Transcript Part and/or Chapter Number and Title

Chapter 15: Fiscal Policy,
Deficits, and Debt
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved
Discretionary Fiscal Policy
 Discretionary fiscal policy consists of deliberate changes
in government spending and tax collections designed to
achieve full employment, control inflation, and encourage
economic growth.
 Expansionary fiscal policy increases aggregate demand;
 Contractionary fiscal policy lowers aggregate demand.
 Nondiscretionary fiscal policy consists of changes in
taxes and government spending that occur automatically,
independent of congressional action.
 Nondiscretionary fiscal policy is also called “passive” or “automatic.”
LO: 15-1
15-2
Expansionary Fiscal Policy
 When the economy is in recession,
expansionary fiscal policy may be in order.
 If the Federal budget is balanced at the outset,
expansionary fiscal policy will create a government
budget deficit.
Expansionary fiscal policy is an increase in
government spending, a decrease in taxes, or some
combination of the two for the purpose of increasing
aggregate demand and real output.
LO: 15-1
15-3
Expansionary Fiscal Policy in
AD-AS Model
Expansionary fiscal policy
Increases Aggregate Demand
And restores full employment
Price Level
AS
Recessions Decrease
Aggregate Demand
P1
AD1
AD2
LO: 15-1
$490
$510
Real Domestic Output, GDP
15-4
Contractionary Fiscal Policy
 When demand-pull inflation occurs,
contractionary fiscal policy may help to
control it.
 If the Federal budget is balanced at the outset,
contractionary fiscal policy will create a government
budget surplus.
Contractionary fiscal policy is a decrease in
government spending, an increase in taxes, or some
combination of the two for the purpose of decreasing
aggregate demand and halting inflation.
LO: 15-1
15-5
Nondiscretionary
Fiscal Policy
 Nondiscretionary policy is a combination of built-in stabilizers.
 Examples include personal income taxes, payroll taxes, corporate
income taxes, sales taxes and excise taxes.
 Reductions in spending are desirable when the economy is
moving toward inflation, whereas increases in spending are
desirable when the economy is slumping.
 Built in stability has reduced the severity of business
fluctuations.
Built-in stabilizer: anything that increases the government’s
budget deficit (or reduce its budget surplus) during a recession and
increases its budget surplus (or reduces its budget deficit) during
an expansion without requiring explicit action by policymakers.
LO: 15-2
15-6
Built-In Stability
Government Expenses, G
and Tax Revenues, T
T
LO: 15-2
Surplus
G
Deficit
GDP1 GDP2
GDP3
Real Domestic Output, GDP
15-7
Status of Fiscal Policy
 In evaluating the status of fiscal policy, we must adjust
deficits and surpluses to eliminate automatic changes in
tax revenues.
 The standardized budget (or full-employment budget) is
used for this purpose.
 The standardized budget deficit is zero at the fullemployment output level.
The standardized budget is a measure of what the Federal
budget deficit or surplus would be with existing tax rates and
government spending programs if the economy had achieved its
full-employment GDP in the year.
LO: 15-3
15-8
Cyclical Deficit
 If the economy slides into a recession, the standardized
budget deficit is still zero because government
expenditure equals the tax revenue that would be
forthcoming at the full-employment GDP.
 The deficit that arises in a recession is a cyclical deficit
and is not caused by government discretionary fiscal
policy.
Cyclical deficit is a Federal deficit that is caused by a recession
and the consequent decline in tax revenue.
LO: 15-3
15-9
Government Expenses, G
and Tax Revenues, T
Cyclical Deficit
LO: 15-3
T
Cyclical deficit
Fiscal policy
neutral
$500
$450
a
b
G
c
GDP2
GDP1
(Year 2)
(Year 1)
Real Domestic Output, GDP
15-10
Government Expenses, G
and Tax Revenues, T
Standardized Deficit
LO: 15-3
Standardized deficit
Expansionary fiscal
policy
$500
d
e
$475
$450
$425
T1
T2
G
h
f
g
GDP4
GDP3
(Year 4)
(Year 3)
Real Domestic Output, GDP
15-11
Problems in Applying
Fiscal Policy
 Problems of timing
 Recognition lag, administrative lag, operational lag
 Political considerations
 Political business cycles (spend more before elections)
 Future policy reversals may lead to consumption
smoothing
 Offsetting state and local finance, which is frequently
procyclical
 Crowding-out effect: a decrease in private investment
caused by higher interest rates that result from the
Federal government’s increased borrowing to finance
deficits
LO: 15-3
15-12
Public Debt
 The national or public debt is essentially the total
accumulation of the deficits (minus the surpluses) that
the Federal government has incurred through time.
 Deficits have emerged because of war financing, recessions,
fiscal policy, and lack of political will by Congress.
 The total public debt represents the total amount of
money owed by the Federal government to the owners
of government securities.
U.S. government securities are Treasury bills, Treasury notes,
Treasury bonds, U.S. savings bonds, and I-bonds issued by the
Federal government to finance expenditures that exceed tax
revenues.
LO: 15-4
15-13
Federal Budget Balance
Actual
Projected
(as of March 2008)
Budget Deficit (-) or Surplus, Billions
$300
LO: 15-4
200
100
0
-100
-200
-300
-400
-500
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Source: Congressional Budget Office
15-14
Burden of Public Debt
 The annual interest charge accruing on the bonds
sold to finance the debt is the primary burden of the
U.S. debt.
 The large U.S. debt does not threaten to bankrupt the
Federal government, leaving it unable to meet its
financial obligations.
 One reason is that the public debt is easily refinanced.
 Another reason is that the Federal government has the
option to impose new taxes or increase existing tax
rates to finance the debt.
LO: 15-4
15-15
Burden of Public Debt
 Ownership of the public debt is concentrated among
wealthier groups.
 A large public debt may impair economic growth if higher
taxes for interest payments on government securities
dampen incentives to bear risk, to innovate, to invest,
and to work.
 External public debt, or the part of the public debt owned
by foreigners, is an economic burden to Americans.
 Financing of the large public debt transfers a real
economic burden to future generations by passing a
smaller stock of capital goods on to them.
LO: 15-4
15-16
Who Holds U.S. Public Debt?
Debt Held Outside
The Federal
Government
and Federal
Reserve (47%)
Debt Held by the
Federal Government
Other – Including
and Federal
State and Local
Reserve (53%)
Governments
U.S. Banks
And other
Financial
Institutions
8%
7%
9%
Federal
Reserve
25%
Foreign
Ownership
7%
LO: 15-4
U.S.
Individuals
44%
U.S.
Government
Agencies
Source: U.S. Treasury
15-17
Imbalance in the Social
Security System
 The most significant fiscal issue in the U.S. is the longterm funding imbalance in the Social Security and
Medicare programs.
 There is a severe long-run shortfall in Social Security funding
because of growing payments to retiring baby boomers.
 The accumulation of monies in the Social Security trust fund
will be greatly inadequate for paying the retirement benefits to
future retirees.
 The problem is one of demographics: the percentage of the
American population age 62 and older will rise substantially
over the next several decades.
LO: 15-5
15-18