31 Fiscal Policy, Monetary Policy, and Growth Blessed are the young, for they shall inherit the national debt. HERBERT HOOVER

Contents Should the Budget Be Balanced? The Short Run Surpluses and Deficits: The Long Run Deficits and Debt: Terminology and Facts Interpreting the Budget Deficit or Surplus Bogus Arguments About the Burden of the Debt Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Contents (continued) Budget Deficits and Inflation Debt, Interest Rates, and Crowding Out The True Burden of the National Debt: Slower Growth The Economics and Politics of the U.S. Budget Deficit Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Should the Budget be Balanced? The Short Run Not always. Attempts to achieve balance during a recession or an inflationary episode would destabilize the economy.

Should the Budget be Balanced? The Short Run The Importance of the Policy Mix The appropriate fiscal policy depends, among other things, on the current monetary policy stance. While a balanced budget may be appropriate under one monetary policy, a deficit or a surplus may be appropriate under another.

FIGURE 31-1 The Interaction of Monetary and Fiscal Policy Potential GDP D Effect of monetary policy S D 1 Price Level A Effect of fiscal policy B Y 1 Y Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Surpluses and Deficits: The Long Run More expansionary fiscal policy and tighter money supply should produce higher real interest rates and therefore lower investment, slowing economic growth. More restrictive fiscal policy and looser monetary policy should reduce real interest rates and hence increase investment and spur economic growth.

FIGURE 31-2 Growth and Investment in 24 Countries 4% Japan Ireland Portugal Norway Italy Iceland 3 Finland T urkey Canada Austria Spain Belgium Greece Luxembourg Germany Average Annual Growth Rate of per Capita Real GDP, 1970–1990 U.K. France 2 Denmark Netherlands Australia U.S. Sweden Switzerland 1 New Zealand 18 20 22 24 26 28 30 32 A verage Investment as Percent of GDP , 1970–1990 Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Deficits and Debt: Terminology and Facts Budget Deficit = excess of a government’s expenditures over its receipts in a period of time A flow National Debt = total value of government indebtedness at a moment in time A stock

Deficits and Debt: Terminology and Facts Some Facts about the National Debt In absolute terms the debt is large, but as a proportion of GDP it is less than one half. Some, but not all, is backed by government assets. Before the 1980s, most of the debt was accumulated in times of war and recession.

FIGURE 31-3 The U.S. National Debt Relative to GDP, 1915-2001 1.00 1981–1982 Recession World War II 1981–1984 Tax cuts 0.67 Great Depression 1993 Budget Agreement Gross Domestic Product Ratio of Public Debt to 1974–1975 Recession 0.50 World War I 0.33 1915 1925 1935 1945 1955 1965 1975 1985 1995 Year Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Interpreting the Budget Deficit or Surplus Deficit rises in a recession and falls in a boom even with no change in fiscal policy. Structural deficit (or surplus) = what the deficit (or surplus) would be at full employment Portion of the deficit unrelated to the business cycle Shows how the deficit is related to government policy

FIGURE 31-4 Official Fiscal-Year Budget Deficits, 1981-2001 $300 250 200 150 Federal Budget Deficit 100 50 ’98 ’99 ’00 ’01 ’81 ’82 ’83 ’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 Fiscal Year –50 –100 –150 –200 –250 Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 31-5 The Effect of the Economy on the Budget = Taxes – Transfers Surplus A Spending and Tax Receipts G Deficit B Y 1 Y 2 Y 3 Gross Domestic Product Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Interpreting the Budget Deficit or Surplus On-budget Versus Off-budget Surpluses Overall budget surplus = off-budget surplus + on-budget surplus Off-budget surplus = revenues – expenditures of off-budget items (primarily Social Security taxes and payments) On-budget surplus = revenues – expenditures of on-budget items (most other items)

TABLE 31-1 Alternative Budget Concepts, 1981-2001 Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Bogus Arguments about the Burden of the Debt Our children will be burdened by high interest payments. Repayment of the debt will ruin the nation. A nation has a limited capacity to borrow.

Budget Deficits and Inflation Deficits   AD Can cause inflation if economy is strong, since AS curves slope upward

FIGURE 31-6 The Inflationary Effects of Deficit Spending Aggregate supply curve shifts inward as wages rise D 1 Potential GDP D S 112 C Price Level 106 B 100 A Deficit spending boosts aggregate demand $5,000 $6,000 $7,000 $8,000 Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Budget Deficits and Inflation The Monetization Issue If the Federal Reserve takes no countervailing actions, an expansionary fiscal policy that increases the budget deficit will tend to  real GDP and prices Cause outward shift of the demand curve for money  interest rates

FIGURE 31-7 Fiscal Expansion and Interest Rates M 1 D M D S M For given Fed policy B Interest Rate A Shift in money demand caused by rising Y and P Quantity of Money Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Budget Deficits and Inflation The Monetization Issue If the Fed does not want interest rates to rise It can engage in expansionary open-market operations, that is, purchase more government debt. The money supply will then increase. The portion of the deficit purchased by the Fed has been monetized.

FIGURE 31-8 Monetization and Interest Rates D S M S 1 M B Interest Rate Expansionary Fed policy A C Quantity of Money Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Monetized Deficit Spending Expansionary fiscal policy Expansionary monetary policy D 2 D 1 D S C B Price Level A Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Debt, Interest Rates, and Crowding Out Occurs when unemployment is low  deficit   interest rates   investment +  capital stock Investment spending is thus crowded out by government deficit.

Debt, Interest Rates, and Crowding Out Crowding in Occurs when unemployment is high  deficit   output   savings +  capacity utilization   investment +  capital stock Crowding-in is likely to dominate in the short run, crowding-out in the long run.

True Burden of the National Debt: Slower Growth Much of the debt prior to the 1980s was accrued during recessions, when crowding-in probably occurred. Since 1980, high deficits have often persisted along with high employment, leading one to think that crowding-out predominated.

True Burden of the National Debt: Slower Growth The arguments that a large national debt may lead the nation into bankruptcy, or unduly burden future generations who have to make onerous payments of interest and principal, are mostly bogus.

True Burden of the National Debt: Slower Growth The national debt will be a burden if It is sold to foreigners. It is contracted in a fully employed, peacetime economy. In the latter case, it will reduce the nation’s capital stock.

True Burden of the National Debt: Slower Growth Under some circumstances, budget deficits are appropriate for stabilization-policy reasons. Until the 1980s, the public debt was mostly contracted as a result of wars and recessions. Precisely the circumstances under which the valid burden-of-the-debt argument does not apply

True Burden of the National Debt: Slower Growth However, the large deficits of the 1980s and 1990s were not mainly attributable to recessions, and were therefore worrisome.

Issue Revisited: Was Fiscal Stimulus Warranted in 2001? Emergency spending and first phase of tax cut after September 11th attacks stimulated economy. Short-run effects: stimulate AD. Long-run effects: perhaps crowding out

FIGURE 31-9 S-R Effect of Larger Deficits or Smaller Surpluses ? FIGURE 31-9 S-R Effect of Larger Deficits or Smaller Surpluses D 1 D S B A Price Level Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

FIG. 31-10 L-R Effect of Larger Deficits or Smaller Surpluses ? FIG. 31-10 L-R Effect of Larger Deficits or Smaller Surpluses Potential GDP D S 1 B S Price Level A Y 1 Y Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

The Economics and Politics of the U.S. Budget Deficit The deficits of the early 1980s came during recessions and hence crowding out was not a serious problem. By 1987 the economy was approaching full employment and hence crowding out was becoming a problem.

The Economics and Politics of the U.S. Budget Deficit Deficit was eliminated by raising taxes and reducing spending; an expanding economy also produced more tax revenues.