Download Lecture32(Ch29)

Fiscal policy
• Focus
– Spending
• distinguish between purchases and spending or
outlays or expenditures
– Tax revenues
• distinguish between tax rates and tax revenues
• let t = tax rate, Y = income,
• then tax revenue is T = tY
– Government debt
• Today’s topics: effect of deficit, debt,
countercyclical policy, structural deficit,
automatic stabilizers, rules versus discretion
29_02
Fiscal year 2000
Jan. 1, 1999 Apr. 1
President submits
budget to Congress
in early February.
July 1
Oct. 1
Congress debates,
modifies, and
passes budget.
Jan. 1, 2000 Apr. 1
July 1
Supplementary budget or
changes in economy may
affect actual spending.
Oct. 1
Jan. 1, 2001
Fiscal year is over;
spending and taxes
are tabulated.
Federal budget summary
(billions of dollars)
Fiscal year 1998 versus 1995
Tax revenues 1721.4
Expenditures 1651.4
Defense
270.4
Interest
243.4
Soc. Sec. 379.2
Medicare 192.8
Surplus
70.0
1351.8
1515.7
272.1
232.2
335.8
159.9
- 163.9
Deficit versus debt
• When the government runs a deficit, it
increases its debt
• When the government runs a surplus, it
reduces its debt
• surplus (‘98) = debt (end ‘97) - debt (end ‘98)
• 70 = 3771.1 - 3701.1
• Government borrows by issuing bonds
– and retires these bonds when in has a surplus
A graph of the deficit and the debt
29_03
BILLIONS
OF DOLLARS
Debt
3,500
3,000
2,500
2,000
1,500
1,000
500
Deficit
0
-500
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
Debt as a share of GDP
• Debt/GDP can stay constant or even fall
when there is a budget deficit
• Example
– 5% growth of GDP
– then ratio stays constant if
• Debt/GDP = Debt(1.05)/GDP(1.05)
• thus $3.7 trillion times (.05) = $185 billion deficit
• Debt/GDP ratio falls with balanced budget
29_04
PERCE NT
OF
80
GDP
High after WWII
70
Ratio just starting
to decline

Late 1980s
60
Steady decline
with small deficits,
some surpluses
50
40
plateau
Deficits
are
back
Big deficits
start
30
20
Post-WWII bottom
10
0
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
Long run effect of deficits or surpluses
• The long run effect of a lower deficit or
higher surplus are those of a lower the share
of G in GDP---use SAM
– real interest rate lower
– I/Y higher, leading to higher potential growth
• Short run negative effects can be mitigated
by being gradual, being credible, and letting
Fed join in (but this is an old issue, now...
The question is how to “use” the
“projected” surplus
• Recent shift from deficit to surplus
• Leave it? Cut taxes? Increase spending?
• The social security problem
– As baby boom generation retires, benefits will
grow relative to payroll tax revenues
– Will need to reduce benefits or increase taxes
– Some suggest privatizing part of social security
Countercyclical fiscal policy
• Argues that increasing government
spending or reducing taxes during a
recession would mitigate the recession
– Suggested by Keynes in 1930s (Keynesian
policy)
• Rationale now for “fiscal stimulus” package
in Japan
• Discretionary versus automatic
Use of countercyclical fiscal policy (G)
to bring the economy back to potential
29_05
INFLATION
Potential GDP
PA
ADI with increase in
government purchases
Old ADI
REAL GDP
INFLATION
Potential GDP
PA
Old ADI
ADI with decrease in
government purchases
REAL GDP
Use of countercyclical fiscal policy (taxes)
to bring economy back to potential
29_06
INFLATION
Potential GDP
PA
Old ADI
ADI with
tax cut
REAL GDP
INFLATION
Potential GDP
PA
Old ADI
ADI with tax
increase
REAL GDP
Case of good timing in using fiscal
policy to hasten the return of real GDP
back to potential GDP
INFLATION
29_08
Potential GDP
Path of economy without
a fiscal stimulus
Path of economy with
a fiscal stimulus
PA
ADI
without
stimulus
Old ADI
ADI with
stimulus
REAL GDP
Effect of fiscal policy on the path of
real GDP: good and bad timing
29_09
29_07
BILLIONS
OF DOLLARS
BILLIONS
OF DOLLARS
Path of real GDP with a fiscal
stimulus that came
too late
Potential GDP
Potential GDP
Path of real GDP
without fiscal stimulus
Path of real GDP
with fiscal stimulus
Path of real GDP
without fiscal stimulus
2000
2001
2002
2003
2004
2005
2000
YEAR
2001
2002
2003
2004
2005
Effect of the economy
on the budget deficit
• Budget deficit is cyclical
– Deficit rises in recessions
– Deficit falls during recoveries and expansions
• To see the reason look at tax revenues and
expenditures
Government tax revenues depend
on the state of the economy
• when real GDP grows more rapidly, tax
revenues rise faster
– more people working, higher incomes
– people move into higher tax brackets
• when real GDP grows more slowly, tax
revenues rise less rapidly
– fewer people working, lower incomes
– people may move into lower tax brackets
Expenditures also depend on the
economy
• When real GDP grows less rapidly or falls,
as in a recession, expenditures grow more
rapidly
– unemployment compensation rises
– welfare payments go up
– more people retire, increasing social security
payments
• When real GDP grows more rapidly, as in a
recovery, expenditures grow less rapidly
Net effect of real GDP on deficit
• deficit = government spending - tax revenue
• thus in a recession the deficit will rise, and in a
recovery the deficit will fall
• Y implies D
– government spending  and tax revenues 
• Y  implies D
– government spending  and tax revenues 
• Explains why “rosy scenarios” make the
deficit look smaller
A NEW GRAPH to show the
effect of real GDP on the deficit
29_11
BUDGET
DEFICIT
When real GDP falls,
the deficit increases.
When real GDP rises,
the deficit falls.
Deficit
0
Surplus
The budget
is balanced
here.
A
B
C
REAL GDP
The structural deficit
• The structural deficit is the deficit that
would exist if real GDP = potential GDP
• Also called full employment deficit
• Purpose is to take out (control for) the
effects of economic fluctuations in real
GDP on the deficit
• Changing structural deficit requires
– change in tax laws, size of government,...
Graphical illustration of the
structural deficit
29_12
BUDGET
DEFICIT
Potential GDP
Actual
deficit
At this point real GDP would
equal potential GDP.
Structural
deficit
0
REAL GDP
Real GDP is less than
potential GDP, as in 1991.
Automatic stabilizers
• The tendency for tax revenues to fall and
government spending to rise in recessions
can have a stabilizing effect on the economy
– the changes offset decline in demand during
recession (as with countercyclical policies)
• these changes are “automatic”
– occur without executive or legal action
– hence fewer lags, timing is better, overall
effects can be very large
Automatic changes in revenues and
expenditures due to recession (FY 1991)
29_01
BILLIONS
OF DOLLARS
1,400
1,324
1,233
1,170
1,200
1,054
1,000
800
600
400
270
200
63
0
Proposed
Actual
Tax Revenue
Proposed
Actual
Expenditures
Proposed
Actual
Deficit
Rules versus discretion debate
in fiscal policy
• Problems with discretion are mainly lags
• recognition, implementation, impact
•
•
•
•
•
•
Rules  automatic stabilizers
Johnson surcharge (1968)
Bush stimulus package (1992)
Clinton stimulus package (1993)
Kennedy tax cut (1964)
Reagan tax cut (1981-82)
END
OF
LECTURE