Download Macroeconomics Chapter 13 Final PPT

Chapter 13
Fiscal Policy,
Deficits, and
Debt
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
• Purposes, tools, and limitations of
fiscal policy
• Built-in stabilizers and the business
cycle
• The standardized budget and U.S.
fiscal policy
• U.S. public debt
13-2
Fiscal Policy
• One major function of the
government is to stabilize the
economy by preventing
unemployment or inflation
• This stabilization can be done by
manipulating the public budget
–By adjusting the spending and tax
collections of government, they can
increase output and employment to
reduce inflation
13-3
Fiscal Policy
• Discretionary fiscal policy refers to the
deliberate manipulation of taxes and
government spending by Congress to
change domestic output and
employment, control inflation and
stimulate growth
• “Discretionary” means the changes are
at the option of the Federal government
• Discretionary fiscal policy changes are
often initiated by the President, on the
advice of his economic advisors
Fiscal Policy
There are some fiscal policy
changes that do not result from
congressional action
• These are called nondiscretionary
policy changes
• They are passive or automatic
and respond to legislation already
enacted
Fiscal Policy
• Expansionary fiscal policy is used to
when the country is facing a
recession because of increasing
unemployment and decreasing GDP
– The government can increase
spending to help lower unemployment
and/or lower taxes to encourage
investment
– If the Federal budget is balanced at
the beginning (tax revenues =
government spending), expansionary
fiscal policy will create a budget deficit
where spending exceeds tax revenues
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Expansionary Fiscal Policy
•
•
•
•
•
•
Suppose full-employment is at $510 billion
Price level is inflexible at P1
Aggregate demand moves to the left
Real GDP drops from $510 to $490 billion
A negative GDP of $20 billion occurs
Unemployment occurs
Expansionary Fiscal Policy
•
•
•
•
•
The government may increase spending
The recession causes the government to spend $5 billion on construction
projects
This shifts the demand curve from AD2 to the dotted line just to its
immediate right
However, because of the multiplier effect, the demand curve moves to AD1
Thus real output rises to $510 billion; up $20 billion from the recessionary
level
Expansionary Fiscal Policy
Recessions
Decrease
Aggregate
Demand
Price Level
$5 Billion
Additional
Spending
AS
Full $20 Billion
Increase in
Aggregate Demand
P1
AD1
AD2
$490
$510
Real Domestic Output, GDP
13-9
Tax reductions
• You can get the same result by reducing
taxes which will shift AD right from AD2 to
AD1
• Cutting personal income taxes by $6.67
billion will increase disposable income by the
same amount
• Consumption will rise by $5 billion; savings
by $1.67 billion
• The horizontal distance between AD2 and
the dashed line represents only the $5 billion
initial increase in consumption spending
Tax reduction
• It is called the “initial” consumption spending
because the multiplier process yields successive
rounds of increased consumer spending
• The AD curve eventually shifts rightward by four
times the $5 billion initial increase in consumption
produced by the tax cut
• Real GDP rises by $20 billion, from $490 billion to
$510 billion, showing a multiplier of 4
• Note that a tax cut must be somewhat larger than
the increase in government savings because part
of the tax reduction increases savings
Contractionary fiscal policy
• When demand-pull inflation occurs (prices rising), a restrictive or
contractionary fiscal policy may be needed
• In Fig. 13.2, full employment is at point a; intersection of AD 3 and
AS with GDP of $510 billion
– Price level is P1
Contractionary fiscal policy
• Assume a $5 billion initial increase in investment and net exports
shifts AD3 to AD4 (ignore dashed line)
• With the upward-sloping AS, the GDP only rises by $12 billion to
$522 billion
• Some of the rightward move of AD causes demand-pull inflation
instead of increased output
• Price level rises from P1 to P2 at pt b
Contractionary fiscal policy
• To eliminate the inflationary GDP gap, the
government must either decrease government
spending, raise taxes, or use a combination of the
two policies
• When the economy faces demand-pull inflation,
fiscal policy should move toward a government
budget surplus – tax revenues in excess of
government spending to slow down investment
and the economy in general
• However, while increases in AD expand real
output beyond full-employment level and the price
level gets racheted up, decreases in the AD don’t
seem to bring prices down very quickly
• This must be taken into account by policy makers
Decreased government spending
• Assume gov. is not aware of racheting effect
• Gov. might assume problem could be solved by causing a $20
billion leftward shift of the AD from AD4 to AD3
• It would do this by reducing gov. spending by $5 billion and allow
multiplier of 4 to expand that initial decrease into a $20 billion
decline in AD back to AD3
Contractionary fiscal policy
• Looks like a good solution; economy is back at pt a with fullemployment and GDP of $510 billion; price level back to P1
• Doesn’t happen! Price level stuck at P2 so that P2 becomes
supply line
• Reduced gov. spending of $5 billion will actually cause a recession
• New equilibrium will be at pt d, where AD3 crosses broken
horizontal line
• At point d, real GDP is only $502; $8 billion below full-employment
level of $510 billion
Contractionary fiscal policy
• With an immediate short-run supply curve,
the multiplier is at full effect
• With price level fixed, and AS horizontal, a
$20 billion leftward shift of the AD causes
a full $20 decline in GDP
• As a result, GDP falls by the full $20
billion, from $522 billion to $502 billion, or
$8 billion below potential output
• By not understanding rachet effect, the
gov. has replaced a $12 billion inflationary
gap with an $8 billion recessionary GDP
gap
Contractionary fiscal policy
• How to avoid problem; gov determines
inflationary GDP gap is $12 billion, that
price level is fixed, that AS is horizontal,
and that multiplier is in full effect
• Thus, any decline in gov. spending will be
multiplied by a factor of 4
• Gov. spending should decline by only $3
billion and not $5 billion
• This is because a decline of $3 billion
times 4 (multiplier) = $12 billion which will
exactly offset the $12 billion GDP gap
Contractionary fiscal policy
• Back to Fig 13.2; the horizontal distance between AD 4 and the
dashed line to its left represents the $3 billion decrease in gov.
spending
• Once multiplier is done, the spending cut will shift the AD leftward
from AD4 to AD5
• With price level fixed at P2, and AS horizontal as shown by dashed
line, economy will come to equilibrium at pt c
Contractionary fiscal policy
• Increased taxes will also get you to the
same point
• If the gov. raised taxes by $4 billion,
savings would be reduced by $1 billion
and consumption by $3 billion
• This initial $3 billion decline in
consumption will cause AD to shift
leftward by $12 billion at each price level
• Economy will move to point c, the
inflationary GDP gap will be closed and
the inflation will be stopped
Fiscal policy actons
• Combined policies of tax increases and
reducing spending will also work
• Gov. could decrease spending by $1.5
billion and increase taxes by $2 billion to
get same result (would need to calculate
mpc and mps to go this)
Which is better; taxes or government
spending?
• Which policy option is better
– If you think gov. is too big, go with tax cuts
during recession and cut government
spending during inflation
– If you think gov has a very large social
responsibility, go with increased spending
during recession and tax increases during
inflation
– Sound like traditoinal “republican” and
“democrat” policy positions?
Built-In Stability
• Built-in stability arises because net taxes (taxes
minus transfers and subsidies) changes with
GDP
• It is desirable that spending rises automatically
when the economy is doing poorly and viceversa when the economy is becoming
inflationary
13-23
Built-In Stabilizers
• 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
such as welfare and unemployment rise,
net tax revenues fall along with GDP
• The size of automatic stability depends
upon how responsive the system is to
changes in taxes compared to changes in
GDP
Built-In Stabilizers
• The size of automatic stability depends
upon the responsiveness of changes in
taxes to changes in GDP
– Progressive tax: the average tax rate rises
with GDP (tax revenue/GDP)
– Proportional tax: the average tax rate
remains constant as the GDP rises
– Regressive tax: the average tax rate falls as
GDP rises
Built-In Stabilizers
• As shown in Fig. 13.3, tax revenues automatically increase as GDP
rises during prosperity
• Increased taxes reduce household and business spending and thus
slow down the economic expansion
• As the economy moves toward a higher GDP, tax revenues
automatically rise and move the budget from deficit toward surplus
• Note that the high inflationary income level GDP3 automatically
generates a contractionary
budget surplus
Built-In Stabilizers
•
•
•
Conversely, as GDP falls during recession, tax revenues automatically
decline, increasing spending and reducing the impact of the economic
contraction
With a falling GDP, tax receipts decline and move the governments budget
from surplus toward deficit
In Fig. 13.3, the low level of income GDP1 will automatically yield an
expansionary budget deficit
Built-In Stabilizers
• The U.S. tax system reduces business
fluctuations by as much as 8 to 10 percent
of the change in GDP that would
otherwise occur
• However, built-in stabilizers can only
reduce, not eliminate, swings in real GDP
• Discretionary fiscal policy such as
changes in tax rates and gov.
expenditures, along with monetary policy,
are needed to correct any large recession
or inflation
Federal Budget Balance
Actual and Projected, Fiscal 1994-2014
Actual
Projected
(as of March 2008)
Budget Deficit (-) or Surplus, Billions
$300
200
100
0
-100
-200
-300
-400
-500
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Source: Congressional Budget Office
13-29
Fiscal Policy Issues
Problems, Criticisms, and Complications
• Recognition lag is the elapsed time
between the beginning of recession
or inflation and awareness of this
occurrence
– It may take several months to detect a
recession or inflation
– Even periods of moderate inflation
have months of high inflation
– Due to this recognition lag, the
economic downslide or the inflation
may become more serious than it
would have if the situation had been
identified and corrected sooner
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Fiscal Policy Issues
• Administrative lag
– Trying to get the house, senate, and the
president to agree on a specific plan of attack
may take months
– In contrast, the Federal Reserve may act within
weeks
• Operational lag
– Even once a policy is decided upon, it may
require weeks to months to years (construction
projects) to get underway
• As a result, discretionary fiscal policy has
increasingly relied on tax changes rather
than on changes in spending as its main tool
Fiscal Policy Issues
• Crowding out effect – when the government
borrows money during a deficit and spends,
its borrowing may increase the interest rate
• This would reduce or crowd out private
investors which overall, would weaken or
cancel the stimulus of fiscal policy
• This phenomenon may not occur during a
recession when little borrowing or investment
occurs
• It is a much more serious problem during
times when the economy is near full
employment GDP
The Public Debt
• The national debt is the total accumulation
of the Federal government’s total deficits
and surpluses that have occurred over time
• The national debt was $9.01 trillion in 2007
and $14 trillion in 2011
• Using the 2007 debt number, 47 percent of
the debt was held by the public and 53
percent by the government, including the
Federal Reserve
• Foreign interests held about 25% of the
public debt in 2007
• The Federal debt held by the public was
about 32% of the GDP in 2007
13-33
The Public Debt
Debt Held Outside
The Federal
Government
and Federal
Reserve (47%)
Other, Including
State and Local
Governments
U.S. Banks
And other
Financial
Institutions
8%
Debt Held by the
Federal Government
and Federal
Reserve (53%)
7%
9%
Federal
Reserve
25%
Foreign
Ownership
7%
44%
U.S.
Government
Agencies
U.S.
Individuals
Total Debt: $9.01 trillion
Source: U.S. Treasury
13-34
Debt and GDP
Federal debt held by the public, percentage of GDP
50
45
Percent of GDP
40
35
30
25
20
15
10
5
0
1970
1975
1980
1985
1990
Year
1995
Source: Economic Report of the President, 2006
2000
2005
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Debt and GDP
Publicly Held Debt: International Comparisons
As a Percentage of GDP, 2007
0
20
40
60
80
100
Italy
Japan
Belgium
Hungary
Germany
United States
United Kingdom
France
Netherlands
Canada
Spain
Poland
Source: Organization for Economic Cooperation and Development
13-36
Debt and GDP
• Interest charges are the main
burden imposed by the debt
– Interest on the debt was $237
billion in 2007 and is the fourth
largest item in the Federal budget
after income security, national
defense, and health
– Interest payments were 1.7% of the
GDP in 2007
– That percentage represents the
average tax rate necessary just to
cover annual interest on the debt
13-37
Debt and GDP
Substantive issues
• Repayment of the debt affects income distribution;
working taxpayers pay interest to wealthier groups who
hold the bonds, probably increasing income inequality
• Since interest is paid out of gov. revenues, a large debt
and high interest rate can increase tax burdens and
may decrease incentives to work and save for taxpayers
• A higher proportion of debt is owed to foreigners than in
the past, and this can increase the burden since
payments leave the country
• Some economists believe public borrowing crowds out
private investment, especially when at full-employment
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Crowding Out
A Large Public Debt to Finance Public Investment Will Cause…
16
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
ID1
15
20
25
30
35
40
Investment (Billions of Dollars)
13-39
The Leading Indicators indicating
potential decline in GDP
1. Average workweek becomes
shorter
2. Initial claims for unemployment
insurance increase
3. New orders for consumer goods
decrease
4. Vendor performance improves
sowing less business demand
5. New orders for capital goods drops
Source: The Conference Board
13-40
The Leading Indicators indicating
potential decline in GDP
6. Building permits for houses decline
7. Stock prices decline
8. Money supply decreases
9. smaller interest rate spread in interest
rates – restrictive monetary policies
10. Consumer expectations decline
Key Terms
• 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
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Money and
Banking
13-43