Fiscal Policy, Deficits, and Debt

Chapter 13

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives

• Purposes, tools, and limitations of fiscal policy

• Built-in stabilizers and the business cycle

• The standardized budget and U.S. fiscal policy

• U.S. public debt

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Fiscal Policy

• One major function of the government is to stabilize the economy by preventing unemployment or inflation

• This stabilization can be done by manipulating the public budget–By adjusting the spending and tax

collections of government, they can increase output and employment to reduce inflation

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Fiscal Policy

• Discretionary fiscal policy refers to the deliberate manipulation of taxes and government spending by Congress to change domestic output and employment, control inflation and stimulate growth

• “Discretionary” means the changes are at the option of the Federal government

• Discretionary fiscal policy changes are often initiated by the President, on the advice of his economic advisors

Fiscal Policy

There are some fiscal policy changes that do not result from congressional action

• These are called nondiscretionary policy changes

• They are passive or automatic and respond to legislation already enacted

• Expansionary fiscal policy is used to when the country is facing a recession because of increasing unemployment and decreasing GDP–The government can increase

spending to help lower unemployment and/or lower taxes to encourage investment

– If the Federal budget is balanced at the beginning (tax revenues = government spending), expansionary fiscal policy will create a budget deficit where spending exceeds tax revenues

Fiscal Policy

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Expansionary Fiscal Policy• Suppose full-employment is at $510 billion• Price level is inflexible at P1• Aggregate demand moves to the left• Real GDP drops from $510 to $490 billion• A negative GDP of $20 billion occurs• Unemployment occurs

Expansionary Fiscal Policy• The government may increase spending

• The recession causes the government to spend $5 billion on construction projects

• This shifts the demand curve from AD2 to the dotted line just to its immediate right

• However, because of the multiplier effect, the demand curve moves to AD1

• Thus real output rises to $510 billion; up $20 billion from the recessionary level

Expansionary Fiscal Policy

Real Domestic Output, GDP

Pri

ce L

evel

AD2

RecessionsDecreaseAggregateDemand

AD1

$5 Billion AdditionalSpending

Full $20 Billion Increase in

Aggregate Demand

AS

$490 $510

P1

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Tax reductions

• You can get the same result by reducing taxes which will shift AD right from AD2 to AD1

• Cutting personal income taxes by $6.67 billion will increase disposable income by the same amount

• Consumption will rise by $5 billion; savings by $1.67 billion

• The horizontal distance between AD2 and the dashed line represents only the $5 billion initial increase in consumption spending

Tax reduction

• It is called the “initial” consumption spending because the multiplier process yields successive rounds of increased consumer spending

• The AD curve eventually shifts rightward by four times the $5 billion initial increase in consumption produced by the tax cut

• Real GDP rises by $20 billion, from $490 billion to $510 billion, showing a multiplier of 4

• Note that a tax cut must be somewhat larger than the increase in government savings because part of the tax reduction increases savings

Contractionary fiscal policy

• When demand-pull inflation occurs (prices rising), a restrictive or contractionary fiscal policy may be needed

• In Fig. 13.2, full employment is at point a; intersection of AD 3 and AS with GDP of $510 billion– Price level is P1

Contractionary fiscal policy• Assume a $5 billion initial increase in investment and net exports

shifts AD3 to AD4 (ignore dashed line)• With the upward-sloping AS, the GDP only rises by $12 billion to

$522 billion• Some of the rightward move of AD causes demand-pull inflation

instead of increased output• Price level rises from P1 to P2 at pt b

Contractionary fiscal policy

• To eliminate the inflationary GDP gap, the government must either decrease government spending, raise taxes, or use a combination of the two policies

• When the economy faces demand-pull inflation, fiscal policy should move toward a government budget surplus – tax revenues in excess of government spending to slow down investment and the economy in general

• However, while increases in AD expand real output beyond full-employment level and the price level gets racheted up, decreases in the AD don’t seem to bring prices down very quickly

• This must be taken into account by policy makers

Decreased government spending

• Assume gov. is not aware of racheting effect• Gov. might assume problem could be solved by causing a $20

billion leftward shift of the AD from AD4 to AD3• It would do this by reducing gov. spending by $5 billion and allow

multiplier of 4 to expand that initial decrease into a $20 billion decline in AD back to AD3

Contractionary fiscal policy• Looks like a good solution; economy is back at pt a with full-

employment and GDP of $510 billion; price level back to P1• Doesn’t happen! Price level stuck at P2 so that P2 becomes

supply line• Reduced gov. spending of $5 billion will actually cause a recession• New equilibrium will be at pt d, where AD3 crosses broken

horizontal line• At point d, real GDP is only $502; $8 billion below full-employment

level of $510 billion

Contractionary fiscal policy

• With an immediate short-run supply curve, the multiplier is at full effect

• With price level fixed, and AS horizontal, a $20 billion leftward shift of the AD causes a full $20 decline in GDP

• As a result, GDP falls by the full $20 billion, from $522 billion to $502 billion, or $8 billion below potential output

• By not understanding rachet effect, the gov. has replaced a $12 billion inflationary gap with an $8 billion recessionary GDP gap

Contractionary fiscal policy

• How to avoid problem; gov determines inflationary GDP gap is $12 billion, that price level is fixed, that AS is horizontal, and that multiplier is in full effect

• Thus, any decline in gov. spending will be multiplied by a factor of 4

• Gov. spending should decline by only $3 billion and not $5 billion

• This is because a decline of $3 billion times 4 (multiplier) = $12 billion which will exactly offset the $12 billion GDP gap

Contractionary fiscal policy• Back to Fig 13.2; the horizontal distance between AD 4 and the

dashed line to its left represents the $3 billion decrease in gov. spending

• Once multiplier is done, the spending cut will shift the AD leftward from AD4 to AD5

• With price level fixed at P2, and AS horizontal as shown by dashed line, economy will come to equilibrium at pt c

Contractionary fiscal policy

• Increased taxes will also get you to the same point

• If the gov. raised taxes by $4 billion, savings would be reduced by $1 billion and consumption by $3 billion

• This initial $3 billion decline in consumption will cause AD to shift leftward by $12 billion at each price level

• Economy will move to point c, the inflationary GDP gap will be closed and the inflation will be stopped

Fiscal policy actons

• Combined policies of tax increases and reducing spending will also work

• Gov. could decrease spending by $1.5 billion and increase taxes by $2 billion to get same result (would need to calculate mpc and mps to go this)

Which is better; taxes or government spending?

• Which policy option is better– If you think gov. is too big, go with tax cuts

during recession and cut government spending during inflation

– If you think gov has a very large social responsibility, go with increased spending during recession and tax increases during inflation

– Sound like traditoinal “republican” and “democrat” policy positions?

Built-In Stability• Built-in stability arises because net taxes (taxes

minus transfers and subsidies) changes with GDP

• It is desirable that spending rises automatically when the economy is doing poorly and vice-versa when the economy is becoming inflationary

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Built-In Stabilizers

• Taxes automatically rise with GDP because incomes rise and tax revenues fall when GDP falls

• Transfers and subsidies rise when GDP falls; when these government payments such as welfare and unemployment rise, net tax revenues fall along with GDP

• The size of automatic stability depends upon how responsive the system is to changes in taxes compared to changes in GDP

Built-In Stabilizers

• The size of automatic stability depends upon the responsiveness of changes in taxes to changes in GDP– Progressive tax: the average tax rate rises

with GDP (tax revenue/GDP)– Proportional tax: the average tax rate

remains constant as the GDP rises– Regressive tax: the average tax rate falls as

GDP rises

Built-In Stabilizers• As shown in Fig. 13.3, tax revenues automatically increase as GDP

rises during prosperity• Increased taxes reduce household and business spending and thus

slow down the economic expansion• As the economy moves toward a higher GDP, tax revenues

automatically rise and move the budget from deficit toward surplus• Note that the high inflationary income level GDP3 automatically

generates a contractionary

budget surplus

Built-In Stabilizers• Conversely, as GDP falls during recession, tax revenues automatically

decline, increasing spending and reducing the impact of the economic contraction

• With a falling GDP, tax receipts decline and move the governments budget from surplus toward deficit

• In Fig. 13.3, the low level of income GDP1 will automatically yield an expansionary budget deficit

Built-In Stabilizers

• The U.S. tax system reduces business fluctuations by as much as 8 to 10 percent of the change in GDP that would otherwise occur

• However, built-in stabilizers can only reduce, not eliminate, swings in real GDP

• Discretionary fiscal policy such as changes in tax rates and gov. expenditures, along with monetary policy, are needed to correct any large recession or inflation

Federal Budget BalanceActual and Projected, Fiscal 1994-2014

Source: Congressional Budget Office

$300

200

100

0

-100

-200

-300

-400

-500

Bu

dg

et D

efic

it (

-) o

r S

urp

lus,

Bill

ion

s

1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Actual Projected (as of March 2008)

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• Recognition lag is the elapsed time between the beginning of recession or inflation and awareness of this occurrence– It may take several months to detect a

recession or inflation–Even periods of moderate inflation

have months of high inflation–Due to this recognition lag, the

economic downslide or the inflation may become more serious than it would have if the situation had been identified and corrected sooner

Problems, Criticisms, and ComplicationsFiscal Policy Issues

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Fiscal Policy Issues

• Administrative lag– Trying to get the house, senate, and the

president to agree on a specific plan of attack may take months

– In contrast, the Federal Reserve may act within weeks

• Operational lag– Even once a policy is decided upon, it may

require weeks to months to years (construction projects) to get underway

• As a result, discretionary fiscal policy has increasingly relied on tax changes rather than on changes in spending as its main tool

Fiscal Policy Issues

• Crowding out effect – when the government borrows money during a deficit and spends, its borrowing may increase the interest rate

• This would reduce or crowd out private investors which overall, would weaken or cancel the stimulus of fiscal policy

• This phenomenon may not occur during a recession when little borrowing or investment occurs

• It is a much more serious problem during times when the economy is near full employment GDP

The Public Debt• The national debt is the total accumulation

of the Federal government’s total deficits and surpluses that have occurred over time

• The national debt was $9.01 trillion in 2007 and $14 trillion in 2011

• Using the 2007 debt number, 47 percent of the debt was held by the public and 53 percent by the government, including the Federal Reserve

• Foreign interests held about 25% of the public debt in 2007

• The Federal debt held by the public was about 32% of the GDP in 2007

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Debt Held by theFederal Government

and FederalReserve (53%)

Debt Held OutsideThe FederalGovernmentand Federal

Reserve (47%)

FederalReserve

U.S.Government

AgenciesU.S.Individuals

ForeignOwnership

U.S. BanksAnd otherFinancial

Institutions

Other, IncludingState and LocalGovernments

Source: U.S. Treasury

9%

7%

25%

8% 7%

44%

The Public Debt

Total Debt: $9.01 trillion13-34

Debt and GDP

Federal debt held by the public, percentage of GDP

Source: Economic Report of the President, 2006

Per

cen

t o

f G

DP

Year

50

45

40

35

30

25

20

15

10

5

01970 1975 1980 1985 1990 1995 2000 2005

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Debt and GDPPublicly Held Debt: International Comparisons

As a Percentage of GDP, 2007

ItalyJapan

BelgiumHungaryGermany

United StatesUnited Kingdom

FranceNetherlands

CanadaSpain

Poland

0 20 40 60 80 100

Source: Organization for Economic Cooperation and Development 13-36

Debt and GDP• Interest charges are the main

burden imposed by the debt– Interest on the debt was $237

billion in 2007 and is the fourth largest item in the Federal budget after income security, national defense, and health

– Interest payments were 1.7% of the GDP in 2007

– That percentage represents the average tax rate necessary just to cover annual interest on the debt

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Debt and GDP

Substantive issues

• Repayment of the debt affects income distribution; working taxpayers pay interest to wealthier groups who hold the bonds, probably increasing income inequality

• Since interest is paid out of gov. revenues, a large debt and high interest rate can increase tax burdens and may decrease incentives to work and save for taxpayers

• A higher proportion of debt is owed to foreigners than in the past, and this can increase the burden since payments leave the country

• Some economists believe public borrowing crowds out private investment, especially when at full-employment

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Crowding Out

5 10 15 20 25 30 35 400

2

4

6

8

10

12

14

16

Rea

l In

tere

st R

ate

(P

erce

nt)

Investment (Billions of Dollars)

ID1

a

b c

Interest RateRise WillDecrease

Investmenta to b

Crowding-Out Effect

A Large Public Debt to Finance Public Investment Will Cause…

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The Leading Indicators indicating potential decline in GDP

1. Average workweek becomes shorter

2. Initial claims for unemployment insurance increase

3. New orders for consumer goods decrease

4. Vendor performance improves sowing less business demand

5. New orders for capital goods drops

Source: The Conference Board 13-40

The Leading Indicators indicating potential decline in GDP

6. Building permits for houses decline 7. Stock prices decline 8. Money supply decreases 9. smaller interest rate spread in interest

rates – restrictive monetary policies 10. Consumer expectations decline

Key Terms

• fiscal policy• Council of Economic

Advisers (CEA)• expansionary fiscal

policy• budget deficit• contractionary fiscal

policy• budget surplus• built-in stabilizer• progressive tax system• proportional tax system

• regressive tax system• standardized budget• cyclical deficit• political business

cycle• crowding-out effect• public debt• U.S. securities• external public debt• public investments

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Money andBanking

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