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Chapter 12
Fiscal Policy and the National Debt
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-1
Chapter Objectives
•
•
•
•
•
•
•
The deflationary gap
The inflationary gap
The multiplier and its applications
Automatic stabilizers
Discretionary fiscal policy
Budget deficits and surpluses
The public debt
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-2
Fiscal Policy
• Fiscal policy is the manipulation of the
federal budget to attain price stability,
relatively full employment, and a
satisfactory rate of economic growth
– To attain these goals, the government must
manipulate its spending and taxes
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-3
Putting Fiscal Policy into
Perspective
• There was no such thing as fiscal policy
until John Maynard Keynes invented it in
the 1930s
– He maintained that
• The only way out of the Depression was to boost
aggregate demand by increasing government
spending
• If we ran a big enough budget deficit, we could
jump-start the economy and, in effect, spend our
way out of the depression
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-4
Putting Fiscal Policy into
Perspective
• It’s important that the aggregate supply
of goods and services equals the
aggregate demand for goods and services
at just the level of spending that will
bring about full employment at stable
prices
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-5
Putting Fiscal Policy into
Perspective
• Equilibrium GDP tells us the level of
spending in the economy
• Full-employment GDP tells us the level of
spending necessary to get the
unemployment rate down to 5% (which
we have been calling full-employment)
• Fiscal policy is used to push equilibrium
GDP toward full-employment GDP
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-6
The Deflationary Gap and the
Inflationary Gap
• Equilibrium GDP is the level of output at
which aggregate demand equals
aggregate supply
– Aggregate demand is the sum of all
expenditures for goods and services (that is,
C + I + G + X n)
– Aggregate supply is the nation’s total output
of final goods and services
– So at equilibrium GDP, everything produced
is sold
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-7
The Deflationary Gap and the
Inflationary Gap
• Full-employment GDP is the level of
spending necessary to provide full
employment of our resources
– If our plant and equipment is operating at
between 85 and 90% of capacity, that’s full
employment
– If only 5% of our labor force is unemployed,
that’s full employment
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-8
The Deflationary Gap & the Inflationary Gap
The Deflationary Gap
When the full-employment
GDP is greater than the
equilibrium GDP, there is a
deflationary gap. How
much is it?
9
8
Def lationary gap
C + I + G + Xn
7
6
5
4
3
2
1
$1 trillion
2
1
2
3
4
Equilibrium GDP
5
6
7
8
9
Full-employment GDP
GDP (in trillions of dollars)
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-9
The Deflationary Gap & the Inflationary Gap
The Inflationary Gap
When equilibrium
GDP is greater
than fullemployment GDP,
there is an
inflationary gap.
How large is it?
2,000
C + I + G + Xn
Inf lationary gap
1,500
1,000
500
$200 trillion
500
0
500
1,000
1,500
Full-employment GDP
2,000
Equilibrium GDP
GDP (in trillions of dollars)
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-10
Summary
• Equilibrium GDP is above the fullemployment GDP
– Spending is too high
– Results in an inflationary gap
• Too eliminate the inflationary gap, we cut G
and/or raise taxes
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-11
Summary
• Equilibrium GDP is less than fullemployment GDP
– Spending is too low
– Results in a deflationary gap
• Too eliminate the deflationary gap, we raise G
and/or cut taxes
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-12
The Multiplier and Its
Applications
• Any change in spending (C, I, or G) will
set off a chain reaction, leading to a
multiplied change in GDP
GDP = C + I + G + Xn
How much the multiplied change is
depends on the MPC and MPS
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12-13
Calculating the Multiplier
• Remember
MPC + MPS = 1, therefore, MPS = 1 - MPC
1
Multiplier = ----------------------1 - MPC
1
Multiplier = ---------------------MPS
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Because the multiplier
(like C) deals with
spending, 1/(1-MPC)
is a more appropriate
formula)
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Calculating the Multiplier
• The MPC is .5.
Find the multiplier
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12-15
Calculating the Multiplier
(Continued)
• The MPC is .5. Find the multiplier
1
1
1
Multiplier = ---------------- = -------- = ----- = 2
1 - MPC
1 – .5
.5
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12-16
Calculating the Multiplier
Step-by-Step Working of the Multiplier When MPC is .5
$1,000.00
$ 500.00
$ 250.00
$ 125.00
$ 62.50
$ 31.25
$ 15.625
$
7.813
$
3.906
$ etc.
$ etc.
$2,000.00
It is surely much easier to use the multiplier of 2
(2 X $1,000 = $2000) than to go through this
process and add up all the figures
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-17
Calculating the Multiplier
(Continued)
• The MPC is .75. Find the multiplier
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12-18
Calculating the Multiplier
(Continued)
• The MPC is .75. Find the multiplier
1
1
1
Multiplier = ---------------- = -------- = ----- = 4
1 - MPC
1 – .75 .25
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-19
Applications of the Multiplier
• The Multiplier is used to calculate the
effect of changes in C, I, or G on GDP
GDP = 2,500; Multiplier = 3; C rises by 10
What is the new level of GDP?
GDPNew = GDPInitial + (Change in spending X Multiplier)
GDPNew = 2500 + ( 10 x 3)
GDPNew = 2500 + ( 30)
GDPNew = 2530
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-20
Applications of the Multiplier
• The Multiplier is used to calculate the
effect of changes in C, I, or G on GDP
GDP = X; Multiplier = 3; C rises by 10
What happens to GDP?
GDPNew = GDPInitial + (Change in spending X Multiplier)
GDPNew = X + ( 10 x 3)
GDPNew = X + ( 30)
GDP increases by 30
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-21
Applications of the Multiplier
• The Multiplier is used to calculate the
effect of changes in C, I, or G on GDP
GDP = X; Multiplier = 7; G falls by 5
What happens to GDP?
GDPNew = GDPInitial + (Change in spending X Multiplier)
GDPNew = X + ( -5 x 7)
GDPNew = X + ( -35)
GDP decreases by 35
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-22
Applications of the Multiplier
• How big is the multiplier (M)?
9
M = distance between the
equilibrium GDP and the fullemployment GDP / by the gap
8
Def lationary gap
C + I + G + Xn
7
6
5
4
3
2
M=2/2=1
1
2
1
2
3
4
5
6
7
8
9
Full-employment GDP
GDP (in trillions of dollars)
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-23
Applications of the Multiplier
• How big is the multiplier (M)?
M = distance between the
equilibrium GDP and the fullemployment GDP / by the gap
2,000
C + I + G + Xn
Inf lationary gap
1,500
1,000
500
M = 500 / 200 = 2.5
500
0
500
1,000
1,500
2,000
Full-employment GDP
GDP (in trillions of dollars)
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-24
Removing the Deflationary Gap
9
8
C1 + I1 + G1 + Xn1
7
C + I + G + Xn
6
To remove the deflationary
gap we raise aggregate
demand from C+I+G+Xn
to C1+I1+G1+Xn1
5
4
3
2
1
1
2
3
4
5
6
7
8
9
Full-employment GDP
This pushes equilibrium
GDP to $7 trillion and
removes the deflationary
gap
GDP (in trillions of dollars)
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-25
Removing the Inflationary Gap
2,500
2,000
C + I + G + Xn
1,500
C1 + I1 + G1 + Xn1
Inf lationary gap
1,000
This pushes equilibrium
GDP down to 1,000 and
removes the inflationary
gap
500
0
500
500
1,000
To remove the inflationary
gap we lower aggregate
demand from C+I+G+Xn
to C1+I1+G1+Xn1
1,500
2,000
2,500
Full-employment GDP
GDP (in billions of dollars)
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-26
The Automatic Stabilizers
• The automatic stabilizers protect us from
the extremes of the business cycle
– Personal Income and Payroll Taxes
• During recessions, tax receipts decline
• During inflations, tax receipts rise
– Personal Savings
• During recessions, saving declines
• During prosperity, saving rises
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-27
The Automatic Stabilizers
• The automatic stabilizers protect us from
the extremes of the business cycle
– Credit Availability
• Credit availability helps get us through
recessions
– Unemployment Compensation
• During recessions more people collect
unemployment benefits
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-28
The Automatic Stabilizers
• The automatic stabilizers protect us from
the extremes of the business cycle
– The Corporate Profits Tax
• During recessions, corporations pay much less
corporate income taxes
– Other Transfer Payments
• Welfare (or public assistance) payments,
Medicaid payments, and food stamps rise during
recessions
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12-29
Discretionary Fiscal Policy
• Making the Automatic Stabilizers More
Effective
– Public Works
• The main fiscal policy to end the Depression was
public works
– Transfer Payments
• The government could extend the benefit period
for unemployment compensation and increase
welfare payments, Social Security, and veteran’s
pensions
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-30
Discretionary Fiscal Policy
• Making the Automatic Stabilizers More
Effective
– Changes in Tax Rates
• To fight inflation, the government can raise taxes
• To fight recession, the government can cut taxes
• Corporate incomes taxes can be raised during periods of
inflation and lowered when recessions occur
– Using tax rate changes as a counter cyclical policy
tool provides a quick fix, however, temporary tax
cuts carried out during recessions should not
become permanent
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-31
Discretionary Fiscal Policy
• Making the Automatic Stabilizers More
Effective
– Changes in Government Spending
• The government increases spending and cuts
taxes to fight recessions
• The government decreases spending and raises
taxes to fight inflation
• In brief, we fight recessions with budget deficits
and inflation with budget surpluses
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12-32
Who Makes Fiscal Policy?
• The President and Congress make fiscal
policy
– This is complicated and can be time
consuming, especially when one political
party controls Congress while the president
belongs to the other party
– No one seems to be in charge of making fiscal
policy
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-33
Who Makes Fiscal Policy?
• The huge budget deficits we’ve been running
since the early 1980s have sharply limited the
government’s ability to use discretionary fiscal
policy to create jobs and to stimulate the
economy
– Between legally mandated spending programs and
legally mandated entitlement programs such as
Social Security, Medicare, and Medicaid, there is
little discretionary income to play with
– The Treasury could borrow even more money but
only if Congress and the president were willing to
allow the budget deficit to grow
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-34
The Deficit Dilemma
• Deficits, Surpluses, and the Balanced
Budget
– When government spending is greater than
tax revenue, we have a federal budget deficit
• The government borrows to make up the
difference
• Deficits are prescribed to fight recession
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12-35
The Deficit Dilemma
• Deficits, Surpluses, and the Balanced
Budget
– When the budget is in a surplus position, tax
revenue is greater than government spending
• Budget surpluses are prescribed to fight inflation
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12-36
The Deficit Dilemma
• Deficits, Surpluses, and the Balanced
Budget
– We have a balanced budget when
government expenditures are equal to tax
revenue
• We’ve never had an exactly balanced budget
• We’re dealing with a budget of nearly $4 trillion
in taxes and spending
– So, if tax revenue and expenditures were within $10
billion of each other, perhaps that would be close
enough to call the budget balanced
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12-37
The Deficit Dilemma
Deficits and Surpluses: The Record
The Federal Budget Deficit, Fiscal Years 1970-2001
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12-38
Why Are Large Deficits So
Bad?
• Large deficits raise interest rates, which,
in turn, discourages investment
– Our real interest rate (the nominal interest
rate less the rate of inflation) during the
latter half of the 1980s and all of the 1990s
was three times a high as the real interest
rate in Japan’ and it was much higher than
those in most Western European countries as
well
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12-39
Why Are Large Deficits So
Bad?
• The federal government has become
increasingly dependent on foreign savers
to finance the deficit
– In the early – and mid – 1990s foreigners
financed more than half the deficit
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-40
Why Are Large Deficits So
Bad?
• Until the mid-1990s the deficit sopped up
more than half the personal savings in
this country, making that much less
savings available to large corporate
borrowers seeking funds for new plant
and equipment
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-41
Why Are Large Deficits So
Bad?
• On the positive side, budget deficits stimulate
the economy
– The only problem is that we should not have needed
this stimulus during the “prosperous” mid-to late
1980s when we were running huge deficits
– We would do well to remember that John Maynard
Keynes would have advocated running surpluses
and paying off the debt during periods of prosperity
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-42
Will We Be Able to Balance
Future Budgets?
• The federal government finally managed to run
a budget surplus in 1998
– This was the first time since 1969
• The congressional Budget Office forecasts a
string of surpluses well into the new
millennium
– Congressional Republicans and Democrats have
already proposed dueling plans to dispose of those
surpluses with various combinations of tax cuts and
spending increases
– No elected official proposed slowing down the
projected increases in Social Security spending
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12-43
Will We Be Able to Balance
Future Budgets?
• A recession, a decline in stock prices, a tax cut,
or an increase in government spending
programs can easily eliminate any surpluses
and replace them with deficits
• After the year 2015, as the baby boom
generation attains senior citizenship, the Social
Security Trust Fund will be quickly depleted
– Unless the government has already raised Social
Security taxes or cut benefits, the federal budget
surplus will quickly become a large and growing
deficit
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-44
The Proposed Balanced Budget
Amendment and the Line Item
Veto
• Must we balance the budget each year?
– The government really tried to balance the
budget each year into the early 1930s
– The economic wisdom today tells us that we
should have deficits in lean years and
surpluses in fat years
• From 1961 through 1997 the government
managed only one surplus
• The national debt rose every year as we ran
budget deficits in fat years
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-45
The Proposed Balanced Budget
Amendment and the Line Item Veto
• The first step in passing a Constitutional
amendment to balance the budget is a
two-thirds vote in both houses of
Congress
– Despite some very close votes in 1994, 1995,
1996, and 1997, the balanced budget
amendment failed in one or the other houses
of Congress
– Most economists oppose such an amendment
because it would put us in an economic
straitjacket
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-46
The Proposed Balanced Budget
Amendment and the Line Item Veto
• In still another effort to lower the deficit,
Congress passed a law in 1996 to permit
the president to veto parts of tax and
spending bills, he or she opposes, without
vetoing the entire legislation
– This line item veto can be eventually
overridden by a two-thirds vote in each
house of Congress
– In February, 1998, a federal judge ruled the
line item veto unconstitutional
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12-47
The Public Debt
• Differentiating between the Deficit and
the Debt
– The deficit occurs when federal government
spending is greater than tax revenue
– The debt is the cumulative total of all the federal
budget deficits less any surpluses
• Suppose that our deficit declined one year from $200
billion to $150 billion
• The national debt would still go up by $150 billion
• So every year that we have a deficit – even a declining one
– the national debt will go up
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12-48
The Public Debt
National Debt, 1975-2000
6
5
4
3
2
1
0
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
Economic Report of the President, 2000
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12-49
The Public Debt
• Who holds the national debt?
– Private American citizens hold a little less than half
– Foreigners hold almost one-third
– The rest is held by banks, other business firms, and
U.S. government agencies
• Is the national debt a burden that will have to
borne by future generations?
– As long as we owe it to ourselves, the answer is no
– If we did owe it mainly to foreigners, and if they
wanted it paid off, it could be a great burden
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-50
The Public Debt
• When do we have to pay off the debt?
– We don’t. All we have to do is roll it over, or
refinance it, as it falls due
– Each year several hundred billion dollars worth of
federal securities fall due
• By selling new ones, the Treasury keeps us going
– In the future, even if we never pay back one penny
of the debt, our children and our grandchildren will
have to pay hundreds of billions of dollars in interest
• At least to that degree, the public debt will be a burden to
future generations
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
12-51
The Public Debt
• Why not go ahead and just pay off the debt?
– Economists predict that following this course would
have catastrophic consequences
– If we tried to pay off the debt too quickly, it might
even send us into a deep depression
– If we keep running large surpluses and pay down
the national debt, this will cause a problem for both
the Social Security Trust Fund and the Federal
Reserve
• As the national debt goes down, eventually there would be
no securities for them to buy
• Still, it is a whole lot better to have problems like these than
those caused by running huge budget deficits every year
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12-52