Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 0

C H A P T E R 19 Deficits, Debts, and Fiscal Policy Learning objectives äUnderstand that, between 1975 and 1996, the federal government ran fiscal deficits. By the end of the 1990s, the federal government was in a fiscal surplus position. äUnderstand that the budgetary deficit is composed of the operating deficit plus interest on the public debt. äUnderstand that the debt to GDP ratio has exhibited three peaks: during the Great Depression, during World War II, and the mid-1990s, when the federal government began reducing budget deficits. äUnderstand that when the government finances its deficit by issuing money, the government is imposing an inflation tax. PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa Copyright 2005 © McGraw-Hill Ryerson Ltd.

Slide 2 Revenues, Expenditures,and Deficits oDirect Taxes: taxes directly applied to persons and corporations, and include items such as personal and corporate income taxes. oIndirect Taxes: Taxes levied on goods such as the GST. oGovernment Purchases: Government spending on currently produced goods and services. oTransfer payments: Spending for which the government does not receive goods or services in return. Chapter 19: Deficits, Debts, and Fiscal Policy

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 3 Revenues, Expenditures,and Deficits Chapter 19: Deficits, Debts, and Fiscal Policy Figure 19-1: Total Revenue and Components, All Governments, (% of GDP)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 4 Revenues, Expenditures,and Deficits Chapter 19: Deficits, Debts, and Fiscal Policy Figure 19-2: Total Expenditure and Components, All Governments, (% of GDP)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 5 Fiscal Policy, the GD, and Keynesian Economics BOXBOX 19-1

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 6 Revenues, Expenditures,and Deficits Chapter 19: Deficits, Debts, and Fiscal Policy Figure 19-3: Total Revenue and Components, Federal Government, (% of GDP)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 7 Revenues, Expenditures,and Deficits Chapter 19: Deficits, Debts, and Fiscal Policy Figure 19-4: Total Expenditures and Components, Federal Government, (% of GDP)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 8 Measuring the Federal Deficit Chapter 19: Deficits, Debts, and Fiscal Policy Figure 19-5: Revenue, Expenditure, and Deficit, Federal Governments, (% of GDP)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 9 Measuring the Federal Deficit Total deficit = Operating Deficit + Interest payment oOperating Deficit: The budget deficit excluding interest payments. oBurden of the debt: oIn 2001, the gross national debt exceeded $600 billion. o$21,000 per person. oCan reduce the capital stock or increase external debt. oDebt-income ratio: Debt/PY = Debt/GDP Chapter 19: Deficits, Debts, and Fiscal Policy

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 10 Fiscal Federalism BOXBOX 19-2 Transfers to Other Governments and Expenditures, as % of GDP.

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 11 Measuring the Federal Deficit Chapter 19: Deficits, Debts, and Fiscal Policy Figure 19-6: Budgetary Deficit, Primary Deficit, and Interest on the Public Debt, Federal Government (% of GDP)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 12 Measuring the Federal Deficit Chapter 19: Deficits, Debts, and Fiscal Policy Figure 19-7: Federal Government Debt-to-Income Ratio, (% of GDP)

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 13 Deficits and the Inflation Tax oGovernment Budget Constraint: A limit that says the government can finance its deficits only by selling bonds (more debt) or by increasing the monetary base. Budget Deficit = Sales of Bonds + Increase in Monetary Base oLinks between deficits and money growth: oHigher deficits in the short run caused by expansionary fiscal policy will rise nominal and real interest rates. The Bank may raise the supply of money to keep interest rates in check. oIncreased money supply to increase revenue in the future. Chapter 19: Deficits, Debts, and Fiscal Policy

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 14 Deficits and the Inflation Tax oMonetization: When the BOC purchases part of the debt sold by the Department of Finance to finance the deficit. oBank of Canada’s Dilemma: Monetize the deficit or not to monetize? oIf doesn’t monetize = crowding out. oIf monetize = Inflation oCanadian Experience: See Figure oInflation Tax: Revenue gained by the government because of inflation’s devaluation of money holdings. oSeigniorage: Revenue derived from the government’s ability to print money. Chapter 19: Deficits, Debts, and Fiscal Policy

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 15 Deficits and the Inflation Tax Chapter 19: Deficits, Debts, and Fiscal Policy Figure 19-8: Money and Deficits,

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 16 Measuring the Federal Deficit Chapter 19: Deficits, Debts, and Fiscal Policy Table 19-1: Inflation and Inflation Tax, (percent) Inflation Tax Revenue = Inflation tax x Real Money Base

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 17 Measuring the Federal Deficit Chapter 19: Deficits, Debts, and Fiscal Policy Figure 19-9: The Inflation Tax

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 18 Real Balances and Inflation BOXBOX 19-3 Increased nominal money growth reduces the long run real money stock. Higher inflation raises the nominal interest rate and hence raises the opportunity cost of holding money. Money holders will reduce the amount of real balances they hold. Prices are rising faster than money.

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 19 Intergenerational Accounting oIntergenerational Accounting: Evaluate the costs and benefits of taxes and spending for various age groups of society. oSize-of-Government Debate oThe Barro-Ricardo problem: oTraditional AD & AS = Lower taxes => higher AD => higher interest rates => more crowding out. o“Are government bonds net wealth?” or The Barro-Ricardo Equivalence Proposition (Ricardian Proposition): Debt financing by bond issue merely postpones taxation and therefore, in many instances, is strictly equivalent to current taxation. Chapter 19: Deficits, Debts, and Fiscal Policy

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 20 Canada Pension Plan oPay-as-Go System: Social security system in which payments to retirees are made with funds provided, not by their social security taxes, but by the social security taxes of the working populace. oCPP/QPP transfer resources from the young to the old for three reasons: 1)Population growth 2)Real income growth 3)Political process oSocial Security and Economic Efficiency. Chapter 19: Deficits, Debts, and Fiscal Policy

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 21 Canada Pension Plan Chapter 19: Deficits, Debts, and Fiscal Policy Table 19-2: The Ratio of Working-Age Population to Retirement Age population

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 22 Chapter Summary The federal government ran budget deficits for each year between 1973 and By the end of the 1990s, it was in a budgetary surplus. The budgetary deficit is composed of the operating deficit plus interest on the public debt. The debt-GDP ratio has exhibited three peaks: GD, WWII, mid 1990s. When the government finances its deficit by issuing money, the government is imposing an inflation tax. Social Security is financed as a pay-as-you-go system. Chapter 19: Deficits, Debts, and Fiscal Policy

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 23 Chapter Summary (cont’d) The current Bank of Canada policy is to set the overnight rate. The Monetary Conditions Index “MCI” is a weighted average of the short term interest rate and the exchange rate. Chapter 19: Deficits, Debts, and Fiscal Policy

Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 24 The End Chapter 19: Deficits, Debts, and Fiscal Policy