Download Ch. 12

Chapter 12
Fiscal Policy and the National Debt
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
12-1
Objectives
•
•
•
•
•
•
•
•
The deflationary gap
The inflationary gap
The multiplier and its applications
Automatic stabilizers
Discretionary fiscal policy
Budget deficits and surpluses
The public debt
Crowding-in and crowding-out
Copyright 2008 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 2008 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 2008 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 2008 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 percent (which we have been
calling full-employment)
• Fiscal policy is used to push equilibrium GDP
toward full-employment GDP
Copyright 2008 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 2008 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 percent of capacity, that’s
considered full employment
– If only 5 percent of our labor force is
unemployed, that’s full employment
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
12-8
The Deflationary Gap and the Inflationary Gap
The Deflationary Gap
When the fullemployment 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 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
12-9
The Deflationary Gap and 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 2008 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
• To eliminate the inflationary gap, we cut G
and/or raise taxes
Copyright 2008 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
• To eliminate the deflationary gap, we raise G
and/or cut taxes
Copyright 2008 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
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
12-13
Calculating the Multiplier
• Remember
– MPC + MPS = 1, therefore, MPS = 1 - MPC
1
Multiplier = ----------------------1 - MPC
1
Multiplier = ---------------------MPS
Copyright 2008 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
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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 2008 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 2008 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 2008 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 2008 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 2008 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 2008 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 2008 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 2008 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 2008 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 2008 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 2008 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
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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 veterans’
pensions
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
12-30
Without the automatic stabilizers, real GDP would fluctuate much
more widely. But you will note that, while the stabilizers do smooth
out the cycle, they do not eliminate it.
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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
12-32
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
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
12-33
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 2008 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
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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
• Perhaps, if the deficit or surplus were less than
$20 billion, we’d call that a balanced budget
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
12-37
The Deficit Dilemma
Deficits and Surpluses: The Record
The Federal Budget Deficit, Fiscal Years 1970-2006
Economic Report of the President and Economic Indicators
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
12-38
The Deficit Dilemma
How does our deficit compare with those of other nations?
The Surplus or Deficit as a Percentage of GDP, Selected Countries , 2006
–
The Economist, December 17, 2005, p 93
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12-39
Why Are Large Deficits So
Bad?
• Large deficits raise interest rates
• The federal government has become
increasingly dependent on foreign savers to
finance the deficit
• The deficit sops up more large amounts of
personal savings in this country, making much
less available to large corporate borrowers
seeking funds for new plant and equipment
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
12-40
Must We Balance the Budget
Every Year?
• In a word, “no!”
– We couldn’t , even if we tried
– During recessions, the budget will automatically go
into deficit
– Events beyond our control can force the federal
government to spend great sums of money
• However, some believe that barring national
emergencies and possibly recessions, the
government should be legally bound to balance
its budget every year.
– During the 1990s, several attempts were made to
pass a constitutional amendment requiring this
– None were successful
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
12-41
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
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
12-42
The Public Debt
National Debt, 1980-2006
Economic Report of the President, 2006
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
12-43
Holders of National Debt
January, 2006
www.publicdebt.treas.gov/opd/opdpdodt.htm
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12-44
The Public Debt
• Who holds the national debt?
– Private American citizens hold a little about one quarter of the
national debt
– Foreigners hold a little over one half
– The rest is held by banks, other business firms, and U.S.
government agencies (mainly the social security trust fund and
the Federal Reserve)
• Is the national debt a burden that will have to borne by
future generations?
– To the degree that we owe it to foreigners, our children and
grandchildren will have to pay them hundreds of billions of
dollars a year in interest
– This appears that it will be a great burden and a disgraceful
legacy to leave our children and grandchildren
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
12-45
Percentage of Outstanding Debt
Held by Foreigners, 1953-2005
Before the 1970s, foreigners held no more than 5 percent
of the outstanding debt; today they hold over 50 percent
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12-46
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 more than three trillion 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 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
12-47
Current Issue: Deficits as Far
as the Eye Can See
• The Baby Boom Catastrophe
– Baby boomers will begin retiring in the second and third decades of
this century
– When they do the Government will have to shell out hundreds of
billions more than they are now in Social Security and Medicare
benefits
• If you think the federal budget deficits are’ large now – you ain’t seen
nothing yet!
• In January 2006 the budget deficit was over $8 trillion on which we paid
$370 billion interest
• It is expected this will run over $400 billion a year the rest of the decade
• In 2011 the we be adding at least $600 billion to the debt in interest
payments alone
• A higher debt will meant higher interest rates
• Higher interest rages will cause the U.S. Treasury to borrow more and
more which will drive interest rates up still further
• The future will be a vicious cycle of rising debt and deficits each
feeding off the other
– A one trillion dollar annual deficit in 10 - 20 years is looking more and
more probable
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12-48