Fiscal Policy, Deficits, and Debt 13 McGraw-Hill/IrwinCopyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Fiscal Policy, Deficits, and Debt

13

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

Fiscal Policy

• Council of Economic Advisors (CEA)

• Deliberate changes in

• Government spending

• Taxes

• Designed to

• Achieve full-employment

• Control inflation

• Encourage economic growth

LO1

Fiscal Policy

• Define:

• Budget deficit

• Budget surplus

• National, or public, debt

LO1

Expansionary Fiscal Policy

• Increases AE, GDP, and employment

• Increase government spending

• Decrease taxes

• Combination of both

• Expansionary policy creates a deficit (G > Tax revenue)

LO1

Equilibrium vs Full Employment

• Recessionary Expenditures Gap

• Amount that AE must increase to reach full-employment, eq. GDP

• Spending is too low at full-employment

• Use expansionary fiscal policy to increase AE

• Desirable to create a deficit

LO1

Contractionary Fiscal Policy

• Decreases AE, GDP, and employment

• Decrease government spending

• Increase taxes

• Combination of both

• Contractionary policy creates a budget surplus (G < Tax revenue)

LO1

Equilibrium vs Full Employment

• Inflationary Expenditures Gap

• Amount that AE must decrease to reach full-employment, eq. GDP

• Spending is too high at full-employment

• Use contractionary fiscal policy to decrease AE

• Desirable to create a surplus

LO1

Policy Options: G or T?

• Expand the size of government

• Increase government spending

• Increase taxes

• Reduce the size of government

• Decrease taxes

• Decrease government spending

LO1

Built-In Stability

• Automatic stabilizers

• Tax revenue varies directly with GDP

• Transfers vary inversely with GDP

•Automatically creating a surplus during inflation and a deficit during recession

• Reduces severity of business fluctuations

LO2

Evaluating Fiscal Policy

• Use the cyclically adjusted budget to evaluate fiscal policy

• Removes impact of built-in stabilizers

• Size of deficit/surplus if the economy is at full-employment for the year

• Cyclically adjusted budget only changes when government changes fiscal policy

LO3

Recent U.S. Fiscal Policy

LO3

Fiscal Policy: The Great Recession

• Financial market problems began in 2007

• In 08 passed $152 billion stimulus consisting of tax breaks

• Most people saved or paid credit cards

• Not very expansionary

LO4

Fiscal Policy: The Great Recession

• In 09 passed American Recovery & Reinvestment Act with $787 billion stimulus

• Decreased taxes for low/middle income

• No lump sum checks

• Increased spending on transportation, ed, and aid to state governments

LO4

Budget Deficits and Projections

LO4

Problems, Criticisms, & Complications

• Problems of Timing

• Recognition lag

• Administrative lag

• Operational lag

• Political considerations– political business cycle

• Future policy reversals

• Off-setting state and local finance

• Crowding-out effectLO4

Problems, Criticisms, & Complications

LO4

• Biggest criticism of fiscal policy is Crowding-Out Effect.

• Crowding-Out Effect – When government borrows money, demand for money increases, and interest rates rise, reducing (crowding-out) investment.– Offsets expansionary impacts of fiscal

policy.

The U.S. Public Debt

• $16.4 trillion in 2012

• The accumulation of years of federal deficits and surpluses

• Owed to the holders of U.S. securities

• Caused by war, recession, and fiscal policy

• Video Debt

LO4

The U.S. Public Debt

• GDP is income of a nation

• Larger income means a greater ability to carry a large debt

• Look at debt as percentage of GDP as better gauge

LO4

The U.S. Public Debt

• Interest charges on debt

• Largest burden of the debt

• Must at least pay interest every year

• 2.3% of GDP in 2012

• When interest as a percent of GDP increases, must raise taxes

LO4

The U.S. Public Debt

• False Concerns

• Bankruptcy

•Refinancing

•Taxation

• Burdening future generations

LO4

The U.S. Public Debt

LO4

The U.S. Public Debt

• 33% of debt is externally held debt – paying it back will decrease RGDP

• 67% of debt is internally held debt – paying it back will not reduce RGDP

• Debt is an asset as owners of debt and a liability as taxpayers

LO4

The U.S. Public Debt

LO4

Global Perspective

LO4

Substantive Issues

• Income distribution

• Incentives

• Foreign-owned public debt

• Crowding-out effect revisited

• Future generations

• Public investment

LO4