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PRINCIPLES OF ECONOMICS
Chapter 30 Government Budgets and Fiscal Policy
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THE GREAT RECESSION
Yellowstone National Park is one of the many national
parks forced to close down during the government shut
down in October 2013.
TREND OF GOVERNMENT SPENDING
Since 1960, total federal spending has ranged from about 18% to
22% of GDP, although it climbed above that level in 2009. The share
spent on national defense has generally declined, while the share
spent on Social Security and on healthcare expenses (mainly
Medicare and Medicaid) has increased.
DISTRIBUTION OF GOVERNMENT SPENDING
About 71% of government spending goes to four major areas:
national defense, Social Security, healthcare, and interest payments
on national debt. This leaves about 29% of federal spending for all
other functions of the U.S. government.
STATE AND LOCAL GOVERNMENT SPENDING
Spending by state and local government increased from about 10% of
GDP in the early 1960s to 14–16% by the mid-1970s. It has remained
at roughly that level since. The single biggest spending item is
education, including both K–12 spending and support for public
colleges and universities, which has been about 5–6% of GDP in
recent decades.
TAX STRUCTURE
Federal tax revenues have been about 17–20% of GDP. The primary
sources of federal taxes are individual income taxes and the payroll
taxes that finance Social Security and Medicare. Corporate income
taxes, excise taxes, and other taxes provide smaller shares of revenue.
STATE AND LOCAL TAX REVENUES
State and local tax revenues from about 8% to over
10% of the GDP. They have increased to match the
rise in state and local spending.
FEDERAL GOVERNMENT DEFICIT
The federal government has run budget deficits for decades. The
budget was briefly in surplus in the late 1990s, before heading into
deficit again in the first decade of the 2000s—and especially deep
deficits in the recession of 2008–2009.
FEDERAL GOVERNMENT DEFICIT
When government spending exceeds taxes, the gap is the budget
deficit. When taxes exceed spending, the gap is a budget surplus. The
recessionary period starting in late 2007 saw higher spending and
lower taxes, combining to create a large deficit in 2009.
FEDERAL GOVERNMENT DEBT
During the 1960s and 1970s, the government often ran small
deficits, but since the debt was growing more slowly than the
economy, the debt/GDP ratio was declining over this time. In the
2008–2009 recession, the debt/GDP ratio rose sharply.
ILLUSTRATION OF A HEALTHY ECONOMY
In this well-functioning economy, each year AD AND AS rise so that
the economy proceeds from equilibrium E0 to E1 to E2. Each year, the
economy produces at potential GDP with only a small inflationary
increase in the price level.
Fiscal Policy: The government’s spending and
taxing policies to stabilize economic activity.
Discretionary Fiscal Policy: Changes in taxes or
spending that are the result of deliberate changes
in government policy.
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FISCAL POLICY
Expansionary Fiscal Policy: Increased
government spending and/or reduced taxes
to increased AD to help the economy grow
faster.
Contractionary Fiscal Policy: decreased
government spending and/or increased
taxes to reduce the AD and reduce
inflation.
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FISCAL POLICY
EXPANSIONARY FISCAL POLICY
An expansionary fiscal policy shifts the AD to the right.
The economy will recover from a recession to reach full
employment equilibrium.
CONTRACTIONARY FISCAL POLICY
An contractionary fiscal policy shifts the AD to the left.
The economy will recover from rapid inflation to reach full
employment equilibrium.
THE CROWDING-OUT EFFECT
To pay for an expansionary fiscal policy, the
government borrows money, increasing the demand
for loanable funds and causing the rate of interest to
rise.
Effectiveness of Stabilization Policy
Stabilization policy describes both monetary and
fiscal policy, the goals of which are to smooth out
fluctuations in output and employment and to keep
prices as stable as possible.
Time lags: Delays in the economy’s response to
stabilization policies.
Attempts to stabilize the economy can prove to be
destabilizing because of time lags.
TIME LAGS
Recognition Lag: The time that takes for policy
makers to recognize the existence of a boom or bust.
Implementation Lag: The time that takes to put the
desired policy into effect once policy makers realize
the economy is in a boom or bust.
Response Lag: The time that takes for the
economy to adjust to the new conditions after a
new policy is implemented; the lag that occurs
because of the operation of the economy itself.
TIME LAGS
Response Lags for Fiscal Policy:
There is a long delay between the time a
fiscal policy action is initiated and the
time the full change in GDP is realized.
Until individuals or firms can revise their
spending plans, extra government
spending does not stimulate extra private
spending.
TIME LAGS
Response Lags for Monetary Policy:
Monetary policy works by changing
interest rates, which then change planned
investment and consumption spending on
durable goods.
The response of consumption and
investment to interest rate changes takes
time.