Copyright © 2005 Pearson Education Canada Inc.11-1 Chapter 11 Fiscal Policy and the Public Debt

Copyright © 2005 Pearson Education Canada Inc.11-2 Learning Objectives 11.1Use the aggregate demand/ aggregate supply model to evaluate the effects of fiscal policy. 11.2Explain the relationship between government budgets and the accumulated debt and describe the current situation for Canadian governments.

Copyright © 2005 Pearson Education Canada Inc.11-3 Learning Objectives 11.3Explain the relationship between a government deficit and a current account deficit. 11.4Discuss ways in which crowding out, direct expenditure offsets, the net export effect, supply-side economics, and the Ricardian equivalence theorem may offset the effectiveness of fiscal policy.

Copyright © 2005 Pearson Education Canada Inc.11-4 Learning Objectives 11.5Explain how fiscal policy time lags complicate the use of fiscal policy to eliminate GDP gaps. 11.6Describe how certain aspects of fiscal policy function as automatic stabilizers for the economy.

Copyright © 2005 Pearson Education Canada Inc.11-5 Fiscal Policy  The discretionary changes in government expenditures and/or taxes in order to achieve certain national economic goals High employment Price stability Economic growth Improvement of international payments balance

Copyright © 2005 Pearson Education Canada Inc.11-6 AD 2 SRAS AD 1 Fiscal Policy Real National Income per Year ($ billions) Price Level 0 LRAS E2E E1E1 Recessionary gap Expansionary Fiscal Policy 1) The recessionary gap is caused by insufficient AD 2) To increase AD, use expansionary fiscal policy to increase government spending 3) With an increase in G AD increases and real GDP increases to full employment

Copyright © 2005 Pearson Education Canada Inc.11-7 AD 1 SRAS 1 SRAS 2 AD 2 Fiscal Policy Real National Income per Year ($ billions) Price Level 0 LRAS E3E3 E2E E1E1 The economy is at full-employment equilibrium -Increase in G increases AD -Real GDP & the price level rise In the Long Run: -Expectations of higher input cost shift SRAS - Equilibrium GDP returns to $700 billion and the price level rises

Copyright © 2005 Pearson Education Canada Inc.11-8 AD 2 SRAS AD 1 Fiscal Policy Real National Income per Year ($ billions) Price Level 0 LRAS E2E E1E1 Expansionary gap Contractionary Fiscal Policy 1) The expansionary gap is caused by SR equilibrium > full employment 2) To decrease AD, use contractionary fiscal policy to decrease government spending 3) With a decrease in G AD decreases and real GDP decreases to full employment

Copyright © 2005 Pearson Education Canada Inc.11-9 SRAS 2 AD 2 SRAS 1 AD 1 Fiscal Policy Real National Income per Year ($ billions) Price Level 0 LRAS E1E1 850 E2E E3E3 The economy is at full-employment equilibrium -Decrease in G decreases AD -Real GDP & the price level fall In the Long Run: -Expectations of lower input cost shift SRAS - Equilibrium GDP returns to $900 billion and the price level falls

Copyright © 2005 Pearson Education Canada Inc Government Budgets and Finances Budget balance  Government revenue minus spending Budget deficit  When government spending exceeds its revenue Budget surplus  When government revenue exceeds its spending

Copyright © 2005 Pearson Education Canada Inc Government Budgets and Finances Financing the federal Deficit  The federal government goes into debt to finance a deficit by selling bonds and other securities. Debt The cumulative total amount of borrowing that the government has undertaken to cover all past deficits.

Copyright © 2005 Pearson Education Canada Inc Fiscal Policy

Copyright © 2005 Pearson Education Canada Inc Fiscal Policy

Copyright © 2005 Pearson Education Canada Inc Government Budgets and Finances Gross Public Debt  All federal government debt, irrespective of who owns it. Net Public Debt  Gross debt minus the value of financial assets held by government agencies.

Copyright © 2005 Pearson Education Canada Inc Government Budgets and Finances

Copyright © 2005 Pearson Education Canada Inc Federal Budget Deficits in an Open Economy Canadian Current Account Balance  $2.6 billion surplus  $28 billion deficit  $23 billion surplus Increased government borrowing results in a large inflow of capital, usually resulting in a current account deficit.

Copyright © 2005 Pearson Education Canada Inc Federal Budget Deficits in an Open Economy

Copyright © 2005 Pearson Education Canada Inc Possible Offsets to Fiscal Policy Crowding-Out Effect  The tendency of expansionary fiscal policy to cause a decrease in planned investment or planned consumption, usually due to a rise in interest rates.

Copyright © 2005 Pearson Education Canada Inc Possible Offsets to Fiscal Policy Government spending exceeds taxes Government spending exceeds taxes Government deficit Increases Government deficit Increases Government sells more bonds Government sells more bonds To sell more bonds, government must offer higher interest yields To sell more bonds, government must offer higher interest yields Fewer private bonds are offered for sale because of higher interest cost Fewer private bonds are offered for sale because of higher interest cost Fewer private investment projects are undertaken and fewer purchases of homes and cars; government spending crowds out private spending Fewer private investment projects are undertaken and fewer purchases of homes and cars; government spending crowds out private spending

Copyright © 2005 Pearson Education Canada Inc Possible Offsets to Fiscal Policy AD 1 SRAS AD 2 Real National Income per Year ($ billions) 0 LRAS E1E1 AD E2E2 E3E Equilibrium GDP below full- employment GDP-- contractionary gap Expansionary policy causing deficit spending initially shifts AD to AD 2. Due to crowding out, AD shifts inward to AD 3. Price Level

Copyright © 2005 Pearson Education Canada Inc Possible Offsets to Fiscal Policy The Net Export Effect Deficit spending leads to an increase in interest rates Foreigners demand more Canadian securities Demand for the dollar increases and supply of foreign currency increases Value of the dollar increases Canadian goods become more expensive and foreign goods become cheaper Exports fall, imports rise Net exports fall

Copyright © 2005 Pearson Education Canada Inc Possible Offsets to Fiscal Policy Combined Government Spending Effect  Local and provincial governments cannot finance deficits, so their spending tends to be pro-cyclical, thus offsetting federal government spending.

Copyright © 2005 Pearson Education Canada Inc Possible Offsets to Fiscal Policy Supply-Side Economics  Creating incentives for individuals and firms to increase productivity will shift the aggregate supply curve to the right.

Copyright © 2005 Pearson Education Canada Inc Possible Offsets to Fiscal Policy The Ricardian Equivalence Theorem  An increase in the government budget deficit has no effect on aggregate demand because individuals discount the increased tax liabilities.

Copyright © 2005 Pearson Education Canada Inc Discretionary Fiscal Policy in Practice Fiscal Policy Mix -- Available Options 1) Permanent change in personal income taxes 2) Permanent change in corporate income taxes 3) Temporary change in personal income taxes 4) Temporary change in corporate income taxes

Copyright © 2005 Pearson Education Canada Inc Discretionary Fiscal Policy in Practice Fiscal Policy Mix -- Available Options 5) Change in payroll taxes, such as EI and CPP contributions 6) Change in depreciation allowance on investment expenditures 7) Change in specific consumption tax, such as on oil

Copyright © 2005 Pearson Education Canada Inc Discretionary Fiscal Policy in Practice Recognition Time Lag  The time required to gather information about the current state of the economy.

Copyright © 2005 Pearson Education Canada Inc Discretionary Fiscal Policy in Practice Action Time Lag  The time required between recognizing an economic problem and putting policy into effect. The action time lag is short for monetary policy but quite long for fiscal policy, which requires legislative approval.

Copyright © 2005 Pearson Education Canada Inc Discretionary Fiscal Policy in Practice Effect Time Lag  The time that elapses between the onset of policy and the results of that policy.

Copyright © 2005 Pearson Education Canada Inc Automatic Stabilizers  Changes in government spending and taxation that occur automatically without deliberate action of the government Examples oThe federal progressive income tax oEmployment Insurance

Copyright © 2005 Pearson Education Canada Inc Automatic Stabilizers Real National Income per Year ($ billions) Government Transfers and Tax Revenues Tax revenues Government transfers 0 Y1Y1 Budget surplus Y2Y2 Budget deficit The automatic changes tend to drive the economy back toward its full- employment output level YfYf