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13 Fiscal Policy, Deficits, and Debt McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Fiscal Policy • Council of Economic Advisors (CEA) • Deliberate changes in • Government spending • Taxes • Designed to • Achieve full-employment • Control inflation • Encourage economic growth LO1 Fiscal Policy • Define: • Budget deficit • Budget surplus • National, or public, debt LO1 Expansionary Fiscal Policy • Increases AE, GDP, and employment • Increase government spending • Decrease taxes • Combination of both • Expansionary policy creates a deficit (G > Tax revenue) LO1 Equilibrium vs Full Employment • Recessionary Expenditures Gap • Amount that AE must increase to reach full-employment, eq. GDP • Spending is too low at fullemployment • Use expansionary fiscal policy to increase AE • Desirable to create a deficit LO1 Contractionary Fiscal Policy • Decreases AE, GDP, and • LO1 employment • Decrease government spending • Increase taxes • Combination of both Contractionary policy creates a budget surplus (G < Tax revenue) Equilibrium vs Full Employment • Inflationary Expenditures Gap • Amount that AE must decrease to reach full-employment, eq. GDP • Spending is too high at fullemployment • Use contractionary fiscal policy to decrease AE • Desirable to create a surplus LO1 Policy Options: G or T? • Expand the size of government • Increase government spending • Increase taxes • Reduce the size of government • Decrease taxes • Decrease government spending LO1 Built-In Stability • Automatic stabilizers • Tax revenues vary directly with • LO2 GDP • Transfers vary inversely with GDP • Automatically creating a surplus during inflation and a deficit during recession Reduces severity of business fluctuations Evaluating Fiscal Policy • Use the cyclically adjusted budget to evaluate fiscal policy • Removes impact of built-in stabilizers • Size of deficit/surplus if the economy is at full-employment for the year • Cyclically adjusted budget only changes when government changes fiscal policy LO3 Recent U.S. Fiscal Policy LO3 Fiscal Policy: The Great Recession • Financial market problems began in • LO4 2007 In 08 passed $152 billion stimulus consisting of tax breaks • Most people saved or paid credit cards • Not very expansionary Fiscal Policy: The Great Recession • In 09 passed American Recovery & Reinvestment Act with $787 billion stimulus • Decreased taxes for low/middle income • No lump sum checks • Increased spending on transportation, ed, and aid to state governments LO4 Budget Deficits and Projections LO4 Problems, Criticisms, & Complications • Problems of Timing • Recognition lag • Administrative lag • Operational lag • Political considerations • • • LO4 – political business cycle Future policy reversals Off-setting state and local finance Crowding-out effect Problems, Criticisms, & Complications • Biggest criticism of fiscal policy is Crowding-Out Effect. • Crowding-Out Effect – When government borrows money, demand for money increases, and interest rates rise, reducing (crowding-out) investment. – Offsets expansionary impacts of fiscal policy. LO4 The U.S. Public Debt • $16.4 trillion in 2012 • The accumulation of years of • • • LO4 federal deficits and surpluses Owed to the holders of U.S. securities Caused by war, recession, and fiscal policy Video Debt The U.S. Public Debt • GDP is income of a nation • Larger income means a greater ability • LO4 to carry a large debt Look at debt as percentage of GDP as better gauge The U.S. Public Debt • Interest charges on debt • Largest burden of the debt • Must at least pay interest every year • 2.3% of GDP in 2012 • When interest as a percent of GDP increases, must raise taxes LO4 The U.S. Public Debt • False Concerns • Bankruptcy • Refinancing • Taxation • Burdening future generations LO4 The U.S. Public Debt LO4 The U.S. Public Debt • 33% of debt is externally held debt – • • LO4 paying it back will decrease RGDP 67% of debt is internally held debt – paying it back will not reduce RGDP Debt is an asset as owners of debt and a liability as taxpayers The U.S. Public Debt LO4 Global Perspective LO4 Substantive Issues • Income distribution • Incentives • Foreign-owned public debt • Crowding-out effect revisited • Future generations • Public investment LO4