Download Section 6 AP Macroeconomics Inflation, Unemployment

Nancy K. Ware, Instructor
Gainesville High School
Gainesville, Georgia
1.
Why do governments calculate the cyclically adjusted
budget balance?
2.
Why might a large public debt be a cause for concern?
3.
Why are implicit liabilities of the government also a cause for
concern?
The Budget Balance
•
•
•
•
Deficits
Surpluses
Good? Bad?
What is your opinion?
• Sgov = Tax Revenue – G Spending - Transfers
• Expansionary policies reduce budget balance
• Contractionary policies increase budget balance
• G Spending has a greater impact than Taxes or Transfers –
Why?
• Changes in budget balance are often the result, not cause,
of economic fluctuations

The budget b__________is the difference between the
government’s t____r________ & its s________, both on
goods and services & on government transfers, in a given
year.

SGovernment = T - G – TR

where T = t_____revenues, G = government s___________
on goods and services, & TR is the value of government
t__________.

A budget surplus= p_______budget balance & a budget
deficit= n________budget balance.

The budget balance is the difference between the
government’s tax revenue and its spending, both on goods
and services and on government transfers, in a given year.

That is, the budget balance—savings by government—is
defined by:

SGovernment = T - G – TR

where T is the value of tax revenues, G is government
spending on goods and services, and TR is the value of
government transfers.

A budget surplus= positive budget balance & a budget
deficit= negative budget balance.
Case 1: R_____________ Gap.
What kind of fiscal policy is used? __________________.
What are your options?
1.
2.
3.

These 3 policies should i____________AD and reverse the recession, but will cause
the budget balance to ____________. This means either a smaller surplus or a
bigger deficit.
Case 2: I_______________ Gap. What kind of fiscal policy is used? ______________.
What are your options?
1.
2.
3.

These 3 policies should d___________AD and reverse the inflation, but will cause
the budget balance to ___________. This means either a bigger surplus or a
smaller deficit.
Case 1: Recessionary Gap.
What kind of fiscal policy is used? Expansionary.
What are your options?
1.
Cut taxes.
2.
Increase transfers.
3.
Increase government spending.

These three policies should increase AD and reverse the recession, but will cause
the budget balance to decrease. This means either a smaller surplus or a bigger
deficit.
Case 2: Inflationary Gap. What kind of fiscal policy is used? Contractionary.
What are your options?
1.
Increase taxes.
2.
Decrease transfers.
3.
Decrease government spending.

These three policies should decrease AD and reverse the inflation, but will cause
the budget balance to increase. This means either a bigger surplus or a smaller
deficit.
Changes in BB don’t always perfectly reflect changes in fiscal
policy.
 2 different changes in fiscal policy that have equal-size
effects on the BB may have quite unequal effects on the
economy.
EXAMPLE: If Government spending increases by $1000, it will
have a larger impact on real GDP than a tax decrease of $1000.
The budget balance would change by $1000 in each case, but
the impacts would be different…why?

Often, changes in the budget balance are themselves the
result, not the cause, of fluctuations in the economy (meaning
they are caused from the business cycle)
• A strong relationship between budget balance and business cycle
exists ~ WHY?
• A strong relationship between budget balance and business cycle
exists ~ WHY?
The budget moves into
deficit when the
economy is in recession
(think g spending), and
deficits shrink when the
economy moves into
expansion (less g
spending, increased tax
revenues). During
expansion, deficits get
smaller or the budget
balance moves into a
surplus.
Budget deficit rises when the UR rises & falls when the UR falls.
Why?
1. A____________________ S________________ ~ programs built into our tax and transfer
system that work to reduce the swings of the business cycle.
2. What happens to the budget balance (taxes & transfer payments) when the economy
heads into a recession?
 Tax revenues d___________ because incomes and profits are d___________.
 T________________ P_____________, like welfare assistance, begin to rise as more
people find themselves unemployed and struggling.
These changes happen without any deliberate fiscal policy changes & BB declines.
3. What happens to the budget balance (taxes & transfer payments) when the economy is
heading into an inflationary period?
 Tax revenues r__________because incomes and profits are r________.
 Transfer payments, like welfare assistance, begin to d________as fewer people find
themselves unemployed and struggling.
These changes happen without any deliberate fiscal policy changes & BB rises.
Budget deficit rises when the UR rises & falls when the UR falls.
Why?
1. Automatic stabilizers ~ programs built into our tax and transfer system that work to
reduce the swings of the business cycle.
2. What happens to the budget balance (taxes & transfer payments) when the economy
heads into a recession?
 Tax revenues decrease because incomes and profits are decreasing.
 Transfer payments, like welfare assistance, begin to rise as more people find themselves
unemployed and struggling.
These changes happen without any deliberate fiscal policy changes & BB declines.
3. What happens to the budget balance (taxes & transfer payments) when the economy is
heading into an inflationary period?
 Tax revenues rise because incomes and profits are rising.
 Transfer payments, like welfare assistance, begin to decrease as fewer people find
themselves unemployed and struggling.
These changes happen without any deliberate fiscal policy changes & BB rises.
1.
In analyzing the budget balance it is necessary to separate out the changes
that occur from deliberate f_________ p_________ & the movements of the
b__________c_________.
2.
WHY?
3.
By removing their effects, the government can analyze and focus on their
taxing and spending policies, and it can be ascertained if they are sustainable
in the L___________ R_______.
4.
An estimation is produced by the government of what the budget balance
would be if there was neither a r_____________ nor an i_____________ gap.
5.
This estimation is the c___________ a______________ b_________
b__________ is an estimate of what the budget balance would be if real GDP
were exactly equal to potential output.
6.
If the effects of the business cycle are adjusted for, and the government is still
running a deficit, then WHAT does that MEAN?
1.
In analyzing the budget balance it is necessary to separate out the changes
that occur from deliberate fiscal policy & the movements of the business
cycle.
2.
WHY? The effects of the business cycle are temporary. Recession and
Inflation don’t last forever.
3.
By removing their effects, the government can analyze and focus on their
taxing and spending policies, and it can be ascertained if they are sustainable
in the LONG RUN.
4.
An estimation is produced by the government of what the budget balance
would be if there was neither a recessionary nor an inflationary gap.
5.
This estimation is the cyclically adjusted budget balance is an estimate of
what the budget balance would be if real GDP were exactly equal to potential
output.
6.
If the effects of the business cycle are adjusted for, and the government is still
running a deficit, then WHAT does that MEAN? Maybe that their fiscal policy
decisions are not sustainable over the long run?
• Cyclically adjusted budget balance
• Political motivation for running
deficits (pet projects) or balancing
the budget (sounds good to voters)
• Economists argue against balanced
budget rule in favor of cyclically
balanced budget. Why?
• Should there be limits on deficits as
a compromise?
What if you were President. What is your opinion: Is it a good idea to require a federal
balanced budget annually? The fast answer is sure…
Case 1 : the economy is in a recessionary gap.
Falling tax revenue and rising transfer payments push the budget toward deficit.
1. How do you balance this deficit & what does this do to the economy?
Case 2: the economy is in an inflationary gap.
Rising tax revenue and falling transfer payments push the budget toward surplus.
2. How would we balance this surplus & what does this do to the economy?
3. What do most economists believe the government should do?
4. Why is this simple solution so difficult to achieve?
5. So are there serious downsides to an unbalanced budget?
What if you were President. What is your opinion: Is it a good idea to require a federal balanced budget
annually?
Case 1 : the economy is in a recessionary gap.
Falling tax revenue and rising transfer payments push the budget toward deficit.
1. How do you counter act this deficit to achieve balance & what does this do to the economy?
Increase taxes or decrease government spending, & how would that impact the recession? It would
make it WORSE.
Case 2: the economy is in an inflationary gap.
Rising tax revenue and falling transfer payments push the budget toward surplus.
2. How would you counter act this surplus to achieve balance & what does this do to the economy?
Decrease taxes or increase government spending, & how would this impact the inflationary period? It
would make it WORSE.
3. What do most Economists believe the government should do?
Balance its budget on average; run deficits in bad years, offset by surpluses in good years.
4. Why is this simple solution so difficult to achieve?
Political pressures (Americans LOVE tax cuts) make this difficult.
5. So are there serious downsides to an unbalanced budget?
When a government spends more than the tax revenue
it receives…..it runs a budget deficit….& it almost
always borrows the extra funds…..and governments
that run persistent budget deficits end up with
substantial debts.  http://www.usdebtclock.org/
Fiscal years….the national debt is the accumulation of
all past fiscal year deficits, minus all past surpluses.
http://www.youtube.com/watch?v=JjvMtGpj2U&feature=related&safety_mode=true&persist
_safety_mode=1&safe=active
Public Debt….government debt held by individuals and
institutions outside the government.
1. Government competes with private sector for
investment funds
2. Financial pressure on future budgets
3. Possibility of Default
4. Monetizing the Debt
5. Cyclical budget
1. Government competes with private sector for
investment funds (crowding out)
2. Financial pressure on future budgets (interest)
3. Possibility of Default (the act of not meeting financial
loan obligations)
4. Monetizing the Debt (just print more money? – what
about inflation?)
5. Cyclical budget (debt begats more debt – a vicious
cycle)
1. What are 2 reasons to be concerned when a government runs persistent budget deficits?
2. So in the future, how can a government pay off the debt? Should they borrow the money?
Option 1 Fiscally Fix the debt:
What are these issues with this solution?
Option 2 Monetarily Fix the debt:
What are the issues with this solution?
1. What are 2 reasons to be concerned when a government runs persistent budget deficits?
 When the government borrows funds in the financial markets, it is competing with firms that plan
to borrow funds for investment spending. The RESULT: the government’s borrowing may “crowd
out” private investment spending, increasing interest rates and reducing the economy’s long-run
rate of growth.
 Today’s deficits, by increasing the government’s debt, place financial pressure on future budgets
& future generations of Americans. Those budgets will have to pay interest on that borrowed
money in the future, and this can take dollars away from other future federal obligations like
social security, education, defense, research grants, space exploration, etc.
2. So in the future, how can a government pay off the debt? Should they borrow the money?
Borrowing to pay off your debt isn’t really an option. That’s like getting a new credit card to pay off
the old credit card. Eventually, that is the road to personal bankruptcy. Nations have essentially
declared bankruptcy in the past. It’s not pretty! (See Ireland, Greece, Cyprus)
Fiscally: Increase taxes or cut spending. Probably the best solution, but isn’t very politically popular
or successful, especially when a nation as become accustomed to low taxes.
Monetarily: Printing money. Basically this means the Fed creates new money to pay the debts of the
Treasury. This proves to be a fast track to serious inflation.
 Debt-GDP Ratio
The debt–GDP ratio, the government’s debt as a percentage of GDP assesses the ability of
governments to pay their debt. This is a good indicator of the potential taxes the
government can collect.
If the government’s debt grows more slowly than GDP, the burden of paying that debt is
actually falling compared with the government’s potential tax revenue.
**On your phone or Ipad, find data from 1990-2000 and from 2000-present . Is the debtGDP ratio rising, falling, or staying roughly the same?
1. Implicit liabilities are
s___________
p____________made by
governments that are effectively a
d______despite the fact that they
are not included in the usual debt
statistics.
2. In the US, promises to honor
S_________ S__________,
M__________ & M__________
amount to 40% of federal spending.
3. Is this a big deal? Why or Why
Not?
1. Implicit liabilities are spending
promises made by governments
that are effectively a debt despite
the fact that they are not included
in the usual debt statistics.
2. In the US, promises to honor
Social Security, Medicare and
Medicaid amount to 40% of
federal spending.
3. Is this a big deal? Why or Why
Not?
Yes because the American
population is aging and these
commitments will only get larger.

Module Review Questions p. 305

Read Module 31 p. 307-312