Part 2 Deficit and Debt Chapter 15-2

Chapter Goals  Define the terms deficit, surplus, and debt and distinguish between a cyclical deficit and a structural deficit  Differentiate between real and nominal deficits and surpluses  Explain why the debt needs to be judged relative to assets  Describe the historical record for the U.S. deficit and debt

Defining Deficits and Surpluses  A deficit is a shortfall of revenues under payments  A surplus is an excess of revenues over payments  In the short run, if the economy is below potential, deficits are good because deficits increase expenditures moving output closer to potential  Long-run surpluses are good because they provide saving for investment

Financing the Deficit  The government finances its deficits by selling bonds to private individuals and to the central bank  Bonds are promises to pay back the money in the future  The central bank can print an unlimited amount of money to buy bonds, but printing too much money can cause serious inflation

Short Run vs. Long Run

Arbitrariness in Defining Surpluses and Deficits Whether a nation has a deficit or surplus depends on what is included as revenuesexpenditures revenues and expenditures

There are many ways to measure expenditures and receipts, so there are many ways to measure deficits and surpluses

Deficit and surplus figures are summary measures of the financial health of the economy

To understand the summary, you must understand the methods that were used to calculate it

Many government revenues and expenditures depend on the level of income in the economy Expenditures are not straight forward! What?.

Structural and Cyclical Deficits and Surpluses  Structural deficit is the part of the budget deficit that would exist even if the economy were at its potential level of output  Cyclical deficit is the part of the deficit that exists because the economy is operating below its potential level of output

The Federal Budget Deficit & The Business Cycle The budget deficit as a percentage of GDP tends to rise during recessions (indicated by shaded areas) and fall during expansions. These Deficits help end the recessions

A ACTUAL DEFICIT = STRUCTURAL DEFICIT + CYCLICAL DEFICIT Actual deficit = structural deficit + cyclical deficit

CYCLICAL DEFICIT = TAX RATE X (POTENTIAL – ACTUAL OUTPUT) Cyclical deficit = tax rate x (potential – actual output) C

S STRUCTURAL DEFICIT = ACTUAL DEFICIT – CYCLICAL DEFICIT Structural deficit = actual deficit – cyclical deficit

Structural and Cyclical Deficits and Surpluses There is disagreement about what percentage of a deficit is structural and what percentage is cyclical

According to your textbook Much of the current deficit is structural and will have to continue to keep the economy where it is today; however, it cannot continue indefinitely

Cyclical Deficits During Recession the number of unemployed During Recession the number of unemployed.. Tax Revenue # of Unemployed Government. …. Spending on. Transfer payment # of Unemployed Government. …. Spending on. Transfer payment

A Depressing Idea Structural Stagnation Theory Structural Stagnation Theory sees Structural Much of the unemployment as Structural Cyclical NOT Cyclical

Projections for the Budget Deficit Percent of GDP History Forecast 2009 Projection 2012 CBO Projection Actual

Nominal and Real Deficits and Surpluses  A nominal deficit is the difference between expenditures and receipts  A real deficit is the nominal deficit adjusted for inflation

debt Inflation reduces the value of the debt

Real deficit = Nominal deficit – (Inflation x Total debt)

Side Effects Include real deficit Lowering the real deficit by inflation is not costless to the government Persistent inflation becomes built into expectations and causes higher interest rates

? But wait… There’s More! Next Slide Covers Debt! The Debt is different from the Deficit…..