The focus in this chapter is on the following questions: How do deficits and surpluses arise? What harm (good) do deficits (surpluses) cause? Who will.

The focus in this chapter is on the following questions:◦ How do deficits and surpluses arise?◦ What harm (good) do deficits (surpluses) cause?◦ Who will pay off the accumulated national debt?

The federal budget is a key policy lever for controlling the economy.

Use fiscal stimulus to eliminate unemployment.

Use fiscal restraint to control inflation.

Reducing tax revenues and increasing federal government spending throws the budget out of balance.

Creates a budget deficit through deficit spending.

Deficit spending is the use of borrowed funds to finance government expenditures that exceed tax revenues.

Budget deficit is the amount by which government spending exceeds government revenue in a given time period.

Budget deficit = government spending – tax revenues > 0

If the government spends less than its tax revenues, a budget surplus is created.

Budget Surplus is an excess of government revenues over government expenditures in a given time period.

At the beginning of each year, the President and Congress put together a budget blueprint for next fiscal year.

Fiscal Year (FY) is the twelve-month period used for accounting purposes – begins on October 1 for the federal government.

To a large extent, most current revenues and expenditures are a result of decisions made in prior years.

In this sense, much of each year’s budget is “uncontrollable”.

Discretionary fiscal spending account for only 20% of the federal budget.

Discretionary fiscal spending are those elements of the federal budget not determined by past legislative or executive commitments.

If most of the budget is uncontrollable, fiscal restraint or fiscal stimulus are less effective.

Fiscal restraint – tax hikes or spending cuts intended to reduce (shift) aggregate demand.

Fiscal stimulus – tax cuts or spending hikes intended to increase (shift) aggregate demand.

Most of the uncontrollable line items in the federal budget change with economic conditions.

Examples include unemployment compensation and other income transfers.

Income transfers are payments to individuals for which no current goods or services are exchanged, such as social security, welfare, unemployment benefits.

Acting as automatic stabilizers, transfer payments increase during recessions.

Automatic stabilizers are federal expenditure or revenue items that automatically respond counter-cyclically to changes in national income.

Automatic stabilizers also exist on the revenue side of the budget.

Income taxes move up and down with the value of spending and output.

Being progressive, personal taxes siphon off increasing proportions of purchasing power as incomes rise.

The size of the federal deficit is sensitive to expansion and contraction of the macro economy.

The cyclical deficit is that portion of the budget deficit attributable to unemployment or inflation.

The cyclical deficit widens when GDP growth slows or inflation decreases.

The cyclical deficit shrinks when GDP growth accelerates or inflation increases.

To isolate effects of fiscal policy, the deficit is broken down into cyclical and structural components.

Total budget deficit = Cyclical deficit + Structural deficit

The structural deficit is federal revenues at full-employment minus expenditures at full employment under prevailing fiscal policy.

Fiscal policy is categorized as follows:

Fiscal stimulus is measured by the increase in the structural deficit (or shrinkage in the structural surplus).

Fiscal restraint is gauged by the decrease in the structural deficit (or increase in the structural surplus).

If government borrows funds to finance deficits, the availability of funds for private sector spending may be reduced.

Crowding-out is the reduction in private-sector borrowing (and spending) caused by increased government borrowing.

Chances of crowding-out rise when the economy gets closer to full employment.

There are four potential uses for a budget surplus:◦ Cut taxes.◦ Increase income transfers.◦ Spend it on goods and services.◦ Pay off old debt (“save it”).

The first two options effectively wipe out the surplus but give consumers more disposable income and change the public-private mix of output.

The third option, spending the surplus, wipes out the surplus and enlarges the relative size of government.

A reduction in debt takes pressure off market interest rates.

Crowding in is the increase in private sector borrowing (and spending) caused by decreased government borrowing.

As interest rates drop, consumers are willing and able to purchase more big-ticket items like cars, appliances, and houses.

Crowding in depends on the state of the economy.

In a recession, a decline in interest rates is not likely to stimulate much spending if consumer and investor confidence is low.

The United States has accumulated a large national debt.

The national debt is the accumulated debt of the federal government.

When the Treasury borrows funds it issues treasury bonds.

Treasury bonds are promissory notes (IOUs) issued by the U.S. Treasury.

The national debt is a stock of IOUs created by annual deficit flows.

Whenever there is a budget deficit, the national debt increases.

In years when a budget surplus exists, the national debt can be pared down.

140130120110100

908070605040302010

1800 1850 1900 1950 2000

World War II

Reagan tax cuts

1990-91 recession

Great DepressionWorld War ICivil War

National debt represents a liability as well as an asset in the form of bonds.◦ Liability – An obligation to make future payment;

debt.◦ Asset – Anything having exchange value in the

marketplace; wealth. The national debt creates as much wealth

(for bondholders) as liabilities (for the U.S. Treasury).

The national debt creates as much wealth (for bondholders) as liabilities (for the U.S. Treasury).

Federal agencies hold roughly 50 percent of the outstanding Treasury bonds.◦ The Federal Reserve acquires Treasury bonds in

its conduct of monetary policy.◦ The Social Security Trust Fund is the largest

owner of U.S. debt.

State and local governments hold 7 percent of the national debt.

The general public directly owns about 6% of the national debt.

The general public indirectly owns over 22% through banks, insurance companies, corporations, etc.

Internal debt is the U.S. government debt (Treasury bonds) held by U.S. households and institutions.

Internal debt equals approximately 80% of the total.

The remaining 20% of the national debt is held by foreign households and institutions.

The external debt is U.S. government debt (Treasury bonds) held by foreign households and institutions.

Federal agencies

17%Social Security 13%Federal Reserve 9%

State and localgovernments 8%

Public Sector

Foreigners

Foreigners 20%

Private Sector

Individuals6%Banks,

corporations,insurance

companies,etc, 8%

The debt has historically been refinanced by issuing new bonds to replace old bonds that have become due.

Refinancing is the issuance of new debt in payment of debt issued earlier.

Debt service is the interest required to be paid each year on outstanding debt.

Interest payments restrict the government’s ability to balance the budget or fund other public sector activities.

Opportunity costs are incurred only when real resources (factors of production) are used.

The process of debt servicing uses few resources, and has negligible opportunity costs.

The true burden of the debt is the opportunity costs of the activities financed by the debt.

Deficit financing tends to change the mix of output in the direction of more public-sector goods.

The burden of the debt is the opportunity costs (crowding out) of deficit-financed government activity.

The primary burden of the debt is incurred when the debt-financed activity takes place.

The real burden of the debt cannot be passed on to future generations.

Future generations will bear some of the debt burden if debt-financed government spending crowds out private investment.

The debate about the burden of the debt is an argument over the optimal mix of output.

External debt presents some special opportunities and problems.

External financing allows us to get more public-sector goods without cutting back on private-sector production.

As long as foreigners are willing to hold U.S. bonds, external financing imposes no real cost.

Extra output (imports)

financed with external debt

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b d

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g2

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Publ

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Out

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units

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Private-sector Output (units per year)

Foreigners may not be willing to hold bonds forever.

External debt must be paid with exports of real goods and services.

Deficit ceilings are an explicit, legislated limitation on the size of the budget deficit.

A debt ceiling is another mechanism for curbing the national debt.

A debt ceiling is an explicit, legislated limit on the amount of outstanding national debt.

Like deficit ceilings, debt ceilings are just political mechanisms for forging political compromises on how to best use budget surpluses or deficits.