McGraw-Hill/Irwin Chapter 15: Fiscal Policy, Deficits, and Debt Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

Discretionary Fiscal Policy  Discretionary fiscal policy consists of deliberate changes in government spending and tax collections designed to achieve full employment, control inflation, and encourage economic growth.  Expansionary fiscal policy increases aggregate demand;  Contractionary fiscal policy lowers aggregate demand.  Nondiscretionary fiscal policy consists of changes in taxes and government spending that occur automatically, independent of congressional action.  Nondiscretionary fiscal policy is also called “passive” or “automatic.” LO:

Expansionary Fiscal Policy  When the economy is in recession, expansionary fiscal policy may be in order.  If the Federal budget is balanced at the outset, expansionary fiscal policy will create a government budget deficit. LO: 15-1 Expansionary fiscal policy is an increase in government spending, a decrease in taxes, or some combination of the two for the purpose of increasing aggregate demand and real output. 15-3

Expansionary Fiscal Policy in AD-AS Model Real Domestic Output, GDP Price Level AD 2 Recessions Decrease Aggregate Demand AD 1 Expansionary fiscal policy Increases Aggregate Demand And restores full employment AS $490$510 P1P1 LO:

Contractionary Fiscal Policy  When demand-pull inflation occurs, contractionary fiscal policy may help to control it.  If the Federal budget is balanced at the outset, contractionary fiscal policy will create a government budget surplus. LO: 15-1 Contractionary fiscal policy is a decrease in government spending, an increase in taxes, or some combination of the two for the purpose of decreasing aggregate demand and halting inflation. 15-5

Nondiscretionary Fiscal Policy  Nondiscretionary policy is a combination of built-in stabilizers.  Examples include personal income taxes, payroll taxes, corporate income taxes, sales taxes and excise taxes.  Reductions in spending are desirable when the economy is moving toward inflation, whereas increases in spending are desirable when the economy is slumping.  Built in stability has reduced the severity of business fluctuations. LO: 15-2 Built-in stabilizer: anything that increases the government’s budget deficit (or reduce its budget surplus) during a recession and increases its budget surplus (or reduces its budget deficit) during an expansion without requiring explicit action by policymakers. 15-6

Built-In Stability G T Deficit Surplus GDP 1 GDP 2 GDP 3 Real Domestic Output, GDP Government Expenses, G and Tax Revenues, T LO:

Status of Fiscal Policy  In evaluating the status of fiscal policy, we must adjust deficits and surpluses to eliminate automatic changes in tax revenues.  The standardized budget (or full-employment budget) is used for this purpose.  The standardized budget deficit is zero at the full- employment output level. LO: 15-3 The standardized budget is a measure of what the Federal budget deficit or surplus would be with existing tax rates and government spending programs if the economy had achieved its full-employment GDP in the year. 15-8

Cyclical Deficit  If the economy slides into a recession, the standardized budget deficit is still zero because government expenditure equals the tax revenue that would be forthcoming at the full-employment GDP.  The deficit that arises in a recession is a cyclical deficit and is not caused by government discretionary fiscal policy. LO: 15-3 Cyclical deficit is a Federal deficit that is caused by a recession and the consequent decline in tax revenue. 15-9

Cyclical Deficit G T GDP 2 GDP 1 Real Domestic Output, GDP Government Expenses, G and Tax Revenues, T (Year 2)(Year 1) $500 $450 a b c Cyclical deficit Fiscal policy neutral LO:

Standardized Deficit G T1T1 GDP 4 GDP 3 Real Domestic Output, GDP Government Expenses, G and Tax Revenues, T (Year 4)(Year 3) $500 $450 d e f $475 $425 g T2T2 h Standardized deficit Expansionary fiscal policy LO:

Problems in Applying Fiscal Policy  Problems of timing  Recognition lag, administrative lag, operational lag  Political considerations  Political business cycles (spend more before elections)  Future policy reversals may lead to consumption smoothing  Offsetting state and local finance, which is frequently procyclical  Crowding-out effect: a decrease in private investment caused by higher interest rates that result from the Federal government’s increased borrowing to finance deficits LO:

Public Debt  The national or public debt is essentially the total accumulation of the deficits (minus the surpluses) that the Federal government has incurred through time.  Deficits have emerged because of war financing, recessions, fiscal policy, and lack of political will by Congress.  The total public debt represents the total amount of money owed by the Federal government to the owners of government securities. LO: 15-4 U.S. government securities are Treasury bills, Treasury notes, Treasury bonds, U.S. savings bonds, and I-bonds issued by the Federal government to finance expenditures that exceed tax revenues

Federal Budget Balance Source: Congressional Budget Office $ Budget Deficit (-) or Surplus, Billions ActualProjected(as of March 2008) LO:

Burden of Public Debt  The annual interest charge accruing on the bonds sold to finance the debt is the primary burden of the U.S. debt.  The large U.S. debt does not threaten to bankrupt the Federal government, leaving it unable to meet its financial obligations.  One reason is that the public debt is easily refinanced.  Another reason is that the Federal government has the option to impose new taxes or increase existing tax rates to finance the debt. LO:

Burden of Public Debt  Ownership of the public debt is concentrated among wealthier groups.  A large public debt may impair economic growth if higher taxes for interest payments on government securities dampen incentives to bear risk, to innovate, to invest, and to work.  External public debt, or the part of the public debt owned by foreigners, is an economic burden to Americans.  Financing of the large public debt transfers a real economic burden to future generations by passing a smaller stock of capital goods on to them. LO:

Who Holds U.S. Public Debt? Debt Held by the Federal Government and Federal Reserve (53%) Debt Held Outside The Federal Government and Federal Reserve (47%) Federal Reserve U.S. Government Agencies U.S. Individuals Foreign Ownership U.S. Banks And other Financial Institutions Other – Including State and Local Governments Source: U.S. Treasury 9% 7% 25% 8% 7% 44% LO:

Imbalance in the Social Security System  The most significant fiscal issue in the U.S. is the long- term funding imbalance in the Social Security and Medicare programs.  There is a severe long-run shortfall in Social Security funding because of growing payments to retiring baby boomers.  The accumulation of monies in the Social Security trust fund will be greatly inadequate for paying the retirement benefits to future retirees.  The problem is one of demographics: the percentage of the American population age 62 and older will rise substantially over the next several decades. LO: