The Short Run: Countercyclical Fiscal Policy Fiscal policy In the short run Has demand-side effects on output and employment Countercyclical fiscal policy A change in government purchases or net taxes Designed to reverse or prevent a recession or a boom 1 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

The Short Run: Countercyclical Fiscal Policy Increase in government purchases Direct way to cure a recession Aggregate expenditure line shifts upward ΔGDP = Multiplier ˣ ΔG ΔG = ΔGDP / Multiplier Multiplier = 1/(1-MPC) 2 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Figure 1: Countercyclical Fiscal Policy 3 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Real GDP ($ billions) Consumption Function Real AE ($ billions) AE 1 45° Initially, the economy’s equilibrium is at full-employment output of $10,000 billion (Point A). Then a decrease in investment spending shifts the aggregate expenditure line down to AE 2, and the economy starts heading toward point B—a recession. The government could shift the AE line back to its original position by increasing its own purchases, or by decreasing net taxes with a change in tax or transfer policies. If the change were enacted quickly enough, the government could prevent the recession. A AE 2 B $9,000 (Recession Output) $10,000 (Full-Employment Output)

The Short Run: Countercyclical Fiscal Policy Cut net taxes (taxes – transfer payments) Indirect way to cure a recession Increase disposable income Increase consumption spending Aggregate expenditure line shifts upward ΔGDP = Net tax multiplier ˣ Δ Net taxes Net tax multiplier = - MPC ˣ Expenditure multiplier = - MPC/(1-MPC) 4 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

The Short Run: Countercyclical Fiscal Policy Problems with countercyclical fiscal policy Timing problems Irreversibility Forward looking behavior Reaction of the Federal Reserve 5 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Long Run: Deficits and the National Debt Budget deficit When government purchases exceed net tax revenue National debt The total amount the federal government still owes to the general public from past borrowing 6 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Long Run: Deficits and the National Debt Government’s spending and its total debt Should be viewed in relation to the economy’s total income Budget-related figures Such as government outlays, tax revenues, or government debt Should be considered relative to a nation’s total income—as percentages of GDP 7 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Long Run: Deficits and the National Debt Government outlays Total outflow of funds for: Government purchases Transfer payments Interest on the national debt Budget surplus = Tax revenue - Outlays Budget deficit = Outlays - Tax revenue 8 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Figure 2a: Federal outlays, revenue, and surplus or deficit, 1959– © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. In any given year, the deficit (relative to GDP) is the difference between federal revenue and federal outlays as percentages of GDP. The deficit rises in recessions (shaded) and rises further if fiscal policy is used to fight the recession, as in 2009.

Figure 2b: Federal outlays, revenue, & surplus or deficit, 1959– © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. In any given year, the deficit (relative to GDP) is the difference between federal revenue and federal outlays as percentages of GDP. The deficit rises in recessions (shaded) and rises further if fiscal policy is used to fight the recession, as in 2009.

Long Run: Deficits and the National Debt In a recession Transfers rise and tax revenue falls Budget deficit automatically increases Or the budget surplus decreases In an expansion Transfers decrease and tax revenue rises Budget deficit automatically decreases Or the budget surplus increases 11 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Long Run: Deficits and the National Debt Economic fluctuations automatically affect Transfer payments and tax revenues Budget deficits Add to the public’s holdings of federal government bonds Add to the national debt 12 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Long Run: Deficits and the National Debt Budget surpluses Decrease the public’s bond holdings Subtract from the national debt Budget deficit or surplus Flow variable National debt Stock variable 13 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Figure 3: National Debt as a Percentage of GDP (1940–2009) 14 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Debt as a percentage of GDP soared during World War II, then fell steadily for several decades. It rose during the 1980s, fell in the 1990s, rose in the early 2000s, and then surged in 2008–2009 due to recession and recession-fighting fiscal policies

The National Debt: Myths and Realities The total national debt In mid-2009, it was approaching $12 trillion Amounts that government owes to the public ($7 trillion) It has macroeconomic impact Amounts that one government agency owes to another ($5 trillion) No macroeconomic impact at all 15 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

The National Debt: Myths and Realities Mythical concerns about the national debt “One day we’ll have to pay it all back” We don’t have to, ever As long as the debt grows by the same percentage as nominal GDP The ratios of debt to GDP and interest payments to GDP will remain constant The government can continue to pay interest on its rising debt without increasing the average tax rate in the economy 16 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

The National Debt: Myths and Realities Genuine concerns about the national debt Interest payments on the debt, each year - come out of current tax revenue Interest on foreign held public debt Transfer of purchasing power from U.S. residents to foreign residents = reduce U.S. living standards Interest to U.S. residents who hold government bonds Tax other U.S. residents Higher average tax rate - can lead to slower economic growth 17 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

The National Debt: Myths and Realities Three scenarios in which a nation’s debt problem can become very costly A national debt that is growing too rapidly A debt approaching a national credit limit Failing to account for future obligations 18 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

The National Debt: Myths and Realities A national debt that is growing too rapidly Debt that rises faster than nominal GDP Impose an opportunity cost in the future A permanently higher tax burden A period of inflation A period of reduced government outlays or higher taxes relative to GDP 19 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

The National Debt: Myths and Realities A debt approaching a national credit limit In recent years - debt has risen as a percentage of GDP U.S. debt levels have not approached a credit limit Based on loss of faith in the U.S. government’s ability to pay interest on its debt 20 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

The National Debt: Myths and Realities Failing to account for future obligations Social Security, Medicare, and Medicaid benefits - projected to rise significantly From 8.3% of GDP in 2007 To around 18.6% of GDP in 2050 Federal government - should take these future obligations into account in its planning process Uncertainty over debt projections 21 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

U.S. Fiscal policy during recession of 2008– Early fiscal stimulus package The American Reinvestment and Recovery Act = $787 billion over two years one-third was tax cuts one-third was greater government purchases One-third was increased transfer payments To help those most directly affected by the recession To state and local governments (to help them avoid raising their own taxes or cutting their own outlays) © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

U.S. Fiscal policy during recession of 2008– Short-run controversy: would the stimulus work? Objections: Timing The likely reaction of the Federal Reserve Objections from economists: Stimulus too small. Stimulus not well designed Stimulus too large Opposition to any stimulus © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Figure 4: Estimated Impact of Fiscal Stimulus on GDP Gap 24 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

U.S. Fiscal policy during recession of 2008– Long run controversy: what will happen later? Enlarging the deficit further – with stimulus package Along with other recession-fighting policies and the long-term budget outlook Could bring the U.S. economy close to its credit limit Debt-to-GDP ratio Already risen substantially by the end of 2008 Projected to rise even more rapidly than in the past For reasons having nothing to do with the recession © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Figure 5a: Current & projected deficits & federal debt relative to GDP 26 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Figure 5b: Current & projected deficits & federal debt relative to GDP 27 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

U.S. Fiscal policy during recession of 2008– Beyond the fiscal stimulus: long-run budget projections “Extended Baseline Scenario” Assumes that there will be no change in current fiscal policies, other than the expiration of temporary stimulus programs Debt ratio rises because of the aging of the population, and increases in Social Security and Medicare payments that will be required under current law © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

U.S. Fiscal policy during recession of 2008– Beyond the fiscal stimulus: long-run budget projections “Alternative Fiscal Scenario” Assumes that Congress will make the adjustments to taxes and transfers Adjustments to Medicare payments to reflect rising medical costs per person, and periodic correction of anomalies in the tax code © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Figure 6: Past and Future Debt: The Very Long Run 30 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.