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THE ECONOMIC EFFECTS OF PUBLIC SECTOR BORROWING McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. Deficits and Debt • The core critique of fiscal stimulus focuses on the budget consequences of government pumppriming – How do deficits arise? – What harm, if any, do deficits cause? – Who will pay off the accumulated national debt? 12-2 Budget Effects of Fiscal Policy • Keynesian theory highlights the potential of fiscal policy to solve macro problems – Fiscal policy: The use of government taxes and spending to alter macroeconomic outcomes • Use of the budget to stabilize the economy implies that federal expenditures and receipts won’t always be equal 12-3 Budget Surpluses and Deficits • Deficit spending: The use of borrowed funds to finance government expenditures that exceed tax revenues • Budget deficit: Amount by which government spending exceeds government revenue in a given time period Budget government tax – 0 deficit spending revenues 12-4 Budget Surpluses and Deficits • If the government spends less than its tax revenues, a budget surplus is created • Budget surplus: An excess of government revenues over government expenditures in a given time period 12-5 Keynesian View • Budget deficits and surpluses are a routine feature of counter-cyclical fiscal policy • The goal of macro policy is not to balance the budget but to balance the economy at fullemployment 12-6 Economic Effects of Deficits • Crowding out: A reduction in private-sector borrowing (and spending) caused by increased government borrowing • Crowding out reminds us that there is an opportunity cost to government spending • Government borrowing to finance deficits puts upward pressure on interest rates 12-7 Public-sector output Crowding Out g2 g1 b Increase in government spending . . . a c Crowds out private spending h2 h1 Private-sector output 12-8 Economic Effects of Surpluses • Four potential uses for a budget surplus: – – – – Spend it on goods and services Cut taxes Increase income transfers Pay off old debt (“save it”) • The economic effects are the mirror image of those for deficits 12-9 Crowding In • Crowding in: An increase in private-sector borrowing (and spending) caused by decreased government borrowing • When the government reduces borrowing, it takes pressure off market interest rates • As interest rates drop, consumers will be more willing and able to purchase big-ticket items 12-10 Crowding Out Hypothesis • Real Source (direct) crowding out • Financial (indirect) crowding out – Disincentive-to work – Disincentive-to-invest • Higher interest rates • Inflation 12-11