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Chapter 6 The Government Budget, the Government Debt, and the Limitations of Fiscal Policy Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 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? Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-2 The Recent US 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↑ Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-3 Wars and the increasing size of the government • Five facts stand out in figure 6.1 1. Government expenditures spike in war years, with WWII having much greater impact 2. Tax revenues exhibit a spike in wartime. 3. The size of the government increased in war years. 4. Expenditures increase more than revenues during 1980s causing a persistent budget deficit. 5. Revenues were 28-30% of GDP in 1980s and 1990s but declining back after. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-4 Figure 6-1 Real Government Expenditures, Real Government Revenues, and the Real Government Budget Deficit, 1900–2010 (1 of 2) Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-5 The effect of recessions • During recessions government revenues decline and transfer payments increase. • Before 1980 deficits during recessions takes a sharp V shape, i.e., the deficits came to zero after recession. • Since 1980 deficits did not disappear after recessions and continued to be large. • The recession of 2008-09 cause by far the largest deficit due to fiscal stimulus and bail out programs. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-6 Figure 6-1 Real Government Expenditures, Real Government Revenues, and the Real Government Budget Deficit, 1900–2010 (2 of 2) Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-7 Automatic stabilization and discretionary fiscal policy • Net tax revenues T can be expressed as the net tax rate t times real income • T = tY • Hence government budget can be written as: • Budget surplus = T - G = tY – G • There are two main sources of changes in surplus or deficit - automatic stabilization (through changes in Y) - discretionary stabilization (through changes in t and G) Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-8 • Automatic stabilization • When Y increases taxes rise and transfer payments fall. • This higher surplus or less deficit helps to stabilize the economy. • In a recession taxes decrease and transfer payments increase help to dampen the recession. • The automatic stabilization effect of Y is illustrated in figure 6.2 • If G0 and t0 are constant, the slope of the budget line (BB) is t0 (tax rate) Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-9 • At YN there is a balanced budget. At Y0 there is a deficit as tax revenues decrease (t0∆Y) • The budget line shows the budget surplus or deficit at different Y levels. • The budget line slopes upward as higher Y raises tax revenues t0Y causing more surplus or less deficit. • Changes in Y causes a movement from along BB curve Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-10 Figure 6-2 The Relation Between the Government Budget Surplus or Deficit and Real Income Budget balance Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-11 Discretionary fiscal policy • Discretionary fiscal policy • alters tax rates or government expenditures deliberately to influence real output and the unemployment rate. • Figure 6.3 shows the effect of discretionary fiscal policy. • Suppose that government spending increases from G0 to G1, the budget line shifts down from BB0 to BB1 causing a lager deficit at Y0. • There are 3 ways to reduce the deficit 1. Movement from C to D (through expansionary monetary policy) causing Y to increase to YN. 2. Movement from C to B (decrease G) 3. increase the tax rate t0 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-12 Figure 6-3 Effect on the Budget Line of an Increase in Government Expenditures Cyclical deficit Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-13 • As shown in 6.3 the budget can affect the economy and the economy can affect the budget. • An in crease in G or a reduction in T shifts the IS to the RHS causing Y to increase and sift BB upwards and vice versa. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-14 The natural employment surplus of deficit • The natural unemployment surplus (NES) (or deficit NED) is the government budget surplus or deficit if actual output Y equals natural output YN. • NES (NED) = tYN - G • NES is sometimes called Structural Deficit. – The CBO uses “Standardized Budget Deficit” for the natural or 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. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-15 Figure 6-4 A Comparison of the Actual Budget and the Natural Employment Budget, 1970– 2010 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-16 Government debt: Basic concepts • 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 (intra-government debt), 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) Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-17 The Future Burden of the Government • The future burden of the debt depends on the type of spending, i.e., consumption or investment. • The burden of government borrowing for investment projects like building highways or schools is 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-18 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) – For stability of D/PY ratio we need: d=p+y – Growth of debt/GDP ration must equal the growth of nominal GDP. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-19 – Stability growth of (D / PY) = 0 d = p + y (1) – Note: Additional debt each year = budget deficit = dD – Multiplying (1) by D on both sides dD = (p + y)D (2) – The allowable deficit equals the rate of growth of nominal GDP times the debt • Result: D / PY remains constant if the budget deficit equals the outstanding debt times the growth rate of nominal GDP! • The deficit must equal (2) for D/PY to remain constant. • Example if p+y=5%, D=9000 billion • dD = (p+y)D= 0.05(9000) = 450 billion. • The maximum allowable deficit is $450 billion for the debt ratio to remain constant Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-20 The Solvency Condition • Note that: • 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. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-21 The Solvency Condition • 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) ↑ Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-22 International Perspective The Debt-GDP Ratio: How Does the U.S. Compare? Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-23 Figure 6-5 The Ratio of U.S. Government Debt to GDP, 1790-2010 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-24 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. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-25 Table 6-1 Multiplier Estimates for Selected Types of Fiscal Stimulus Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-26 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 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-27 Table 6-2 Size of Fiscal Stimulus Measures in 2008-10 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-28 Figure 6-6 The Role of Automatic Stabilizers in the Recession of 2008-09 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-29 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! Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-30 • 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. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 6-31