Download cyclically adjusted budget balance

Pump Primer: 30
List the three options for Expansionary Fiscal
Policy that should increase AD and reverse the
recession, but will cause the budget balance to
decrease.
List the three options for Contractionary Fiscal
Policy that should decrease AD and reverse
the inflation, but will cause the budget balance
to increase.
Module 30
Long-run Implications
of Fiscal Policy: Deficits
and the Public Debt
KRUGMAN'S
MACROECONOMICS for AP*
Margaret Ray and David Anderson
Biblical Integration:
• Christians are called to be good stewards of
the "things" given unto us. A budget is a good
way to ensure you are spending and saving
your money wisely. How we spend and save
our money is a testimony to others, so we need
to make sure it is done wisely. (Eph.5:15; 1 Tim
6: 15- 17)
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
• We hear a lot about the
federal, or your state,
government’s attempts to
balance a budget. If there is
a surplus, this is usually
considered to be a good
outcome. If there is a deficit,
this is cause for concern.
• Before we decide whether
something normatively
“good” or “bad”, let’s analyze
the particulars.
The Budget Balance as a
Measure of Fiscal Policy
• The budget balance is the difference between the
government’s tax revenue and its spending, both
on goods and services and on government
transfers, in a given year.
• That is, the budget balance—savings by
government—is defined by:
SGovernment = T −G −TR
• Where T is the value of tax revenues, G is
government purchases of goods and services, and
TR is the value of government transfers.
The Budget Balance as a
Measure of Fiscal Policy
• A budget surplus is a
positive budget balance and
a budget deficit is a negative
budget balance.
• How does this relate to fiscal
policy discussed in previous
modules?
The Budget Balance as a
Measure of Fiscal Policy
Case 1: Recessionary Gap
Expansionary fiscal policy is in order (3 options):
• Cut taxes.
• Increase transfers.
• Increase government spending.
• These three policies should increase AD and
reverse the recession, but will cause the budget
balance to decrease. This means either a smaller
surplus or a bigger deficit.
The Budget Balance as a
Measure of Fiscal Policy
Case 2: Inflationary Gap.
Contractionary fiscal policy is in order (3 options):
• Increase taxes.
• Decrease transfers.
• Decrease government spending.
• These three policies should decrease AD and
reverse the inflation, but will cause the budget
balance to increase. This means either a bigger
surplus or a smaller deficit.
The Budget Balance as a
Measure of Fiscal Policy
But, changes in the budget balance don’t
always perfectly reflect changes to fiscal policy.
Two important reasons why it is more
complicated.
• Two different changes in fiscal policy that
have equal-size effects on the budget
balance may have quite unequal effects on
the economy.
.
The Budget Balance as a
Measure of Fiscal Policy
Example: If government spending increases by
$1000, it will have a larger impact on real GDP
than a tax decrease of $1000. The budget
balance would change by $1000 in each case, but
the impacts would be different.
• Often, changes in the budget balance are
themselves the result, not the cause, of
fluctuations in the economy.
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
• Cyclically adjusted budget balance
The Business Cycle and the Cyclically
Adjusted Budget Balance
The budget deficit almost always rises when the
unemployment rate rises and falls when the
unemployment rate falls.
Why? Is it a deliberate result of expansionary
fiscal policy? Not necessarily.
Recall the automatic stabilizers discussed in
earlier modules. These are programs built into our
tax and transfer system that work to reduce the
swings of the business cycle.
The Business Cycle and the Cyclically
Adjusted Budget Balance
Several things happen to the budget balance
when the economy heads into a recession.
• Tax revenues decline because incomes and
profits are declining.
• Transfer payments, like welfare assistance,
begin to rise as more people find themselves
unemployed and struggling.
These changes happen without any deliberate
fiscal policy changes and the budget balance
declines.
The Business Cycle and the Cyclically
Adjusted Budget Balance
On the other hand,
Several things happen to the budget balance when the
economy is heading into an inflationary period.
• Tax revenues rise because incomes and profits are
rising.
• Transfer payments, like welfare assistance, begin to
fall as fewer people find themselves unemployed and
struggling.
These changes happen without any deliberate fiscal
policy changes and the budget balance rises.
The Business Cycle and the Cyclically
Adjusted Budget Balance
What we need is a way to separate out two
effects on the budget balance:
• The impact due to deliberate changes in
fiscal policy.
• The impact due to the current state of the
business cycle.
To do this many governments produce an
estimate of what the budget balance would
be
The Business Cycle and the Cyclically
Adjusted Budget Balance
The cyclically adjusted budget balance is
an estimate of what the budget balance
would be, if there was neither a recessionary
nor an inflationary gap,
The Business Cycle and the Cyclically
Adjusted Budget Balance
• It takes into account the extra tax revenue the
government would collect and the transfers it
would save if a recessionary gap were
eliminated—or the revenue the government
would lose and the extra transfers it would
make if an inflationary gap were eliminated.
• If we adjust for the effects of the business cycle,
and the government is still running a deficit,
then we might come to the conclusion that their
fiscal policy decisions are not sustainable over
the long run.
Should the Budget Be Balanced?
Would it be a good idea to require a balanced budget
annually? Most economists don’t think so.
What if: the economy is in a recessionary gap.
• Falling tax revenue and rising transfer payments
push the budget toward deficit.
• How would we balance this deficit?
We would need to increase taxes or decrease
government spending.
• How would that impact the recession? It would
worsen it!
Should the Budget Be Balanced?
What if: the economy is in an inflationary gap.
• Rising tax revenue and falling transfer
payments push the budget toward surplus.
• How would we balance this surplus?
• We would need to decrease taxes or
increase government spending.
• How would this impact the inflationary period?
It would worsen it.
Should the Budget Be Balanced?
Most economists believe that the government
should only balance its budget on average—
that it should be allowed to run deficits in bad
years, offset by surpluses in good years.
Political pressures (who doesn’t like tax cuts?)
make this difficult. So are there serious
downsides to an unbalanced budget.
Deficits, Surpluses, and Debt
Many politicians, voters, and cable news
commentators seem to be worried about the
growing debt in the U.S. economy. Let’s look at
how economists evaluate this situation.
When a government spends more than the tax
revenue it receives—when it runs a budget
deficit—it almost always borrows the extra
funds. Governments that run persistent budget
deficits end up with substantial debts.
Deficits, Surpluses, and Debt
The national debt is the accumulation of all past
deficits, minus all past surpluses.
Public debt: government debt held by individuals
and institutions outside the government. US
federal government’s public debt was “only” $5.8
trillion, or 40% of GDP at the end of the 2008
fiscal year.
$5,800,000,000,000 That’s a lot of zeroes!
Is this a big deal?
Problems Posed by Rising
Government Debt
Two reasons to be concerned when a
government runs persistent budget deficits.
1. When the government borrows funds in
the financial markets, it is competing
with firms that plan to borrow funds for
investment spending. As a result, the
government’s borrowing may “crowdout” private investment spending,
increasing interest rates and reducing
the economy’s long-run rate of growth.
Problems Posed by Rising
Government Debt
2. Today’s deficits, by increasing the
government’s debt, place financial
pressure on future budgets. Interest
must be paid in the future, and this can
take dollars away from other future
obligations like education, the military,
space exploration, etc.
Problems Posed by Rising
Government Debt
So out into the future, how can a government
pay off the debt?
• Borrowing to pay off your debt isn’t really an
option. That’s like getting a new credit card to
pay off the old credit card. Eventually, that is
the road to personal bankruptcy. Nations have
essentially declared bankruptcy in the past. It’s
not pretty.
Problems Posed by Rising
Government Debt
• Increase taxes or cut spending. Probably the
best solution, but isn’t very politically
successful, especially when a nation has
become accustomed to low taxes.
• Printing money. Basically this means the Fed
creates new money to pay the debts of the
Treasury. This proves to be a fast track to
serious inflation.
Deficits and Debt in Practice
To assess the ability of governments to pay their
debt, we often use the debt–GDP ratio, the
government’s debt as a percentage of GDP.
We use this measure, rather than simply looking
at the size of the debt, because GDP, which
measures the size of the economy as a whole, is
a good indicator of the potential taxes the
government can collect.
Deficits and Debt in Practice
If the government’s debt grows more
slowly than GDP, the burden of
paying that debt is actually falling
compared with the government’s
potential tax revenue.
Deficits and Debt in Practice
•Debt-GDP Ratio
Implicit Liabilities
Implicit liabilities are spending promises made
by governments that are effectively a debt
despite the fact that they are not included in the
usual debt statistics.
In the U.S., promises to honor Social Security,
Medicare and Medicaid amount to 40% of
federal spending.
Big deal? Maybe, because the American
population is aging and these commitments will
only get larger.