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

30-2 Chapter Objectives Purposes, Tools, and Limitations of Fiscal Policy Role of Built-In Stabilizers in Moderating Business Cycles How the Standardized Budget Reveals the Status of U.S. Fiscal Policy The Size, Composition, and Consequences of the U.S. Public Debt

30-3 Fiscal Policy Council of Economic Advisers (CEA) Discretionary fiscal policy –Eliminate recessionary or inflationary gap –Countercyclical Nondiscretionary fiscal policy –Passive or automatic

30-4 Fiscal Policy and the AD-AS Model or AE Model Expansionary Fiscal Policy –Increased Government Spending –Tax Reductions –Some Combination of the Two –Political considerations Budget Deficit

30-5 Expansionary Fiscal Policy Real Domestic Output, GDP Price Level AD 2 Recessions Decrease Aggregate Demand AD 1 $5 Billion Additional Spending Full $20 Billion Increase in Aggregate Demand AS $490$510 P1P1

30-6 Equilibrium Versus Full-Employment GDP Recessionary Expenditure Gap Real GDP (billions of dollars) Aggregate Expenditures (billions of dollars) ° AE 0 AE 1 Full Employment Recessionary Expenditure Gap = $5 Billion $5 Billion Gap Yields $20 Billion GDP Change

30-7 Fiscal Policy and the AD-AS Model Contractionary Fiscal Policy –Decreased Government Spending –Increased Taxes –Some Combination of the Two Budget Surplus Policy Options: G or T? Political considerations G 11.1

30-8 Contractionary Fiscal Policy Real Domestic Output, GDP Price Level AD 3 Reduce Demand Pull Inflation AD 4 $5 Billion Initial Decrease In Spending Full $20 Billion Decrease in Aggregate Demand AS $510$522 P1P1

30-9 Equilibrium Versus Full-Employment GDP Inflationary Expenditure Gap Real GDP (billions of dollars) Aggregate Expenditures (billions of dollars) ° AE 0 AE 2 Full Employment Inflationary Expenditure Gap = $5 Billion $5 Billion Gap Yields $20 Billion GDP Change

30-10 Built-In Stability Automatic stabilizers –Taxes and transfers Economic importance Tax progressivity –Progressive tax system –Proportional tax system –Regressive tax system

30-11 Built-In Stability G T Deficit Surplus GDP 1 GDP 2 GDP 3 Real Domestic Output, GDP Government Expenses, G and Tax Revenues, T

30-12 Evaluating Fiscal Policy Standardized budget –Full-employment budget Cyclical deficit Recent U.S. fiscal policy Budget deficits and projections Social security considerations

Evaluating Fiscal Policy Is the fiscal policy… Expansionary? Neutral? Contractionary? Use the cyclically adjusted budget to evaluate LO

30-14 Evaluating Fiscal Policy G T GDP 2 GDP 1 Real Domestic Output, GDP Government Expenses, G and Tax Revenues, T (Year 2)(Year 1) $500 $450 a b c Cyclical deficit Fiscal policy neutral

30-15 Evaluating Fiscal Policy G T1T1 GDP 4 GDP 3 Real Domestic Output, GDP Government Expenses, G and Tax Revenues, T (Year 4)(Year 3) $500 $450 d e f $475 $425 g T2T2 h Standardized deficit Expansionary fiscal policy

30-16 (1) Year (2) Actual Deficit (-) or Surplus (+) (3) Standardized Deficit (-) or Surplus (+) Budget Balances as % of GDP % -3.8% -2.9% -2.2% -1.4% -0.3% +0.8% +1.4% +2.5% +1.3% -1.5% -3.4% -3.5% -2.6% -1.9% -1.3% -2.9% -2.1% -2.0% -1.2% -1.0% -0.4% +0.1% +1.1% +1.0% -1.2% -2.5% -2.4% -1.9% -1.8% -1.4% Source: Congressional Budget Office

Recent U.S. Fiscal Policy Federal Deficits (-) and Surpluses (+) as Percentages of GDP, (1) Year (2) Actual Deficit – or Surplus + (3) Cyclically Adjusted Deficit – or Surplus +* As a percentage of potential GDP Source: Congressional Budget Office, LO

Fiscal Policy: The Great Recession Financial market problems began in 2007 Credit market freeze Pessimism spreads to the overall economy Recession officially began December 2007 and lasted 18 months LO

Global Perspective LO

Budget Deficits and Projections Source: Congressional Budget Office, $ Budget Deficit (-) or Surplus, Billions Actual Projected (as of March 2010) LO

30-21 Problems of timing –Recognition lag –Administrative lag –Operational lag Political considerations –Political Business Cycle –Annual balanced budgets –Cyclically balanced budgets Future policy reversals Offsetting state and local finance Crowding-out effect Problems, Criticisms, and Complications Fiscal Policy Issues

Current Thinking on Fiscal Policy Let the Federal Reserve handle short- term fluctuations Fiscal policy should be evaluated in terms of long-term effects Use tax cuts to enhance work effort, investment, and innovation Use government spending on public capital projects LO

The U.S. Public Debt $11.9 trillion in 2009 ($9.01 Trillion 2007 and $7.96 Trillion in 2005) The accumulation of years of federal deficits and surpluses Owed to the holders of U.S. securities Treasury bills Treasury notes Treasury bonds U.S. savings bonds LO

The U.S. Public Debt LO4 Debt held outside the Federal government and the Federal Reserve: 57% Debt held by the Federal government and the Federal Reserve: 43% 13-24

The U.S. Public Debt LO

Global Perspective Public Sector Debt as Percentage of GDP, 2009 Italy Japan Greece Belgium France United States France Germany United Kingdom Spain Netherlands Canada Source: Organization for Economic Cooperation and Development, OECD LO

The U.S. Public Debt Interest charges on debt Largest burden of the debt 1.3% of GDP in 2009 False Concerns Bankruptcy Refinancing Taxation Burdening future generations LO

30-28 Debt and GDP Substantive issues –Income distribution –Incentives –Foreign-owned public debt Crowding-out effect revisited –Burden on future generations –Public investment as an offset –Graphically

30-29 Crowding Out Real Interest Rate (Percent) Investment (Billions of Dollars) ID 1 ID 2 a bc Interest Rate Rise Will Decrease Investment a to b Crowding- Out Effect A Large Public Debt to Finance Public Investment Will Cause… If Public Spending Spurs More Private Investment Will Increase to ID 2

30-30 The Leading Indicators 1.Average workweek 2.Initial claims for unemployment insurance 3.New orders for consumer goods 4.Vendor performance 5.New orders for capital goods 6.Building permits for houses 7.Stock prices 8.Money supply 9.Interest-rate spread 10.Consumer expectations Source: The Conference Board

Social Security, Medicare Shortfalls More Americans will be receiving benefits as they age Social security shortfalls Income during retirement Funds will be depleted by 2037 Medicare shortfalls Medical care during retirement Funds will be depleted by

Social Security, Medicare Shortfalls Possible options “to fix” include: Increasing the retirement age Increasing the portion of earnings subject to the social security tax Disqualifying wealthy individuals Redirecting low-skilled immigrants to higher-skilled, higher paying work Defined contribution plans owned by individuals 13-32

30-33 Key Terms fiscal policy Council of Economic Advisers (CEA) expansionary fiscal policy budget deficit contractionary fiscal policy budget surplus built-in stabilizer progressive tax system proportional tax system regressive tax system standardized budget cyclical deficit political business cycle crowding-out effect public debt U.S. securities external public debt public investments