Fiscal Policy, Deficits, and Debt 13 McGraw-Hill/IrwinCopyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Fiscal Policy Council of Economic Advisors (CEA) Deliberate changes in Government spending Taxes Designed to Achieve full-employment Control inflation Encourage economic growth LO1

Fiscal Policy Define: Budget deficit Budget surplus National, or public, debt LO1

Expansionary Fiscal Policy Increases AE, GDP, and employment Increase government spending Decrease taxes Combination of both Expansionary policy creates a deficit (G > Tax revenue) LO1

Equilibrium vs Full Employment Recessionary Expenditures Gap Amount that AE must increase to reach full-employment, eq. GDP Spending is too low at full- employment Use expansionary fiscal policy to increase AE Desirable to create a deficit LO1

Contractionary Fiscal Policy Decreases AE, GDP, and employment Decrease government spending Increase taxes Combination of both Contractionary policy creates a budget surplus (G < Tax revenue) LO1

Equilibrium vs Full Employment Inflationary Expenditures Gap Amount that AE must decrease to reach full-employment, eq. GDP Spending is too high at full- employment Use contractionary fiscal policy to decrease AE Desirable to create a surplus LO1

Policy Options: G or T? Expand the size of government Increase government spending Increase taxes Reduce the size of government Decrease taxes Decrease government spending LO1

Built-In Stability Automatic stabilizers Tax revenue varies directly with GDP Transfers vary inversely with GDP Automatically creating a surplus during inflation and a deficit during recession Reduces severity of business fluctuations LO2

Evaluating Fiscal Policy Use the cyclically adjusted budget to evaluate fiscal policy Removes impact of built-in stabilizers Size of deficit/surplus if the economy is at full-employment for the year Cyclically adjusted budget only changes when government changes fiscal policy LO3

Recent U.S. Fiscal Policy LO3

Fiscal Policy: The Great Recession Financial market problems began in 2007 In 08 passed $152 billion stimulus consisting of tax breaks Most people saved or paid credit cards Not very expansionary LO4

Fiscal Policy: The Great Recession In 09 passed American Recovery & Reinvestment Act with $787 billion stimulus Decreased taxes for low/middle income No lump sum checks Increased spending on transportation, ed, and aid to state governments LO4

Budget Deficits and Projections LO4

Problems, Criticisms, & Complications Problems of Timing Recognition lag Administrative lag Operational lag Political considerations – political business cycle Future policy reversals Off-setting state and local finance Crowding-out effect LO4

Problems, Criticisms, & Complications LO4 Biggest criticism of fiscal policy is Crowding-Out Effect. Crowding-Out Effect – When government borrows money, demand for money increases, and interest rates rise, reducing (crowding-out) investment. –Offsets expansionary impacts of fiscal policy.

The U.S. Public Debt $16.4 trillion in 2012 The accumulation of years of federal deficits and surpluses Owed to the holders of U.S. securities Caused by war, recession, and fiscal policy Video DebtDebt LO4

The U.S. Public Debt GDP is income of a nation Larger income means a greater ability to carry a large debt Look at debt as percentage of GDP as better gauge LO4

The U.S. Public Debt Interest charges on debt Largest burden of the debt Must at least pay interest every year 2.3% of GDP in 2012 When interest as a percent of GDP increases, must raise taxes LO4

The U.S. Public Debt False Concerns Bankruptcy Refinancing Taxation Burdening future generations LO4

The U.S. Public Debt LO4

The U.S. Public Debt 33% of debt is externally held debt – paying it back will decrease RGDP 67% of debt is internally held debt – paying it back will not reduce RGDP Debt is an asset as owners of debt and a liability as taxpayers LO4

The U.S. Public Debt LO4

Global Perspective LO4

Substantive Issues Income distribution Incentives Foreign-owned public debt Crowding-out effect revisited Future generations Public investment LO4