Download Figure 1 - Cengage Learning

Budget Deficits in the Short
and Long Run
Blessed are the young, for they shall inherit the
national debt.
HERBERT HOOVER
PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
Balanced Budget? Short Run
• Should the budget always be balanced?
The short run
• Balancing the government budget
– Fiscal policy: focus on balancing
aggregate supply and aggregate demand
– Desired budget deficits, when
• Private demand [C+I+G+(X-IM)] is weak
– Desired budget surpluses, when
• Private demand [C+I+G+(X-IM)] is strong
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2
Balanced Budget? Short Run
• Balancing the government budget
– Balanced budget
• When C+I+G+(X-IM) approximately equals
potential GDP
• Balancing the budget
– During recessions: will prolong and
deepen slumps
– During booms: may lead to inappropriate
fiscal policy
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
3
The Importance of the Policy Mix
• Government – can influence aggregate
demand
– Through fiscal policy
– Through monetary policy
• The appropriate fiscal policy
– Depends, among other things, on the
current stance of monetary policy
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4
The Importance of the Policy Mix
• Balanced budget
– May be appropriate under one monetary
policy
– A deficit or a surplus may be appropriate
under another
• Given target for aggregate demand
– Any change in monetary policy will alter the
appropriate fiscal policy
– Any change in fiscal policy will alter the
appropriate monetary policy
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5
Figure 1
The Interaction of Monetary and Fiscal Policy
Potential
GDP
Price Level
Effect of
Monetary
policy
D0
D1
S
B
Effect of
fiscal policy
A
S
D0
D1
Y1
Y0
Real GDP
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6
The Importance of the Policy Mix
• Deficit is too large or too small?
– Strength of private-sector aggregate
demand
– Stance of monetary policy
– Desired composition of GDP
• Monetary policy
– Affects interest rates
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
7
The Importance of the Policy Mix
• Fiscal policy – affects interest rates
– Increases in government spending or tax
cuts
• Push interest rates up
– Restrictive fiscal policies
• Pull interest rates down
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8
Figure 2
The Effect of Expansionary Fiscal Policy on the Market for
Bank Reserves
D1
S
D0
Interest Rate
E1
Effect of a
higher Y or P
E0
D1
S
D0
Bank Reserves
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
9
The Importance of the Policy Mix
• Reasons why the oversimplified formula
overstates the multiplier
1.
2.
3.
4.
It ignores variable imports
It ignores price-level changes
It ignores the income tax
It ignores the rising interest rates that
accompany any autonomous increase in
spending
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
10
The Importance of the Policy Mix
• Lower budget deficits
– Should lead to higher levels of private
investment spending
– Contractionary fiscal policy
• Reduce spending or raise taxes
• Reduce real interest rates
• Spur investment
• Higher budget deficits
– Should lead to less private investment
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11
The Importance of the Policy Mix
• Aggregate demand – unchanged
– And real GDP – unchanged
– Combinations of fiscal and monetary
policy
– E.g.
• Government – raise taxes
– Reduce aggregate demand
• The Fed – cut interest rates
– Increase aggregate demand
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12
The Importance of the Policy Mix
• More expansionary fiscal policy and tight
monetary policy
– Higher interest rates
– Lower investment – less capital formation
– Slower growth of potential GDP
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13
The Importance of the Policy Mix
• Tighter budget (fiscal policy) and looser
monetary policy
– Lower interest rates
– Higher investment
– Faster growth of potential GDP
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14
The Importance of the Policy Mix
• Composition of aggregate demand
– Major determinant
• Rate of economic growth
– Larger fraction of GDP – investment
• Capital stock - grow faster
• Aggregate supply schedule
– Shift more quickly to right
• Accelerated growth
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15
Figure 3
Growth and Investment in 24 Countries
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16
Deficits and Debt
• Deficits and debt: terminology and facts
• Budget deficit
– Amount by which the government’s
expenditures
– Exceed its receipts
• During a specified period of time, usually a
year
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17
Deficits and Debt
• Budget surplus
– Amount by which the government’s
receipts
– Exceed its expenditures
• During a specified period of time, usually a
year
• 2010, the federal government
– Budget deficit: $1.3 trillion
• Receipts: $2.2 trillion
• Expenditures: $3.5 trillion
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18
Deficits and Debt
• National debt (public debt)
– The federal government’s total
indebtedness at a moment in time
– The result of previous budget deficits
– End of 2010: $13.5 trillion
• Government accumulates debt
– By running deficits
• Government reduces its debt
– By running surpluses
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19
Deficits and Debt
• Some facts about the national debt
– How large a public debt do we have?
– How did we get it?
– Who owes it?
– Is it growing or shrinking?
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20
Deficits and Debt
• How large a public debt do we have?
– Enormous, $13.5 trillion
• $43,000 per person
– Net national debt: $9 trillion
• Because one-third of the national debt: one
branch of the government owed it to another
– Net national debt relative to GDP
• 60% of GDP
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21
Figure 4
The U.S. National Debt Relative to GDP, 1915–2010
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22
Deficits and Debt
• How did we get it?
– Until about 1983, from
• Financing wars or from the loss of tax
revenues that accompany recessions
– 1983 - 1993, it grew faster
• No wars, only one recession
– 2001, Large tax cuts
– Great Recession
• Huge losses of tax
• Dramatic fiscal policy efforts to fight it
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23
Interpreting Deficit or Surplus
• Interpreting the budget deficit or surplus
• Deficit = G + Transfers – Taxes =
= G – (Taxes – Transfers) =
=G–T
• No change in fiscal policy, deficit
– Rises in a recession
– Falls in a boom
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24
Figure 5 (a)
Official Fiscal-Year Budget Deficits, 1981–2010
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25
Figure 5 (b)
Official Fiscal-Year Budget Deficits, 1981–2010
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26
Figure 6
Spending and Tax Receipts
The Effect of the Economy on the Budget
T =Taxes - Transfers
A
Surplus
G
Deficit
B
Y1
Y2
Y3
Gross Domestic Product
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27
Interpreting Deficit or Surplus
• Structural budget deficit or surplus
– The hypothetical deficit or surplus we
would have under current fiscal policies
– If the economy were operating near full
employment
– Doesn’t depend on state of economy
– Changes
• Only when policy changes
• Not when GDP changes
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28
Table 1
Alternative Budget Concepts, 1981–2009
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29
Interpreting Deficit or Surplus
• Overall budget deficit
= On-budget deficit + Off-budget deficit
• Off-budget
– Social Security expenditures
– Payroll tax receipts - finance them
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30
Interpreting Deficit or Surplus
• What happened to the deficit?
– Early 1980s - large Reagan tax cuts
• From $79 billion to $212 billion – structural
– Late 1980s, started rising again
• Even though Social Security began to run
small surpluses
– 1991, $269 billion, then began to shrink
• Social Security surplus
• Strong economy
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31
Interpreting Deficit or Surplus
• What happened to the deficit?
– The Clinton years: tax increases and
expenditure restraint
• Got the budget under control
– The George W. Bush administration
• Large tax cuts, a burst of spending, and
weaker economic growth
• New record high: $378 billion in 2003
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32
Interpreting Deficit or Surplus
• What happened to the deficit?
– Recession, late 2007
• Depressed economy plus the government’s
massive anti-recession measures
• Colossal $1.4 trillion deficit
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33
National Debt - a Burden?
• Why is the national debt considered a
burden?
• National debt owned by domestic citizens
– Future interest payments
• Transfer funds from one group of Americans
to another
• National debt owned by foreigners
– Burden on the nation as a whole
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34
National Debt - a Burden?
• Fundamental difference
– Nations that borrow in their own currency
• Don’t default on their debt
• The U.S.
– Nations that borrow in some other
currency
• Might have to default on their debts
• Often, the U.S. dollar
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35
Budget Deficits and Inflation
• Deficit spending
– Increase aggregate demand
• Higher real GDP
• Higher price level
• Budget deficits - inflationary
– Slope of aggregate supply curve
– Degree of resource utilization
– Policy mix
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36
Figure 7
The Inflationary Effects of Deficit Spending
D1
Potential
GDP
D0
S
C
112
Price Level
Aggregate supply curve shifts
inward as wages rise
106
Deficit spending
boosts aggregate
demand
B
100
A
D1
S
D0
0
$5,000 $6,000 $7,000 $8,000
Real GDP
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37
Budget Deficits and Inflation
• Monetize the deficit
– Central bank
– Purchases bonds issued by government
• Deficit spending
– Higher GDP and price level
– Increase demand for bank reserves
– Fed – no action
• Interest rates – increase
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38
Budget Deficits and Inflation
• Deficit spending
– Higher GDP and price level
– Increase demand for bank reserves
– Fed – expansionary monetary policy
• Purchase government debt
• Increase supply of bank reserves
• No increase in interest rates
• Increase money supply
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39
Figure 8
Monetization and Interest Rates
D1
S0
S1
D0
Interest Rate
B
Expansionary
Fed policy
A
C
D1
S0
S1
D0
Quantity of Bank Reserves
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40
Debt, Interest Rates, Crowding Out
• Large budget deficit and no Fed
monetization
– Higher interest rate
– Lower investment
– Future
• Less capital
• Smaller potential GDP
– Burden future generations
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41
Debt, Interest Rates, Crowding Out
• Crowding out
– When deficit spending by government
• Higher interest rates
– Forces private investment spending to
contract
– Dominates in the long run
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42
Debt, Interest Rates, Crowding Out
• Crowding in
– When government spending
• By raising real GDP
– Induces increases in private investment
spending
– More powerful – short run
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43
Debt, Interest Rates, Crowding Out
• The bottom line
– Unless the economy produces enough
additional saving, more government
borrowing
• Will force out some private borrowers -
discouraged by the higher interest rates
• Reduce investment spending
• Cancel out some of the expansionary effects
of higher government spending
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44
Debt, Interest Rates, Crowding Out
• The bottom line
– Crowding out is rarely strong enough to
cancel out the entire expansionary thrust
of government spending
– If deficit spending induces substantial
GDP growth
• The crowding-in effect: more income and
more saving
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45
Debt, Interest Rates, Crowding Out
• The bottom line
– The crowding-out effect dominates
• In the long run
• Or when the economy is operating near full
employment
– The crowding-in effect dominates
• In the short run, especially when the
economy has a great deal of slack
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46
Slower Growth
• The main burden of the national debt:
slower growth
• Government budget deficits
– For: high-employment economy
– Crowding-out effect – dominates
• Less investment
– Smaller capital stock, lower potential GDP
• To future generations
– Burden
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47
Slower Growth
• Government budget deficits
– For: high unemployment economy
– More investment
– Crowding-in effect dominates
– Higher growth
– Blessing
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48
Figure 9
The Short-Run Effect of Larger Deficits or Smaller
Surpluses
D1
Price Level
D0
S
B
A
S
D1
D0
Real GDP
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49
Figure 10
The Long-Run Effect of Larger Deficits or Smaller
Surpluses
Potential
GDP
Potential
GDP
S1
D
Price Level
S0
B
S1
A
D
S0
Y1
Y0
Real GDP
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50
Economics and Politics
• The economics and politics of the U.S.
budget deficit
1. Have the deficits of the 1980s, 1990s,
and 2000s been a problem?
– Recessions: 1981–1982, 1990–1991,
2001, since late 2007, weak economy
– Crowding out - more serious issue as the
economy recovered
– Rising structural deficit: 1980s, 2002 -2004
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51
Economics and Politics
2. How did we get rid of the deficit in the
1990s?
– Raising taxes and reducing spending
• Contentious but bipartisan budget agreement
in 1990
• Highly partisan deficit reduction package in
1993
• Smaller bipartisan budget deal in 1997
– Well coordinated fiscal and monetary
policies
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52
Economics and Politics
2. How did we get rid of the deficit in the
1990s?
– Contractionary fiscal policy
– Expansionary monetary policy
– Surprisingly rapid economic growth in the
late 1990s
• Generated much more tax revenue
– Increasing: the off-budget surplus
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53
Economics and Politics
3. How did the surplus give way to such
large deficits so rapidly in the 2000s?
– Under President George W. Bush
• Recession, Tax cuts
• Higher levels of spending
– National defense, homeland security, and
Medicare
– Under President Obama
• The economy deteriorated
• Extraordinary measures
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54
Economics and Politics
• 4. What are the future prospects for the
federal budget deficit?
– Not good
– Beginning in 2011, baby boomers
• Eligible for Medicare and full Social Security
benefits
– Sharp rise in federal spending
– No new tax increases
– No cut in promised benefits
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55