Chapter 30 Fiscal Policy, Deficits, and Debt McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives Purposes, tools, and limitations of fiscal policy Built-in stabilizers and the business cycle The standardized budget and U.S. fiscal policy U.S. public debt

Fiscal Policy Council of Economic Advisers (CEA) Discretionary fiscal policy Eliminate recessionary or inflationary gap Countercyclical Nondiscretionary fiscal policy Passive or automatic

Fiscal Policy Expansionary fiscal policy Contractionary fiscal policy Increased spending and/or lower taxes Budget deficit Contractionary fiscal policy Lower spending and/or higher taxes Budget surplus Policy options?

Expansionary Fiscal Policy Recessions Decrease Aggregate Demand $5 Billion Additional Spending AS Price Level Full $20 Billion Increase in Aggregate Demand P1 AD1 AD2 $490 $510 Real Domestic Output, GDP

Contractionary Fiscal Policy Reduce Demand Pull Inflation $5 Billion Initial Decrease In Spending AS Price Level Full $20 Billion Decrease in Aggregate Demand P1 AD4 AD3 $510 $522 Real Domestic Output, GDP

Automatic stabilizers Built-In Stability Automatic stabilizers Taxes and transfers Economic importance Tax progressivity Progressive tax system Proportional tax system Regressive tax system

Built-In Stability Surplus Deficit T Government Expenses, G and Tax Revenues, T G Deficit GDP1 GDP2 GDP3 Real Domestic Output, GDP

Evaluating Fiscal Policy Standardized budget Full-employment budget Cyclical deficit Recent U.S. fiscal policy Budget deficits and projections Social security considerations

Evaluating Fiscal Policy Cyclical deficit Fiscal policy neutral b a Government Expenses, G and Tax Revenues, T $500 G $450 c GDP2 GDP1 (Year 2) (Year 1) Real Domestic Output, GDP

Evaluating Fiscal Policy Standardized deficit Expansionary fiscal policy T1 T2 e d Government Expenses, G and Tax Revenues, T $500 G $475 h $450 f $425 g GDP4 GDP3 (Year 4) (Year 3) Real Domestic Output, GDP

Budget Balances as % of GDP (1) Year (2) Actual Deficit (-) or Surplus (+) (3) Standardized 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 -4.5% -3.8% -2.9% -2.2% -1.4% -0.3% +0.8% +1.4% +2.5% +1.3% -1.5% -3.4% -3.5% -2.6% -1.9% -1.3% -2.9% -2.1% -2.0% -1.2% -1.0% -0.4% +0.1% +1.1% +1.0% -2.5% -2.4% -1.9% -1.8% -1.4% Source: Congressional Budget Office

Standardized Budget Balance Percentage of Potential GDP, 2007 Deficits Surpluses -6 -4 -2 2 4 6 Denmark New Zealand Ireland Canada Norway France United States United Kingdom Japan Source: Organization for Economic Cooperation and Development

Federal Budget Balance Actual and Projected, Fiscal 1994-2014 Actual Projected (as of March 2008) $300 200 100 -100 -200 -300 -400 -500 Budget Deficit (-) or Surplus, Billions 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Source: Congressional Budget Office

Fiscal Policy Issues Problems of timing Operational lag Problems, Criticisms, and Complications Problems of timing Recognition lag Administrative lag Operational lag Political considerations Future policy reversals Offsetting state and local finance Crowding-out effect Current thinking on fiscal policy

The Public Debt National or public debt $9.01 trillion Ownership U.S. securities 53% owned by federal government and Federal Reserve 47% held outside the federal government and Federal Reserve

The Public Debt Debt Held Outside The Federal Government and Federal Reserve (47%) Debt Held by the Federal Government and Federal Reserve (53%) Other, Including State and Local Governments U.S. Banks And other Financial Institutions 8% 7% 9% Federal Reserve 25% Foreign Ownership 44% 7% U.S. Government Agencies U.S. Individuals Source: U.S. Treasury Total Debt: $9.01 trillion

Debt and GDP Federal debt held by the public, percentage of GDP Percent of GDP Year 50 45 40 35 30 25 20 15 10 5 1970 1975 1980 1985 1990 1995 2000 2005 Source: Economic Report of the President, 2006

Debt and GDP Publicly Held Debt: International Comparisons As a Percentage of GDP, 2007 0 20 40 60 80 100 Italy Japan Belgium Hungary Germany United States United Kingdom France Netherlands Canada Spain Poland Source: Organization for Economic Cooperation and Development

Debt and GDP Interest charges False concerns Primary burden 1.7% of GDP 2007 False concerns Bankruptcy Refinancing Taxation Burdening future generations

Debt and GDP Substantive issues Crowding-out effect revisited Income distribution Incentives Foreign-owned public debt Crowding-out effect revisited Burden on future generations Public investment as an offset Graphically

Crowding Out A Large Public Debt to Finance Public Investment Will Cause… 2 4 6 8 10 12 14 16 If Public Spending Spurs More Private Investment Will Increase to ID2 b c Real Interest Rate (Percent) a Interest Rate Rise Will Decrease Investment a to b Crowding- Out Effect ID2 ID1 5 10 15 20 25 30 35 40 Investment (Billions of Dollars)

The Leading Indicators Average workweek Initial claims for unemployment insurance New orders for consumer goods Vendor performance New orders for capital goods Building permits for houses Stock prices Money supply Interest-rate spread Consumer expectations Source: The Conference Board

Key Terms fiscal policy regressive tax system Council of Economic Advisers (CEA) expansionary fiscal policy budget deficit contractionary fiscal policy budget surplus built-in stabilizer progressive tax system proportional tax system regressive tax system standardized budget cyclical deficit political business cycle crowding-out effect public debt U.S. securities external public debt public investments

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