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Copyright 2005 © McGraw-Hill Ryerson Ltd. Slide 0 CHAPTER 19 Deficits, Debts, and Fiscal Policy Learning objectives Understand that, between 1975 and 1996, the federal government ran fiscal deficits. By the end of the 1990s, the federal government was in a fiscal surplus position. Understand that the budgetary deficit is composed of the operating deficit plus interest on the public debt. Understand that the debt to GDP ratio has exhibited three peaks: during the Great Depression, during World War II, and the mid-1990s, when the federal government began reducing budget deficits. Understand that when the government finances its deficit by issuing money, the government is imposing an inflation tax. PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa Copyright 2005 © McGraw-Hill Ryerson Ltd. Revenues, Expenditures,and Deficits Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 19: Deficits, Debts, and Fiscal Policy o Direct Taxes: taxes directly applied to persons and corporations, and include items such as personal and corporate income taxes. o Indirect Taxes: Taxes levied on goods such as the GST. o Government Purchases: Government spending on currently produced goods and services. o Transfer payments: Spending for which the government does not receive goods or services in return. Slide 2 Revenues, Expenditures,and Deficits Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 19: Deficits, Debts, and Fiscal Policy Figure 19-1: Total Revenue and Components, All Governments, 1961-2002 (% of GDP) Slide 3 Revenues, Expenditures,and Deficits Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 19: Deficits, Debts, and Fiscal Policy Figure 19-2: Total Expenditure and Components, All Governments, 1961-2002 (% of GDP) Slide 4 BOX Fiscal Policy, the GD, and Keynesian Economics 19-1 Copyright 2005 © McGraw-Hill Ryerson Ltd. Slide 5 Revenues, Expenditures,and Deficits Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 19: Deficits, Debts, and Fiscal Policy Figure 19-3: Total Revenue and Components, Federal Government, 1961-2002 (% of GDP) Slide 6 Revenues, Expenditures,and Deficits Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 19: Deficits, Debts, and Fiscal Policy Figure 19-4: Total Expenditures and Components, Federal Government, 19612002 (% of GDP) Slide 7 Measuring the Federal Deficit Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 19: Deficits, Debts, and Fiscal Policy Figure 19-5: Revenue, Expenditure, and Deficit, Federal Governments, 19612002 (% of GDP) Slide 8 Measuring the Federal Deficit o Operating Deficit: The budget deficit excluding interest payments. o Burden of the debt: o In 2001, the gross national debt exceeded $600 billion. o $21,000 per person. o Can reduce the capital stock or increase external debt. o Debt-income ratio: Debt/PY = Debt/GDP Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 19: Deficits, Debts, and Fiscal Policy Total deficit = Operating Deficit + Interest payment Slide 9 BOX 19-2 Fiscal Federalism Transfers to Other Governments and Expenditures, as % of GDP. Copyright 2005 © McGraw-Hill Ryerson Ltd. Slide 10 Measuring the Federal Deficit Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 19: Deficits, Debts, and Fiscal Policy Figure 19-6: Budgetary Deficit, Primary Deficit, and Interest on the Public Debt, Federal Government 1961-2002 (% of GDP) Slide 11 Measuring the Federal Deficit Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 19: Deficits, Debts, and Fiscal Policy Figure 19-7: Federal Government Debt-to-Income Ratio, 1926-2001 (% of GDP) Slide 12 Deficits and the Inflation Tax Budget Deficit = Sales of Bonds + Increase in Monetary Base o Links between deficits and money growth: o Higher deficits in the short run caused by expansionary fiscal policy will rise nominal and real interest rates. The Bank may raise the supply of money to keep interest rates in check. o Increased money supply to increase revenue in the future. Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 19: Deficits, Debts, and Fiscal Policy o Government Budget Constraint: A limit that says the government can finance its deficits only by selling bonds (more debt) or by increasing the monetary base. Slide 13 Deficits and the Inflation Tax o If doesn’t monetize = crowding out. o If monetize = Inflation o Canadian Experience: See Figure 19-8. o Inflation Tax: Revenue gained by the government because of inflation’s devaluation of money holdings. Chapter 19: Deficits, Debts, and Fiscal Policy o Monetization: When the BOC purchases part of the debt sold by the Department of Finance to finance the deficit. o Bank of Canada’s Dilemma: Monetize the deficit or not to monetize? o Seigniorage: Revenue derived from the government’s ability to print money. Copyright 2005 © McGraw-Hill Ryerson Ltd. Slide 14 Deficits and the Inflation Tax Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 19: Deficits, Debts, and Fiscal Policy Figure 19-8: Money and Deficits, 1963-2001 Slide 15 Measuring the Federal Deficit Inflation Tax Revenue = Inflation tax x Real Money Base Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 19: Deficits, Debts, and Fiscal Policy Table 19-1: Inflation and Inflation Tax, 1983-1988 (percent) Slide 16 Measuring the Federal Deficit Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 19: Deficits, Debts, and Fiscal Policy Figure 19-9: The Inflation Tax Slide 17 BOX Real Balances and Inflation 19-3 Increased nominal money growth reduces the long run real money stock. Higher inflation raises the nominal interest rate and hence raises the opportunity cost of holding money. Money holders will reduce the amount of real balances they hold. Prices are rising faster than money. Copyright 2005 © McGraw-Hill Ryerson Ltd. Slide 18 Intergenerational Accounting Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 19: Deficits, Debts, and Fiscal Policy o Intergenerational Accounting: Evaluate the costs and benefits of taxes and spending for various age groups of society. o Size-of-Government Debate o The Barro-Ricardo problem: o Traditional AD & AS = Lower taxes => higher AD => higher interest rates => more crowding out. o “Are government bonds net wealth?” or The Barro-Ricardo Equivalence Proposition (Ricardian Proposition): Debt financing by bond issue merely postpones taxation and therefore, in many instances, is strictly equivalent to current taxation. Slide 19 Canada Pension Plan 1) Population growth 2) Real income growth 3) Political process Chapter 19: Deficits, Debts, and Fiscal Policy o Pay-as-Go System: Social security system in which payments to retirees are made with funds provided, not by their social security taxes, but by the social security taxes of the working populace. o CPP/QPP transfer resources from the young to the old for three reasons: o Social Security and Economic Efficiency. Copyright 2005 © McGraw-Hill Ryerson Ltd. Slide 20 Canada Pension Plan Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 19: Deficits, Debts, and Fiscal Policy Table 19-2: The Ratio of Working-Age Population to Retirement Age population Slide 21 Chapter Summary Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 19: Deficits, Debts, and Fiscal Policy • The federal government ran budget deficits for each year between 1973 and 1996. By the end of the 1990s, it was in a budgetary surplus. • The budgetary deficit is composed of the operating deficit plus interest on the public debt. • The debt-GDP ratio has exhibited three peaks: GD, WWII, mid 1990s. • When the government finances its deficit by issuing money, the government is imposing an inflation tax. • Social Security is financed as a pay-as-you-go system. Slide 22 Chapter Summary (cont’d) Copyright 2005 © McGraw-Hill Ryerson Ltd. Chapter 19: Deficits, Debts, and Fiscal Policy • The current Bank of Canada policy is to set the overnight rate. • The Monetary Conditions Index “MCI” is a weighted average of the short term interest rate and the exchange rate. Slide 23 The End Chapter 19: Deficits, Debts, and Fiscal Policy Copyright 2005 © McGraw-Hill Ryerson Ltd. Slide 24