Module 30 LONG-RUN IMPLICATIONS OF FISCAL POLICY: DEFICITS AND THE DEBT

Key Economic Concepts Fiscal policy directly affects the budget balance equation: Government = 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. A budget surplus is a positive budget balance and a budget deficit is a negative budget balance.

The Budget Balance Case 1: Recessionary Gap Exists 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 Case 2: Inflationary Gap Exists 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 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. 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 the result, not the cause, of fluctuations in the economy.

The Budget Balance The budget deficit almost always rises when the unemployment rate rises and falls when the unemployment rate falls. 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 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.

Should the Budget Be Balanced? 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. 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.

Long-Run Implications of Fiscal Policy 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. The national debt is the accumulation of all past deficits, minus all past surpluses. CURRENT NATIONAL DEBT $19,230,859,763,079.97

Long-Run Implications of Fiscal Policy 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 “crowd out” private investment spending, increasing interest rates and reducing the economy’s long-run rate of growth.

Long-Run Implications of Fiscal Policy

Problems Posed by Rising Government Debt 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 payoff the old credit card. Eventually, that is the road to personal bankruptcy. Nations have essentially declared bankruptcy in the past—defaulting on 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.

Long-Run Implications of Fiscal Policy To assess the ability of governments to pay their debt, we often use the debt to GDP ratio, the government’s debt as a percentage of GDP.

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 over half of federal spending