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

30-2 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

30-3 Fiscal Policy Council of Economic Advisers (CEA) Discretionary fiscal policy –Eliminate recessionary or inflationary gap –Countercyclical Nondiscretionary fiscal policy –Passive or automatic

30-4 Expansionary fiscal policy –Increased spending and/or lower taxes –Budget deficit Contractionary fiscal policy –Lower spending and/or higher taxes –Budget surplus Policy options? Fiscal Policy

30-5 Expansionary Fiscal Policy Real Domestic Output, GDP Price Level AD 2 Recessions Decrease Aggregate Demand AD 1 $5 Billion Additional Spending Full $20 Billion Increase in Aggregate Demand AS $490$510 P1P1

30-6 Contractionary Fiscal Policy Real Domestic Output, GDP Price Level AD 3 Reduce Demand Pull Inflation AD 4 $3 Billion Initial Decrease In Spending Full $12 Billion Decrease in Aggregate Demand AS $510$522 P1P1

30-7 Built-In Stability Automatic stabilizers –Taxes and transfers Economic importance Tax progressivity –Progressive tax system –Proportional tax system –Regressive tax system

30-8 Built-In Stability G T Deficit Surplus GDP 1 GDP 2 GDP 3 Real Domestic Output, GDP Government Expenses, G and Tax Revenues, T

30-9 Evaluating Fiscal Policy Standardized budget –Full-employment budget –Compare Govt. spending with potential tax revenues at full employment Cyclical deficit Recent U.S. fiscal policy Budget deficits and projections Social security considerations

30-10 Evaluating Fiscal Policy G T GDP 2 GDP 1 Real Domestic Output, GDP Government Expenses, G and Tax Revenues, T (Year 2)(Year 1) $500 $450 a b c Cyclical deficit Fiscal policy neutral

30-11 Evaluating Fiscal Policy G T1T1 GDP 4 GDP 3 Real Domestic Output, GDP Government Expenses, G and Tax Revenues, T (Year 4)(Year 3) $500 $450 d e f $475 $425 g T2T2 h Standardized deficit Expansionary fiscal policy

30-12 (1) Year (2) Actual Deficit (-) or Surplus (+) (3) Standardized Deficit (-) or Surplus (+) Budget Balances as % of GDP % -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% -1.2% -2.5% -2.4% -1.9% -1.8% -1.4% Source: Congressional Budget Office

30-13 Standardized Budget Balance Percentage of Potential GDP, 2007 Source: Organization for Economic Cooperation and Development Denmark New Zealand Ireland Canada Norway France United States United Kingdom Japan Deficits Surpluses

30-14 Federal Budget Balance Actual and Projected, Fiscal Source: Congressional Budget Office $ Budget Deficit (-) or Surplus, Billions ActualProjected(as of March 2008)

30-15 Problems of timing –Recognition lag –Administrative lag –Operational lag Political considerations –What is the #1 goal of every politician? –How does a coin flip affect fiscal decisions? Future policy reversals Problems, Criticisms, and Complications Fiscal Policy Issues

Offsetting state and local finance –Budget restraints can be pro-cyclical Crowding-out effect –Recession vs. full employment effects –Accelerator effect during recession Unused capital resources Current thinking on fiscal policy –Vs. Monetary Policy –When is it appropriate? 30-16

30-17 The Public Debt National or public debt $14.19 trillion and was 96.8% of calendar year 2010's annual GDP of $14.66 trillion. Ownership –U.S. securities –53% owned by federal government and Federal Reserve –47% held outside the federal government and Federal Reserve

30-18 Debt Held by the Federal Government and Federal Reserve (53%) Debt Held Outside The Federal Government and Federal Reserve (47%) Federal Reserve U.S. Government Agencies U.S. Individuals Foreign Ownership U.S. Banks And other Financial Institutions Other, Including State and Local Governments Source: U.S. Treasury 9% 7% 25% 8% 7% 44% The Public Debt Total Debt: $9.01 trillion

30-19 Debt and GDP Federal debt held by the public, percentage of GDP

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30-21 Debt and GDP Publicly Held Debt: International Comparisons As a Percentage of GDP, 2007 Italy Japan Belgium Hungary Germany United States United Kingdom France Netherlands Canada Spain Poland Source: Organization for Economic Cooperation and Development 2011

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Why did interest expenses decrease?

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30-27 Debt and GDP Interest charges –Primary burden –1.7% of GDP 2007 False concerns –Bankruptcy –Refinancing –Taxation –Burdening future generations

30-28 Debt and GDP Substantive issues –Income distribution –Incentives –Foreign-owned public debt Crowding-out effect revisited –Burden on future generations –Public investment as an offset –Graphically

30-29 Crowding Out Real Interest Rate (Percent) Investment (Billions of Dollars) ID 1 ID 2 a bc Interest Rate Rise Will Decrease Investment a to b Crowding- Out Effect A Large Public Debt to Finance Public Investment Will Cause… If Public Spending Spurs More Private Investment Will Increase to ID 2

30-30 The Leading Indicators 1.Average workweek 2.Initial claims for unemployment insurance 3.New orders for consumer goods 4.Vendor performance 5.New orders for capital goods 6.Building permits for houses 7.Stock prices 8.Money supply 9.Interest-rate spread 10.Consumer expectations Source: The Conference Board

30-31 Key Terms fiscal policy 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

30-32 Next Chapter Preview… Money and Banking