Download Inflation, Unemployment and Stabilization Policies: Long

Inflation, Unemployment,
and Stabilization Policies:
Long-run Implications of
Fiscal Policy
AP Economics
Mr. Bordelon
Budget Balance as a Measure of Fiscal Policy
NOTE: Do not think of balanced budgets as either good or bad.
Balanced budget is the difference between government tax
revenue and spending on g/s and transfers in a given year.
Sgovernment = T – G – TR
Sgovernment: government savings
T: tax revenues
G: gov’t purchases of g/s
TR: government transfers
Budget surplus. Positive budget balance.
Budget deficit. Negative budget balance.
Budget Balance as a Measure of Fiscal Policy
Recessionary Gap. Expansionary fiscal policy.
Cut taxes.
Increase transfers.
Increase government spending.
These policies would increase AD and reverse the
recession, and cause the budget balance to decrease.
Result: Smaller surplus or bigger deficit.
Budget Balance as a Measure of Fiscal Policy
Inflationary Gap. Contractionary fiscal policy.
Increase taxes.
Decrease transfers.
Decrease government spending.
These policies would decrease AD and reverse inflation,
and cause the budget balance to increase.
Result: Bigger surplus or smaller deficit.
Budget Balance as a Measure of Fiscal Policy
Changes in budget balance do not always reflect
changes to fiscal policy.
Two different changes in fiscal policy that have equalsize effects on the budget balance may have unequal
effects on the economy.
Gov’t spending increases by $1,000. It will have a larger
impact on real GDP than a tax decrease of $1,000. The
budget balance would change by $1,000 in each case, but
the impacts would be different.
Changes in the budget balance itself are sometimes the
result of fluctuations in the economy (cyclical).
Business Cycle and Cyclically Adjusted Budget Balance
Budget deficit almost always increases when
unemployment rate increases and decreases when
unemployment rate decreases.
This is not necessarily a result of expansionary fiscal
policy—automatic stabilizers!
Business Cycle and Cyclically Adjusted Budget Balance
Recession and the budget balance
Tax revenues decrease because incomes and profits decrease.
Transfer payments (unemployment, welfare, etc.) increase as
more people struggle.
This happens without deliberate fiscal policy changes and
budget balance decreases.
Inflation and the budget balance
Tax revenues increase because incomes and profits increase.
Transfer payments decrease as less people struggle.
This happens without any deliberate fiscal policy changes
and budget balance increases.
Business Cycle and Cyclically Adjusted Budget Balance
Awesome. So how do we figure out the effect of the
business cycle on the budget balance?
Deliberate changes in fiscal policy.
Current state of the business cycle.
Governments estimate what the budget balance would
be if there was neither a recessionary nor an
inflationary gap.
Business Cycle and Cyclically Adjusted Budget Balance
Cyclically adjusted budget balance. Estimate of what the budget
balance would be if real GDP equaled potential output (YP).
This takes into account the extra tax revenue the gov’t would
collect and transfers would save if a recessionary gap were
eliminated.
This also takes into account the tax revenue the gov’t would lose
and transfers it would make if an inflationary gap were eliminated.
If we adjust for the effects of the business cycle, and the
government is still running a deficit, then it’s a good bet the
gov’t’s fiscal policy decisions are not sustainable over the long run.
Should the Budget Be Balanced?
No, Shane, it should not. Why?
Recessionary gap
Tax revenue decreases and transfer payments increase, pushing the budget towards
a deficit.
To balance the deficit, taxes would need to increase and/or gov’t spending would
have to decrease.
This would make the recession worse.
Inflationary gap
Tax revenue increases and transfer payments decrease, pushing the budget towards
a surplus.
To balance the surplus, taxes would need to decrease and/or gov’t spending would
have to increase.
This would make inflation worse.
I love you too, Shane.
Fiscal Policy in the Long-Run
Deficits, Surpluses, and Debt. When a government
spends more than the tax revenue it receives (budget
deficit) it almost always borrows the extra funds.
Governments that run persistent budget deficits end
up with substantial debts.
National debt. Accumulation of all past deficits minus
all past surpluses.
Public debt. Gov’t debt held by individuals and
institutions outside the gov’t.
In fiscal year 2010, the public debt was $6.4 trillion.
Problem?
Fiscal Policy in the Long-Run
Problems Posed by Rising Government Debt
Crowding out. When the government borrows funds
in financial markets, it competes with firms that plan to
borrow funds for investment spending. Government’s
borrowing can crowd-out private investment spending,
increasing interest rates and reducing the economy’s
long-run rate of growth.
Pressure on future budgets. Today’s deficits, by
increasing government’s debt, place financial pressure
on future budgets. Interest must be paid in the future,
and this can take dollars away from other future
obligations.
Fiscal Policy in the Long-Run
Problems Posed by Rising Government Debt
How can gov’ts pay off debt?
Borrowing to pay off your debt. Bad idea—more debt.
Print money. Fed creates new money to pay debts of the
Treasury. Bad idea—lots of inflation.
Increase taxes or cut spending. Best solution, but
politically dangerous.
Fiscal Policy in the Long-Run
Deficits and Debt in Practice
Debt-GDP ratio. Gov’t’s debt as a percentage of GDP.
This measure is used because GDP measures the size of
the economy as a whole, and is a good indicator of the
potential taxes the government can collect.
If gov’t’s debt grows more slowly than GDP, burden of
paying that debt is actually falling compared with the
gov’t’s potential tax revenue.
Fiscal Policy in the Long-Run
Implicit Liabilities
Implicit liabilities. Spending promises made by gov’t’s
that are effectively a debt despite the fact that they are
not included in debt statistics.
For the U.S., promises to honor Society Security,
Medicare, and Medicaid amount to 40% of federal
spending. This is a problem because the American
population is aging and these commitments will continue
to grow.
Question 1
The government’s budget surplus in Macroland has risen
consistently over the past five years. Two government
policy makers disagree as to why this has happened. One
argues that a rising budget surplus indicates a growing
economy; the other argues that it shows that the
government is using contractionary fiscal policy. Can you
determine which policy maker is correct? If not, why not?
Question 2
You are an economic adviser to a candidate for national
office. She asks you for a summary of the economic
consequences of a balanced-budget rule for the federal
government and for your recommendation on whether she
should support such a rule. How do you respond?
Question 3
In which of the following cases does the size of the government’s debt
and the size of the budget deficit indicate potential problems for the
economy?
The government’s debt is relatively low, but the government is
running a large budget deficit as it builds a high-speed rail system
to connect the major cities of the nation.
The government’s debt is relatively high due to a recently ended
deficit-financed war, but the government is now running only a
small budget deficit.
The government’s debt is relatively low, but the government is
running a budget deficit to finance the interest payments on the
debt.