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Module 30
Long-run Implications
of Fiscal Policy: Deficits
and the Public Debt
KRUGMAN'S
MACROECONOMICS for AP*
Margaret Ray and David Anderson
What you will learn
in this Module:
• Why governments calculate the cyclically
adjusted budget balance
• Why a large public debt may be a cause
for concern
• Why implicit liabilities of the government
are also a cause for concern
The Budget Balance
• Deficits
• Surpluses
• Good? Bad?
The Budget Balance as a
Measure of Fiscal Policy
•The Budget Balance is …
•Savings by the government
•Sgov = T – G – TR
•T = value of tax revenues
•G = government purchases of g/s
•TR = value of government transfers
•Budget Surplus = positive budget balance
•Budget Deficit = negative budget balance
The Budget Balance as a
Measure of Fiscal Policy
•How does this relate to fiscal policy?
1. Recessionary Gap
1. Expansionary Fiscal Policy
1. Cut taxes
2. Increase transfers
3. Increase government spending
2. AD increases and reverses the recession
1. Budget balance with decrease
1. Smaller surplus OR
2. Bigger deficit
The Budget Balance as a
Measure of Fiscal Policy
•How does this relate to fiscal policy?
1. Inflationary Gap
1. Contractionary Fiscal Policy
1. Increase taxes
2. Decrease transfers
3. Decrease government spending
2. AD decreases and reverses the inflation
1. Budget balance will increase
1. Bigger surplus OR
2. Smaller deficit
The Business Cycle and the
Cyclically Adjusted Budget Balance
1. The Budget Deficit almost always …
1. Rises when U% rises
2. Falls when U% falls
Is this due to changes in fiscal policy?
Maybe, Maybe not!
The Business Cycle and the
Cyclically Adjusted Budget Balance
1. Automatic Stabilizers ( we talked about these before)
1. Heading into a recession ( budget balance
happenings)
1. Tax revenue declines
1. Incomes and profits declining
2. Transfer Payments (like welfare) rise
1. Unemployment rises
The Business Cycle and the
Cyclically Adjusted Budget Balance
1. Automatic Stabilizers ( we talked about these before)
1. Heading into an inflationary period ( budget balance
happenings)
1. Tax revenue rises
1. Incomes and profits rising
2. Transfer Payments (like welfare) fall
1. Unemployment decreasing
The Business Cycle and the Cyclically
Adjusted Budget Balance
• Strong relationship between budget balance
and business cycle
The Business Cycle and the
Cyclically Adjusted Budget Balance
1. We need a way to separate the two effects on the budget
balance.
1. Effect One – impact due to changes in fiscal policy
2. Effect Two – impact due to current state of the
business cycle
The Business Cycle and the
Cyclically Adjusted Budget Balance
Cyclically Adjusted Budget Balance is …
1. An estimate of what the budget balance WOULD BE IF
1. No recessionary gap OR
2. Inflationary gap
2. CABB takes into account …
1. Extra tax revenue + transfer IF recessionary gap
eliminated
2. Lost Revenue + extra transfers IF inflationary Gap
eliminated
Cyc
The Business Cycle and the Cyclically
Adjusted Budget Balance (Continued)
Should the Budget Be Balanced?
• Political motivation for running deficits or
balancing the budget
• Economists argue against balanced budget
rule in favor of cyclically balanced budget
• Limits on deficits as a compromise
Deficits, Surpluses, and Debt
When spending exceeds tax revenue, government borrows
•National Debt =
• accumulation of al past deficits – all past surpluses
•Public Debt = government debt help by individuals and
institutions outside the government
Problems Posed by Rising
Government Debt
Two reasons to be concerned when a government runs
persistent budget deficits
1. G borrows funds in financial markets
1. Competes with firm borrowing for investment
2. Crowding Out effect
3. Interest Rates Increase
4. Reducing economy long-run growth rate
2. Today’s deficits – increasing G debt
1. Financial pressure on future budgets
2. Interest paid in the future
3. $$$ goes here rather than
1. Education, military, space exploration, + others
Problems Posed by Rising
Government Debt
How can a government pay off its debt?
1. Borrowing $$$$$
1. Like getting a new credit card to pay off the old one.
BANCKRUPTCY
2. Increase taxes or cut spending.
POLICICALLY UNPOPULAR
3. Print Money
FAST TRACK TO SERIOUS INFLATION
Deficits and Debt in Practice
•Debt-GDP Ratio = G debt as a % of GDP
Implicit Liabilities
Implicit Liabilities – spending promises made
by the government (debt not included in the
usual debt stats)
Demographics – aging population = increase in
• Social Security
• Medicare
• Medicaid