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Chapter 11
11
Fiscal Policy, Deficits,
and Debt
11-1
Copyright 2008 The McGraw-Hill Companies
Chapter 11
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.
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Copyright 2008 The McGraw-Hill Companies
Chapter 11
Fiscal Policy and the
AD-AS Model
• Fiscal Policy.
– Changes in government spending and tax
collections designed to achieve fullemployment and non-inflationary domestic
output.
– This is also called discretionary fiscal policy.
• Council of Economic Advisers (CEA).
– Discretionary fiscal policy changes are often
initiated by the President, on the advice of
the Council of Economic Advisers (CEA).
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Chapter 11
Fiscal Policy and the
AD-AS Model
• Discretionary Fiscal Policy.
– Discretionary fiscal policy refers to the
deliberate manipulation of taxes and
government spending by Congress to alter
real domestic output and employment,
control inflation, and stimulate economic
growth.
– “Discretionary” means the changes are at the
option of the Federal government.
• Nondiscretionary Fiscal Policy.
– Changes not directly resulting from
congressional action are referred to as
nondiscretionary (or “passive”) fiscal
policy.
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Copyright 2008 The McGraw-Hill Companies
Chapter 11
Fiscal Policy and the
AD-AS Model
• Expansionary Fiscal Policy.
– Increased Government Spending.
– Tax Reductions.
– Some Combination of the Two.
• Budget Deficit.
– If the budget was initially balanced,
expansionary fiscal policy creates a
budget deficit.
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Chapter 11
Fiscal Policy and the
AD-AS Model
Expansionary Fiscal Policy
Full $20 Billion
Increase in
Aggregate Demand
Price Level
$5 Billion
Additional
Spending
AS
Recessions
Decrease
Aggregate
Demand
P1
AD1
AD2
$490
$510
Real Domestic Output, GDP
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Copyright 2008 The McGraw-Hill Companies
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Chapter 11
Fiscal Policy and the
AD-AS Model
• Contractionary Fiscal Policy.
– Decreased Government Spending.
– Increased Taxes.
– Some Combination of the Two.
• Budget Surplus.
– If the budget was initially balanced,
contractionary fiscal policy creates a
budget surplus.
• Policy Options: G or T?
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Copyright 2008 The McGraw-Hill Companies
Chapter 11
Fiscal Policy and the
AD-AS Model
Contractionary Fiscal Policy
Recessions
Decrease
Aggregate
Demand
$5 Billion
Initial Decrease
In Spending
Price Level
AS
Full $20 Billion
Decrease in
Aggregate Demand
P1
AD4
AD3
$510
$522
Real Domestic Output, GDP
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Copyright 2008 The McGraw-Hill Companies
Chapter 11
Built-In Stability
• Automatic or Built-In Stabilizers.
– Built in stability arises because net taxes
(taxes minus transfers and subsidies) change
with GDP.
– Taxes automatically rise with GDP because
incomes rise and tax revenues fall when
GDP falls.
– Transfers and subsidies rise when GDP falls;
when these government payments (welfare,
unemployment, etc.) rise, net tax revenues
fall along with GDP.
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Chapter 11
Built-In Stability
• Economic Importance.
– The size of automatic stability depends on
responsiveness of changes in taxes to
changes in GDP.
– The more progressive the tax system, the
greater the economy’s built in stability.
• Tax Progressivity.
– Progressive Tax System.
– Proportional Tax System.
– Regressive Tax System.
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Copyright 2008 The McGraw-Hill Companies
Chapter 11
Built-In Stability
Government Expenses, G
and Tax Revenues, T
T
Surplus
G
Deficit
GDP1 GDP2
GDP3
Real Domestic Output, GDP
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Copyright 2008 The McGraw-Hill Companies
Chapter 11
Evaluating Fiscal Policy
• Standardized Budget (Full-Employment
Budget).
– A standardized budget in Year 1 is illustrated
in Figure 11.4(a) because budget revenues
equal expenditures when full employment
exists at GDP1.
•
•
•
•
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Cyclical Deficit.
Recent U.S. Fiscal Policy.
Budget Deficits and Projections.
Social Security Considerations.
Copyright 2008 The McGraw-Hill Companies
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Chapter 11
Evaluating Fiscal Policy
Government Expenses, G
and Tax Revenues, T
T
a
b
$500
$450
G
c
GDP2
(Year 2)
GDP1
(Year 1)
Real Domestic Output, GDP
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Copyright 2008 The McGraw-Hill Companies
Chapter 11
Evaluating Fiscal Policy
Government Expenses, G
and Tax Revenues, T
T1
T2
d
e
$500
$475
G
h
$450
f
g
$425
GDP4
(Year 4)
GDP3
(Year 3)
Real Domestic Output, GDP
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Copyright 2008 The McGraw-Hill Companies
Chapter 11
Recent U.S. Fiscal Policy
Federal Deficits and Surpluses – 1990 - 2005
as a Percentage of Potential GDP
(1)
Year
(2)
Actual
Deficit (-) or
Surplus (+)
(3)
Standardized
Deficit (-) or
Surplus (+)
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
-3.9%
-4.4%
-4.5%
-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%
-2.2%
-2.5%
-2.9%
-2.9%
-2.1%
-2.0%
-1.2%
-1.0%
-0.4%
+0.1%
+1.1%
+1.1%
-1.1%
-2.7%
-2.4%
-1.8%
Source: Congressional Budget Office
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Chapter 11
Recent U.S. Fiscal Policy
Global Perspective
Full-Employment Budget Deficits or Surpluses
as a Percentage of Potential GDP, 2005
Deficits
-4
-2
-6
0
Surpluses
2
4
New Zealand
+3.1
Denmark
+1.2
Canada
-1.3
Ireland
-2.4
France
-3.0
Norway
-3.0
United Kingdom
-3.6
United States
Japan
6
+4.6
-6.3
Source: Organization for Economic Cooperation and Development
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Copyright 2008 The McGraw-Hill Companies
Chapter 11
Recent U.S. Fiscal Policy
Federal Budget Deficits and Surpluses
Actual and Projected, Fiscal 1992-2012
Actual
Projected
(as of March 2006)
Budget Deficit (-) or Surplus, Billions
$300
200
100
0
-100
-200
-300
-400
-500
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Source: Congressional Budget Office
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Copyright 2008 The McGraw-Hill Companies
Chapter 11
Recent U.S. Fiscal Policy
Problems, Criticisms, and Complications
• Problems of Timing.
– Recognition Lag.
– Administrative Lag.
– Operational Lag.
• Political Considerations.
– Political Business Cycle.
• Future Policy Reversals.
• Offsetting State and Local Finance.
• Crowding-Out Effect.
• Current Thinking on Fiscal Policy.
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Chapter 11
The Public Debt
• The national or public debt is the total
accumulation of the Federal
government’s total deficits and surpluses
that have occurred through time.
• National or Public Debt $7.96 Trillion in
2005.
• Ownership.
– U.S. Securities.
– 51% Owned by Federal Government and
Federal Reserve.
– 49% Held Outside the Federal
Government and Federal Reserve.
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Copyright 2008 The McGraw-Hill Companies
Chapter 11
The Public Debt
Total Debt
$7.96 Trillion
Debt Held Outside
The Federal
Government
and Federal
Reserve (49%)
Other – Including
State and Local
Governments
U.S. Banks
And other
Financial
Institutions
8%
Debt Held by the
Federal Government
and Federal
Reserve (51%)
8%
9%
Federal
Reserve
25%
Foreign
Ownership
8%
42%
U.S.
Government
Agencies
U.S.
Individuals
Source: U.S. Treasury
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Copyright 2008 The McGraw-Hill Companies
Chapter 11
Debt and GDP
Federal Debt Held by the Public as a
Percentage of GDP, 1970 - 2005
50
45
Percent of GDP
40
35
30
25
20
15
10
5
0
1970
1975
1980
1985
1990
Year
1995
2000
2005
Source: Economic Report of the President, 2006
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Chapter 11
Debt and GDP
Global Perspective
Publicly Held Debt:
International Comparisons
As a Percentage of GDP - 2005
0
20
40
60
80
100
101.3
Italy
Belgium
Japan
Germany
France
United States
Hungary
Netherlands
United Kingdom
Spain
Canada
Poland
86.3
80.9
58.8
46.5
45.7
39.6
39.3
39.1
28.7
26.4
17.0
Source: Organization for Economic Cooperation and Development
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Chapter 11
Debt and GDP
• Interest Charges.
• False Concerns.
– Bankruptcy.
• Refinancing.
• Taxation.
– Burdening Future Generations.
• In 2005 the per capita federal debt in U.S.
was $26,834.
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Chapter 11
Debt and GDP
Substantive Issues.
– Income Distribution.
• Repayment of the debt affects income
distribution.
– Incentives.
• A large debt and high interest can
increase tax burden and may decrease
incentives to work, save, and invest for
taxpayers.
– Foreign-Owned Public Debt.
– Crowding-Out Effect Revisited.
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Chapter 11
Debt and GDP
The Investment Demand Curve
and the Crowding-Out Effect
A Large Public Debt to Finance Public Investment Will Cause…
16
If Public Spending
Spurs More Private
Investment Will
Increase to ID2
Real Interest Rate (Percent)
14
12
b
10
c
8
a
6
Interest Rate
Rise Will
4
Decrease
2 Investment
a to b
0
5
10
CrowdingOut Effect
ID2
ID1
15
20
25
30
35
40
Investment Demand (Billions of Dollars)
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Copyright 2008 The McGraw-Hill Companies
Chapter 11
Debt and GDP
• Public Investments and Public-Private.
Complementarities.
• Public Investments.
– Public Goods Spending.
– Human Capital Spending.
– Reduction on Crowding-Out Effect.
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Copyright 2008 The McGraw-Hill Companies
Chapter 11
Key Terms
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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
Copyright 2008 The McGraw-Hill Companies
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Chapter 11
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Money and Banking
Chapter 12
11-28
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