The accumulation of years of

federal deficits and surpluses

• Owed to the holders of U.S. securities

• Treasury bills

• Treasury notes

• Treasury bonds

•U.S. savings bonds

LO4 30-16

The U.S. Public Debt

LO4

Debt held

outside

the Federal

government

and the

Federal

Reserve:

57%

Debt held by

the Federal

government

and the

Federal

Reserve:

43%

30-17

Global Perspective

Public Sector Debt as

Percentage of GDP, 2009

Italy

Japan

Greece

Belgium

France

United States

France

Germany

United Kingdom

Spain

Netherlands

Canada

0 20 40 60 80 100

Source: Organization for Economic Cooperation and Development, OECD

LO4 30-18

The U.S. Public Debt

• Interest charges on debt

• Largest burden of the debt

• 1.3% of GDP in 2009

• False Concerns

•Bankruptcy

•Refinancing

•Taxation

•Burdening future generations

LO4 30-19

Substantive Issues

• Income distribution

• Incentives

• Foreign-owned public debt

• Crowding-out effect revisited

• Future generations

•Public investment

LO4 30-20

Crowding-Out Effect

5 10 15 20 25 30 35 40 0

2

4

6

8

10

12

14

16

Real in

tere

st

rate

(p

erc

en

t)

Investment (billions of dollars)

ID1

ID2

a

b c

Increase in

investment

demand

Crowding-out

effect

LO4 30-21