15 Budget Deficits in the Short and Long Run Blessed are the young, for they shall inherit the national debt. HERBERT HOOVER Budget Deficits in the Short and Long Run Blessed are the young, for they shall inherit the national debt. HERBERT HOOVER

●Should the Budget Be Balanced? The Short Run ●Surpluses and Deficits: The Long Run ●Deficits and Debt: Terminology and Facts ●Interpreting the Budget Deficit or Surplus ●Why is the National Debt Considered a Burden? ●Should the Budget Be Balanced? The Short Run ●Surpluses and Deficits: The Long Run ●Deficits and Debt: Terminology and Facts ●Interpreting the Budget Deficit or Surplus ●Why is the National Debt Considered a Burden? Contents Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

●Budget Deficits and Inflation ●Debt, Interest Rates, and Crowding Out ●The Main Burden of the National Debt: Slower Growth ●The Economics and Politics of the U.S. Budget Deficit ●Budget Deficits and Inflation ●Debt, Interest Rates, and Crowding Out ●The Main Burden of the National Debt: Slower Growth ●The Economics and Politics of the U.S. Budget Deficit Contents (continued) Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

●Not always. ♦Attempts to achieve balance during a recession or an inflationary episode would destabilize the economy. ●Not always. ♦Attempts to achieve balance during a recession or an inflationary episode would destabilize the economy. Should the Budget be Balanced? The Short Run

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Should the Budget be Balanced? The Short Run ●The Importance of the Policy Mix ♦The appropriate fiscal policy depends, among other things, on the current monetary policy stance. ♦While a balanced budget may be appropriate under one monetary policy, a deficit or a surplus may be appropriate under another. ●The Importance of the Policy Mix ♦The appropriate fiscal policy depends, among other things, on the current monetary policy stance. ♦While a balanced budget may be appropriate under one monetary policy, a deficit or a surplus may be appropriate under another.

FIGURE 1: The Interaction of Monetary and Fiscal Policy Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Effect of fiscal policy Effect of monetary policy S S Y 1 D 0 D 0 Y 0 Real GDP Price Level Potential GDP D 1 D 1 A B

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●More expansionary fiscal policy and tighter money supply should produce higher real interest rates and therefore lower investment, slowing economic growth. ●More restrictive fiscal policy and looser monetary policy should reduce real interest rates and hence increase investment and spur economic growth. ●More expansionary fiscal policy and tighter money supply should produce higher real interest rates and therefore lower investment, slowing economic growth. ●More restrictive fiscal policy and looser monetary policy should reduce real interest rates and hence increase investment and spur economic growth. Surpluses and Deficits: The Long Run

FIGURE 2: Growth and Investment in 24 Countries Copyright © 2006 South-Western/Thomson Learning. All rights reserved Japan Norway Portugal Finland Austria Luxembourg Italy Spain Iceland Ireland Canada Greece Germany France Australia Switzerland New Zealand Netherlands Sweden Denmark U.S. Turkey Belgium U.K Average Investment as Percent of GDP, 1970–1990 Average Annual Growth Rate of per Capita Real GDP, 1970– %

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Deficits and Debt: Terminology and Facts ●Budget Deficit = excess of a government’s expenditures over its receipts in a period of time ♦A flow ●National Debt = total value of government indebtedness at a moment in time ♦A stock ●Budget Deficit = excess of a government’s expenditures over its receipts in a period of time ♦A flow ●National Debt = total value of government indebtedness at a moment in time ♦A stock

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Deficits and Debt: Terminology and Facts ●Some Facts about the National Debt ♦In absolute terms the debt is large, but as a proportion of GDP it is less than one half. ♦Some, but not all, is backed by government assets. ♦Before the 1980s, most of the debt was accumulated in times of war and recession. ●Some Facts about the National Debt ♦In absolute terms the debt is large, but as a proportion of GDP it is less than one half. ♦Some, but not all, is backed by government assets. ♦Before the 1980s, most of the debt was accumulated in times of war and recession.

FIGURE 3: The U.S. National Debt Relative to GDP, Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Ratio of Public Debt to Gross Domestic Product Ratio of Public Debt to Gross Domestic Product 0.33 Ratio of Public Debt to Gross Domestic Product Year World War I Great Depression World War II 1974–1975 Recession 1981–1984 Tax cuts 1981–1982 Recession Budget Agreement 2001–2003 Tax cuts 1915 Ratio of Public Debt to Gross Domestic Product

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Deficit rises in a recession and falls in a boom even with no change in fiscal policy. ●Structural deficit (or surplus) = what the deficit (or surplus) would be at full employment ♦Portion of the deficit unrelated to the business cycle ♦Shows how the deficit is related to government policy ●Deficit rises in a recession and falls in a boom even with no change in fiscal policy. ●Structural deficit (or surplus) = what the deficit (or surplus) would be at full employment ♦Portion of the deficit unrelated to the business cycle ♦Shows how the deficit is related to government policy Interpreting the Budget Deficit or Surplus

FIGURE 4: Official Fiscal-Year Budget Deficits, Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Fiscal Year Federal Budget Deficit 0 –100 –150 –200 –300 –250 –400 – – $400 ’00’01 ’02 3’04 ’ ’ ’97 ’98’99 Deficits Surpluses

FIGURE 5: The Effect of the Economy on the Budget Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Gross Domestic Product Spending and Tax Receipts Surplus Deficit G A Y 3 Y 2 Y 1 T = Taxes – Transfers B

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●On-budget Versus Off-budget Surpluses ♦Overall budget surplus = off-budget surplus + on-budget surplus ♦Off-budget surplus = revenues – expenditures of off-budget items (primarily Social Security taxes and payments) ♦On-budget surplus = revenues – expenditures of on-budget items (most other items) ●On-budget Versus Off-budget Surpluses ♦Overall budget surplus = off-budget surplus + on-budget surplus ♦Off-budget surplus = revenues – expenditures of off-budget items (primarily Social Security taxes and payments) ♦On-budget surplus = revenues – expenditures of on-budget items (most other items) Interpreting the Budget Deficit or Surplus

TABLE 1: Alternative Budget Concepts, Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

Why the National Debt is Considered a Burden ●“Our children will be burdened by high interest payments.” ♦Only a burden if the debt is held by foreigners. ♦If held by domestic citizens, then future interest payments just transfer funds from one group of Americans to another. ●“Our children will be burdened by high interest payments.” ♦Only a burden if the debt is held by foreigners. ♦If held by domestic citizens, then future interest payments just transfer funds from one group of Americans to another.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Why the National Debt is Considered a Burden ●“A nation has a limited capacity to borrow.” ♦Debt is paid in U.S. dollars, so that the government can always print more money to repay the debt and avoid default. ♦If debt is denominated in some other currency, then it may be forced to default. ●“A nation has a limited capacity to borrow.” ♦Debt is paid in U.S. dollars, so that the government can always print more money to repay the debt and avoid default. ♦If debt is denominated in some other currency, then it may be forced to default.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Deficits   AD ♦Can cause inflation if economy is strong, since AS curves slope upward ●Deficits   AD ♦Can cause inflation if economy is strong, since AS curves slope upward Budget Deficits and Inflation

FIGURE 6: The Inflationary Effects of Deficit Spending Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Deficit spending boosts aggregate demand Aggregate supply curve shifts inward as wages rise Real GDP S S D 0 D 0 $8,000$7,000$6,000$5, Price Level 100 D 1 D 1 Potential GDP C B A

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Budget Deficits and Inflation ●The Monetization Issue ♦If the Federal Reserve takes no countervailing actions, an expansionary fiscal policy that increases the budget deficit will tend to ■  real GDP and prices ■Cause outward shift of the demand curve for money ■  interest rates ●The Monetization Issue ♦If the Federal Reserve takes no countervailing actions, an expansionary fiscal policy that increases the budget deficit will tend to ■  real GDP and prices ■Cause outward shift of the demand curve for money ■  interest rates

FIGURE 7: Fiscal Expansion and Interest Rates Copyright © 2006 South-Western/Thomson Learning. All rights reserved. S S D 0 D 0 Interest Rate Shift in reserve demand caused by risingY andP For given Fed policy Quantity of Bank Reserves D 1 D 1 A B

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Budget Deficits and Inflation ●The Monetization Issue ♦If the Fed does not want interest rates to rise ■It can engage in expansionary open-market operations, that is, purchase more government debt. ■The money supply will then increase. ■The portion of the deficit purchased by the Fed has been monetized. ●The Monetization Issue ♦If the Fed does not want interest rates to rise ■It can engage in expansionary open-market operations, that is, purchase more government debt. ■The money supply will then increase. ■The portion of the deficit purchased by the Fed has been monetized.

FIGURE 8: Monetization and Interest Rates Copyright © 2006 South-Western/Thomson Learning. All rights reserved. S 0 S 0 D 0 D 0 Interest Rate Expansionary Fed policy Quantity of Bank Reserves S 1 S 1 D 1 D 1 C B A

Monetized Deficit Spending Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Real GDP Expansionary monetary policy Price Level Expansionary fiscal policy D 0 D 0 D 1 D 1 D 2 D 2 S S A B C

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Crowding out ♦Occurs when unemployment is low ♦  deficit   interest rates   investment +  capital stock ♦Investment spending is thus crowded out by government deficit. ●Crowding out ♦Occurs when unemployment is low ♦  deficit   interest rates   investment +  capital stock ♦Investment spending is thus crowded out by government deficit. Debt, Interest Rates, and Crowding Out

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Debt, Interest Rates, and Crowding Out ●Crowding in ♦Occurs when unemployment is high ♦  deficit   output   savings +  capacity utilization   investment +  capital stock ●Crowding-in is likely to dominate in the short run, crowding-out in the long run. ●Crowding in ♦Occurs when unemployment is high ♦  deficit   output   savings +  capacity utilization   investment +  capital stock ●Crowding-in is likely to dominate in the short run, crowding-out in the long run.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Main Burden of the National Debt: Slower Growth ●Much of the debt prior to the 1980s was accrued during recessions, when crowding- in probably occurred. ●Since 1980, high deficits have often persisted along with high employment, leading one to think that crowding-out predominated. ●Much of the debt prior to the 1980s was accrued during recessions, when crowding- in probably occurred. ●Since 1980, high deficits have often persisted along with high employment, leading one to think that crowding-out predominated.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Main Burden of the National Debt: Slower Growth ●The arguments that a large national debt may lead the nation into bankruptcy, or unduly burden future generations who have to make onerous payments of interest and principal, are mostly bogus.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Main Burden of the National Debt: Slower Growth ●The national debt will be a burden if ♦It is sold to foreigners. ♦It is contracted in a fully employed, peacetime economy. ♦In the latter case, it will reduce the nation’s capital stock. ●The national debt will be a burden if ♦It is sold to foreigners. ♦It is contracted in a fully employed, peacetime economy. ♦In the latter case, it will reduce the nation’s capital stock.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Main Burden of the National Debt: Slower Growth ●Under some circumstances, budget deficits are appropriate for stabilization-policy reasons. ●Until the 1980s, the public debt was mostly contracted as a result of wars and recessions. ♦Precisely the circumstances under which the valid burden-of-the-debt argument does not apply ●Under some circumstances, budget deficits are appropriate for stabilization-policy reasons. ●Until the 1980s, the public debt was mostly contracted as a result of wars and recessions. ♦Precisely the circumstances under which the valid burden-of-the-debt argument does not apply

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Main Burden of the National Debt: Slower Growth ●However, the large deficits of the 1980s and 1990s were not mainly attributable to recessions, and were therefore worrisome.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Issue Revisited: Was Fiscal Stimulus Warranted in 2001? ●Emergency spending and first phase of tax cut after September 11th attacks stimulated economy. ♦Short-run effects: stimulate AD. ♦Long-run effects: perhaps crowding out ●Emergency spending and first phase of tax cut after September 11th attacks stimulated economy. ♦Short-run effects: stimulate AD. ♦Long-run effects: perhaps crowding out ?

FIGURE 9: S-R Effect of Larger Deficits or Smaller Surpluses Copyright © 2006 South-Western/Thomson Learning. All rights reserved. S S Price Level Real GDP ? D 1 D 1 B D 0 D 0 A

FIGURE 10: L-R Effect of Larger Deficits or Smaller Surpluses Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Potential GDP Y 1 Y 0 Price Level Real GDP ? D D S 1 S 1 S 0 S 0 A B

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Economics and Politics of the U.S. Budget Deficit ●The deficits of the early 1980s came during recessions and hence crowding out was not a serious problem. ●By 1987 the economy was approaching full employment and hence crowding out was becoming a problem. ●The deficits of the early 1980s came during recessions and hence crowding out was not a serious problem. ●By 1987 the economy was approaching full employment and hence crowding out was becoming a problem.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Economics and Politics of the U.S. Budget Deficit ●In the 1990s, the deficit was eliminated by ♦raising taxes and ♦reducing spending; ♦an expanding economy also produced more tax revenues. ●In the 1990s, the deficit was eliminated by ♦raising taxes and ♦reducing spending; ♦an expanding economy also produced more tax revenues.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Economics and Politics of the U.S. Budget Deficit ●Large deficits again ♦2001 recession reduced tax revenue; ♦government spending on national defense; ♦tax cuts in 2001 and ●Large deficits again ♦2001 recession reduced tax revenue; ♦government spending on national defense; ♦tax cuts in 2001 and 2003.