Module 30: Long-run Implications of Fiscal Policy: Deficits and the Public Debt 1 1

Fiscal Policy Revisited Recessionary Gap The gap that exists whenever equilibrium real GDP per year is less than full- employment real GDP as shown by the position of the LRAS curve. 2

Fiscal Policy Revisited Inflationary Gap The gap that exists whenever equilibrium real GDP per year is greater than full- employment real GDP as shown by the position of the LRAS curve. 3

Fiscal Policy Revisited Fiscal Policy—the discretionary changes in government expenditures and/or taxes in order to achieve the national economic goals of: High employment (low unemployment) Price stability Economic growth

Fiscal Policy Revisited Expansionary fiscal policy can close the recessionary gap. Increase government spending Decrease taxes Direct and indirect effects cause the aggregate demand curve to shift outward. Assume there is a recessionary gap

Fiscal Policy Revisited Contractionary fiscal policy can close the recessionary gap. Decrease government spending Increase taxes Direct and indirect effects cause the aggregate demand curve to shift inward. Assume there is a inflationary gap

The Budget Balance Other things equal, expansionary fiscal policies (i.e. government purchases of goods/services, higher government transfers, or lower taxes) reduce the budget balance for that year. Other things equal, contractionary fiscal policies (i.e. reduced government purchases, lower government transfers, or higher taxes) increase the budget balance for that year.

The Budget Balance Budget Balance Government Budget Deficit The difference between the government’s tax revenue and its spending in a given year. Government Budget Deficit Negative budget balance Government Budget Surplus Positive budget balance

Federal Government Deficits and Surpluses since 1940 The Budget Balance— Federal Government Deficits and Surpluses since 1940

The Federal Budget Deficit Expressed as a Percentage of GDP

The Business Cycle and the Cyclically Adjusted Budget Balance Historically, the budget tends to move into deficit when the economy experiences a recession, but the deficits shrink or turn into surpluses when the economy is expanding.

The Business Cycle and the Cyclically Adjusted Budget Balance The relationship is even clearer if we compare the budget deficit as a percentage of GDP with the unemployment rate.

The Cyclically Adjusted Budget Balance In assessing budget policy, we need to separate movements in the budget balance due to the business cycle… Caused by automatic stabilizers. Effects are temporary and tend to be eliminated in the long-run.

The Cyclically Adjusted Budget Balance …from the movements in the budget balance due to discretionary fiscal policy changes. Caused by deliberate changes in government purchases, transfers or taxes. When we remove the cyclical effects, this sheds light on whether the government’s taxing and spending policies are sustainable in the long-run.

The Cyclically Adjusted Budget Balance It is an estimate of what the budget balance would be if real GDP were exactly equal to potential output.

Should the Budget Be Balanced? Politicians are always tempted to run deficits because this allows them to cater to voters by cutting taxes without cutting spending or by increasing spending without increasing taxes. Most economists don’t believe the government should be forced to run a balanced budget every year because this would undermine the role of taxes and transfers as automatic stabilizers.

Problems Posed by Government Deficits In the short run, deficits can have two potentially damaging effects on the economy If the economy is at full employment, a government deficit is inflationary. Deficits raise interest rates which can retard growth in investment and housing activities. In the long run, deficits can add to a rising government debt. 17

Problems Posed by Rising Government Debt For 2012, the U.S. federal government had total debt equal to $16.43 trillion. A large federal debt puts financial pressure on future budgets If a large portion of the debt is held by other countries, then foreigners have a large claim on U.S. resources About half our “public debt” is owned by foreign investors, the largest of which were China and Japan at just over $1.1 trillion each. If the national debt rises at a rate faster than GDP, then this can have negative ramifications for the future growth potential of the U.S. 18

Deficits and Debts in Practice Although we haven’t balanced deficits with surpluses, these deficits have not led to runaway debt. To assess the ability of governments to pay their debt, we often use the debt-GDP ratio If the government’s debt grows more slowly than GDP, the burden of paying that debt is actually falling. Although the federal debt has grown in almost every year, the debt-GDP ratio fell for 30 years after the end of WWII. 19

Deficits and Debts in Practice Comparing panels (a) and (b), you can see that in many years the debt-GDP ratio has declined in spite of government deficits. 20

Deficits and Debts in Practice Still, a government that runs persistent large deficits will have a rising debt-GDP ratio when debt grows faster than GDP. 21

Deficits and Debts in Practice Our deficit for 2012 was $1.089 trillion Our public debt at the end of 2012 was $11.59 trillion. Our GDP for 2012 was $15.86 trillion. Budget deficit as a percent of GDP: 6.8% Public debt-GDP ratio: 73% A recent study reported that among the 20 advanced countries studied, average annual GDP growth was 3– 4% when debt was relatively moderate or low (i.e. under 60% of GDP), but it dips to just 1.6% when debt was high (i.e., above 90% of GDP). 22

Implicit Liabilities Despite our steady debt-GDP ratio, some experts on long-run budget issues view the situation in the U.S. with alarm due to implicit liabilities. Spending promises made by governments that represent a future debt but are not included in the usual debt statistics (i.e. transfer payments). Social Security, Medicare and Medicaid currently account for almost 40% of federal spending. 23

Implicit Liabilities For this reason, many economists argue that the total federal debt of $15 trillion, the sum of public debt and government debt held by Social Security and other trust funds, is a more accurate indication of the government’s fiscal health than the smaller amount owed to the public alone. 24