Section 6 Lecture January 2016 Mr. Gammie AP Macroeconomics Section 6 Lecture January 2016 Mr. Gammie

$1, 300, 000, 000, 000

$2.2 Billion Surplus --- still a 65 billion of debt

Should the budget be balanced?

Budget Balance Is a budget deficit bad and a budget surplus good?

The Budget Balance as a Measure of Fiscal Policy The Budget Balance Formula: Sgovernment = T- G - TR Where: T is the value of tax revenues G is government purchases of goods and services TR is the value of government transfers

This is affected by fiscal policy. Budget Balance Surplus = positive budget balance Deficit = negative budget balance This is affected by fiscal policy.

Budget Balance and Fiscal Policy Recessionary Gap > Run __________ fiscal policy. > 3 options to do so: 1. 2. 3. All else equal this will ________ the budget balance.

Budget Balance and Fiscal Policy Inflationary Gap > Run __________ fiscal policy. > 3 options to do so: 1. 2. 3. All else equal this will ________ the budget balance.

How can we measure fiscal policy How can we measure fiscal policy? Will changes in the budget balance always reflect changes fiscal policy?

Two Reasons Why it Doesn’t Reason 1: Two different changes in fiscal policy that have equal-sized effects on the budget balance might have 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.

Two Reasons Why it Doesn’t Reason 2: Often, changes in the budget balance are themselves the result, not the cause, of fluctuations in the economy. http://www.cbc.ca/news2/interactives/canada-deficit/index.html - show now

The Business Cycle and the Cyclically Adjusted Budget Balance The budget deficit almost always rises when the unemployment rate rises and falls when the unemployment rate falls. Explain why this statement is true.

Automatic Stabilizers These are programs built into our tax and transfer system that work to reduce the swings of the business cycle. When the economy heads into a recession: Tax revenues decline because incomes and profits are declining. Transfer payments rise as more people tend to find themselves unemployed and struggling. This leads to a negative change in the budget surplus without any deliberate fiscal policy.

On the reverse side… When the economy is heading into an inflationary period: Tax revenues rise because incomes and profits are rising. Transfer payments fall as fewer people find themselves unemployed and struggling.

If we are going to measure fiscal policy, we need a way to separate out two effects on the budget balance: The impact due to deliberate changes in fiscal policy. The impact due to the current state of the business cycle. This is an estimate of what the budget balance would be if there was neither a recessionary or inflationary gap.

The Cyclically Adjusted Budget Balance An estimate of what the budget balance would be if the real GDP were exactly equal to potential output. Takes into account extra revenue the gov’t would collect and transfers it would save if recessionary gap were eliminated. And vice versa. If after this adjustment is made the gov’t is still running a deficit, then we might make the conclusion that their fiscal policy decisions are not sustainable over the long run.

Should the budget be balanced?

Balanced Budgets What would be the result of legislation that required the government to balance the budget on an annual basis? How would the economy be affected? How would people be affected?

Balanced Budgets If this was the case and there was 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 G How would that impact the recession? It would worsen it!

Balanced Budgets If there was 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 G How would this impact the inflationary period? It would worsen it!

So what should the government do? Most economists believe that the govt should only balance its budget on average – that is should be allowed to run deficits in bad years, offset by surpluses in good years. What forces present in the economy make this difficult? Political pressures.

Homework Assignment Go home over the weekend and “interview” a family member/neighbor/etc. who was of voting age in the last federal election. Ask them the following questions… these will be discussed in class on Tuesday. What is your opinion about the Federal Liberals running a budget deficit? Should Canada have a national debt? Should the government actively work to reduce the national debt? If so what should they do? If not, why not? Any other comments you would like to make regarding this issue?

http://www.nationaldebtclocks.org/debtclock/unitedstates http://www.nationaldebtclocks.org/debtclock/canada Should we be worried?

Long-Run Implications of Fiscal Policy Governments that runs persistent deficits end up with substantial debts. National Debt: the accumulation of all past deficits, minus all past surpluses. Public debt: Government debt held by individuals and institutions outside the government.

Rising Government Debt Two reasons for concern: 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. Today’s deficits, by increasing the government’s debt, place financial pressure on future budgets. Interest must be paid in the future, and this can take dollars away from other future obligations like education, social services, space exploration, etc.

How can the government pay off debt? Borrowing more to pay it off? Print more money? Increase taxes or cut spending?

Deficits and Debt in Practice To assess the ability of governments to pay off their debt, we use the debt-GDP ratio This measures the gov’ts debt as a % of GDP Why? GDP is a good indicator of the potential taxes the gov’t can collect. If the gov’ts debt grows more slowly than GDP, the burden of paying that debt is actually falling compared with potential tax revenue.

Is the debt-GDP ratio rising, falling, or staying the same? Check US and Canada

Implicit Liabilities Implicit Liabilities are spending promises made by the gov’t that are debt despite the fact they are not included in usual debt statistics. Examples include social security, Medicare, Medicaid. How will demographic trends affect future spending on these programs? HW WS TB CYU #1, 2, 3 MC #1-5