Lecture Nine Government budget and Fiscal Policy Cyclically Adjusted Budget Public Debt

 Since 1945, fiscal policy has been one of the government’s main stabilization policy tools  “active” if changes in government spending or taxes are at the option of the government  “non-discretionary” if independent of parliamentary action 2Lecture 9

 Used when Recession Occurs  Options:  Increased Government Spending  Tax Reductions  Combined Government Spending Increases and Tax Reductions  May Create a Budget Deficit 3Lecture 9

Real GDP (billions) Price level AD 2 AD 1 $5 billion increase in spending Full $20 billion increase in aggregate demand AS $490$510 P1P1 Recessions Decrease AD 4 Lecture 9

 Used to Combat Demand-pull Inflation  Options:  Decreased Government Spending  Increased Taxes  Combined Government Spending Decreases and Tax Increases 5Lecture 9

Real GDP (billions) Price level AD 3 AD 4 $3 billion initial decrease in spending Full $12 billion decrease in aggregate demand AS $502 $ 522 P2P2 AD 5 $ 510 d b a P1P1 c Lecture 96

 To expand the size of government  If recession, then increase government spending  If inflation, then increase taxes  To reduce the size of government  If recession, then decrease taxes  If inflation, then decrease government spending Lecture 97

 Net tax revenues vary directly with GDP  Taxes rise when GDP rises, and vice versa  Transfer payments fall when GDP rises, and vice versa  Leads to automatic stabilization over the business cycle. 8 Lecture 9

GDPNTGBB GDPNTGBB G =200 NT = tY = 0.2Y BB = NT – G = 0.2Y Lecture 9

 A structure of taxation and spending that:  Increases the deficit (reduces the surplus) during recession  Increases the surplus (reduces the deficit) during inflation 10 Lecture 9

 The stabilizers will automatically restrain economic expansion and cushion economic contraction.  Taxes reduce spending and aggregate demand.  Reductions in spending are desirable when the economy is developing inflationary pressures, whereas increases in spending are desirable when the economy is slumping. 11 Lecture 9

G T Deficit Surplus GDP 1 GDP 2 GDP 3 Real domestic output, GDP Government expenditures, G, and tax revenues, T Lecture 9

The built-in stability depends on:  Tax Progressivity  Progressive  Proportional  Regressive  The more progressive the tax system, the greater the economy’s built-in stability 13 Lecture 9

 To evaluate fiscal policy stance, must  Adjust deficits and surpluses to eliminate automatic changes in tax revenues  Compare adjusted budgets to GDP 14 Lecture 9

 The cyclically adjusted budget shows what the budget balance would be if the economy were operating at full employment 15Lecture 9

G T GDP 2 GDP 1 Real domestic output, GDP Government expenditures, G, and tax revenues, T (billions) (year 2)(year 1) $ a b c 16 Lecture 9

G T1T1 GDP 4 GDP 3 Real domestic output, GDP Government expenditures, G, and tax revenues, T (billions) (year 4)(year 3) $ d e f g T2T2 h 17 Lecture 9

 Neutral to mildly expansionary in the early 1990s  Contractionary in late 1990s  Between 1995 and 2007, actual deficits have given way to actual surpluses  In 2008, “Canada’s Economic Action Plan” and the federal budget moved quickly to a deficit  In 2009, expansionary fiscal policy 18Lecture 9

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Percentage of Potential GDP, 2011 Source: Organization for Economic Cooperation and Development Denmark New Zealand Ireland Canada Norway France United States United Kingdom Japan Deficits Surpluses Lecture 9

 Problems of Timing  Recognition Lag  Administration Lag  Operational Lag  Political Considerations  Future Policy Reversals  Offsetting Provincial and Municipal Finance 21Lecture 9

 Crowding-Out Effect Expansionary fiscal policy may lead to  higher interest rates  reduction in interest-sensitive spending  May not be significant in a recession  Fiscal policy can be accommodated by increases in money supply 22Lecture 9

Real domestic output, GDP Price level AD 0 AS P0P0 P1P1 GDP GDP 1 GDP f AD 1 c a b 0 AD’ 1 With an upward-sloping aggregate supply curve, a part of the impact of an expansionary policy will be reflected in a rise in the price level rather than an increase in real output and employment. With an upward-sloping aggregate supply curve, a part of the impact of an expansionary policy will be reflected in a rise in the price level rather than an increase in real output and employment. 23Lecture 9

 Most economists believe fiscal policy is a useful policy lever  not for “fine-tuning”  major discretionary fiscal policy should be held in reserve  should be evaluated for impact on long-run productivity growth 24Lecture 9

Budget Surplus  Annual amount by which government revenues exceed government expenditures Budget Deficit  Annual amount by which government expenditures exceed taxes Public Debt  Accumulation of all past deficits and surpluses 25Lecture 9

 Debt and GDP  relative size of the debt now decreasing  International Comparisons  our debt is among lowest as % of GDP among world’s industrialized nations  Interest Charges  Ownership 26Lecture 9

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 Bankruptcy  Refinancing  Taxation  Burdening Future Generations  Canada owes a substantial portion of the public debt to itself 30Lecture 9

 Read Chapter 11  Understanding Government Budget and Cyclically Adjusted Budget  Lyryx Lab 9 31Lecture 9