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Chapter 6
The Government
Budget, the
Government Debt,
and the Limitations
of Fiscal Policy
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Key Questions
• Can fiscal policy rescue monetary policy from
ineffectiveness?
• What are the side effects of running a large budget
deficit?
• Why did the Great Depression last over a decade
(from 1929 to 1941)?
• What are the lessons to be learned for applying
fiscal policy to the Global Economic Crisis?
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The Recent Government Budget Deficit
• 1998-2001: The U.S. ran a rare budget surplus,
but subsequently reverted back to running deficits.
Why?
– 2001-03: Political philosophy that favored tax cuts  T↓
– Partially in response to 9/11 attacks  Military spending↑
– 2008: The Global Economic Crisis  T↓ while Tr↑
– 2008-10: Large fiscal stimulus package  T↓, Tr↑ and G↑
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Effects of a Budget Deficit
• Recall the “Magic Equation” from Chapter 2:
T – G = (I + NX) – S
• The Magic Equation suggests 3 ways to finance a
budget deficit (i.e. T – G < 0)
– Private saving (S) can go up
– Investment (I) can fall
– Foreign investment (NX) can fall
• Because an increase in the budget deficit increases
the total public debt, persistent budget deficits can
lead to higher taxes in the future.
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Figure 6-1 Real Government Expenditures,
Real Government Revenues, and the Real
Government Budget Deficit, 1900–2010 (1 of 2)
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Figure 6-1 Real Government Expenditures,
Real Government Revenues, and the Real
Government Budget Deficit, 1900–2010 (2 of 2)
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Budget Deficit (and Surplus)
Definitions
• The Structural Deficit is the what the deficit of the economy
would be if the economy were operating at natural real GDP.
– The structural deficit is sometimes call the Natural Employment
Deficit (NED).
– The CBO uses “Standardized Budget Deficit” for the structural
budget deficit
• The Cyclical Deficit is the amount by which the actual
government budget deficit exceeds the structural deficit.
– The Structural Surplus (or equivalently, the Natural
Employment Surplus (NES)) and the Cyclical Surplus are the
same as the deficit concepts with the signs reversed.
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Automatic vs. Discretionary Fiscal
Policy
•
Algebraically, the Budget surplus = T – G = tY – G
(where t = the average net tax rate)
•
Automatic stabilization of the budget deficit occurs
because government tax revenues depend on income
– If Y  T which helps to restrain expansions
– If Y  T which helps to dampen recessions
•
Discretionary fiscal policy alters tax rates and/or
government expenditures in a deliberate attempt to influence
real output and unemployment
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Figure 6-2 The Relation Between the
Government Budget Surplus or Deficit and Real
Income
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Figure 6-3 Effect on the Budget Line of an
Increase in Government Expenditures
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Figure 6-4 A Comparison of the Actual Budget
and the Natural Employment Budget, 1970–
2010
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Public Debt: Gross vs. Net
• The public debt is the total amount of bonds and other
government liabilities (or securities) that the government has
issued.
– The gross debt is the same as the public debt.
– The net debt subtracts out debt held inside the government,
including government securities held by the Federal Reserve and
the trust funds of Social Security and Medicare.
• The public debt is also the sum of all fiscal deficits (and/or
surpluses) over time:
Debt (end of 2011) = Debt (end of 2010)
+ Fiscal Deficit (during 2011)
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The Future Burden of the
Government
• What is the burden of government borrowing for investment
projects like building highways or schools?
– None, as long as the future return is greater than the social cost
of the project!
– If some investment projects, like a rarely used highway, yield a
very low return, then there will be future costs.
• What about the burden of government borrowing to pay for
consumption items like bullets and food stamps?
– Since government consumption spending has only current
benefits, there will costs to pay in the future.
• Future costs = interest plus debt principal repayment
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Will the Government Remain
Solvent?
• How can we tell if the budget deficit is too high?
– Key variable: Debt to nominal GDP ratio (D / PY)
– Notation: The level of a variable is represented by a capital letter,
while the growth rate of the variable is lowercase.
• The government will be able to afford its debt if the debt to
nominal GDP ratio is stable over time.
–
–
–
–
It can be shown that the growth of (D / PY) = d – (p + y)
Stability  growth of (D / PY) = 0  d = p + y
Note: Additional debt each year = budget deficit = dD
Multiplying (1) by D on both sides  dD = (p + y)D
(1)
(2)
• Result: D / PY remains constant if the budget deficit equals the
outstanding debt times the growth rate of nominal GDP!
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The Solvency Condition
• The basic limitation on the amount of government debt is that the
government must pay interest on its debt.
– But as long as nominal GDP is growing and interest rates are low, the
government can borrow more to pay the yearly interest expense and
still maintain a constant D / PY.
• The solvency condition states that the government can meet its
interest bill forever by issuing more bonds without increasing the
debt-GDP ratio only if the economy’s growth rate (p + y) equals or
exceeds its actual nominal interest rate (r).
• What about the U.S. debt level in 2010?
– D = $9,000B and suppose (p + y) = 5%
– Stability  d = 5%  Allowable deficit = 0.05*($9,000B) = $450B
– Actual deficit was much higher than $450B  (D / PY) ↑
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International Perspective The Debt-GDP
Ratio: How Does the U.S. Compare?
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Figure 6-5 The Ratio of U.S.
Government Debt to GDP, 1790-2010
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The Fiscal Policy Multiplier Effect
• Recall from Chapter 3 that the multiplier effect of an increase
in G is greater than a cut in T because G has a direct effect on
spending
• Other factors decreasing the multiplier effect include:
– Leakages from the spending stream that reduce induced
consumption
• Income Taxes
• Imports
• Corporate Profits
– Higher interest rates that reduce interest-sensitive spending
– Capacity constraints when the economy is close to full
employment  government purchases push aside private
purchases
• Lesson: Fiscal stimulus is much more appropriate and effective
when the economy is weak.
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Table 6-1 Multiplier Estimates for
Selected Types of Fiscal Stimulus
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Table 6-2 Size of Fiscal Stimulus
Measures in 2008-10
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Figure 6-6 The Role of Automatic
Stabilizers in the Recession of 2008-09
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The Overall Effectiveness of the
Bush-Obama Fiscal Stimulus
• The overall results from the stimulus are mixed
– Hundreds of billions in tax cuts had little impact on GDP
– Infrastructure spending was rolled out very slowly (only
40% spent by 2010)
– Most effective parts of the stimulus were aid to state and
local governments and unemployment benefit extensions.
• Overall benefit according to one study = 7.8% of
GDP
– Compare to overall cost of 7.6% of GDP
– Result: Overall multiplier = 7.8 / 7.6 = 1.03
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Bailouts as Unconventional Stimulus
•
The severity of the 2008-09 crisis necessitated additional policies to prevent
economic collapse.
– These novel policies have been called “financial policies” or “bailout policies.”
– These policies do not count as monetary or fiscal policies because they were carried
out by both the Federal Reserve and the Treasury in cooperation with each other.
•
The core bailout program was the Troubled Asset Relief Program (TARP).
– Initiated two weeks after the fall of Lehman Brothers
– Lent government money to financial institutions on the brink of insolvency due to
insufficient equity capital
– Also prevented the sale of GM and Chrysler Motors
– Initial cost = $700B, but after loan repayment, estimated cost = $100B
•
Measures of success of bailouts
– Risk premium fell from 5.5% (winter 2009) to 2.7% (mid 2010)
– One study: Without bailouts, Y would have been 5% lower and U = 12.5%
•
Controversies persist because…
– Benefits not widely publicized
– Bailout of financial institutions seemed to reward those who caused the crisis!
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