Chapter 12 Fiscal Policy and the National Debt 12-1 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Objectives The deflationary gap The inflationary gap The multiplier and its applications Automatic stabilizers Discretionary fiscal policy Budget deficits and surpluses The public debt Crowding-in and crowding-out 12-2 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Fiscal Policy Fiscal policy is the manipulation of the federal budget to attain price stability, relatively full employment, and a satisfactory rate of economic growth –To attain these goals, the government must manipulate its spending and taxes 12-3 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

There was no such thing as fiscal policy until John Maynard Keynes invented it in the 1930s –He maintained that The only way out of the Depression was to boost aggregate demand by increasing government spending If we ran a big enough budget deficit, we could jump-start the economy and, in effect, spend our way out of the depression Putting Fiscal Policy into Perspective 12-4 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

It’s important that the aggregate supply of goods and services equals the aggregate demand for goods and services at just the level of spending that will bring about full employment at stable prices Putting Fiscal Policy into Perspective 12-5 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Equilibrium GDP tells us the level of spending in the economy Full-employment GDP tells us the level of spending necessary to get the unemployment rate down to 5 percent (which we have been calling full-employment) Fiscal policy is used to push equilibrium GDP toward full-employment GDP Putting Fiscal Policy into Perspective 12-6 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Deflationary Gap and the Inflationary Gap Equilibrium GDP is the level of output at which aggregate demand equals aggregate supply –Aggregate demand is the sum of all expenditures for goods and services (that is, C + I + G + X n ) –Aggregate supply is the nation’s total output of final goods and services –So at equilibrium GDP, everything produced is sold 12-7 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Full-employment GDP is the level of spending necessary to provide full employment of our resources –If our plant and equipment is operating at between 85 and 90 percent of capacity, that’s considered full employment –If only 5 percent of our labor force is unemployed, that’s full employment The Deflationary Gap and the Inflationary Gap 12-8 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Deflationary Gap and the Inflationary Gap 12-9 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. Equilibrium GDP The Deflationary Gap When the full- employment GDP is greater than the equilibrium GDP, there is a deflationary gap. How much is it? $1 trillion

The Deflationary Gap and the Inflationary Gap Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. The Inflationary Gap Equilibrium GDP When equilibrium GDP is greater than full- employment GDP, there is an inflationary gap. How large is it? $200 trillion

Summary Equilibrium GDP is above the full- employment GDP –Spending is too high –Results in an inflationary gap To eliminate the inflationary gap, we cut G and/or raise taxes Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Summary Equilibrium GDP is less than full- employment GDP –Spending is too low –Results in a deflationary gap To eliminate the deflationary gap, we raise G and/or cut taxes Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Multiplier and Its Applications Any change in spending (C, I, or G) will set off a chain reaction, leading to a multiplied change in GDP GDP = C + I + G + Xn How much the multiplied change is depends on the MPC and MPS Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Calculating the Multiplier Remember –MPC + MPS = 1, therefore, MPS = 1 - MPC Multiplier = MPC Multiplier = MPS Because the multiplier (like C) deals with spending, 1/(1-MPC) is a more appropriate formula) Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Calculating the Multiplier The MPC is.5 - Find the multiplier Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Calculating the Multiplier (Continued) The MPC is.5. Find the multiplier Multiplier = = = = MPC – Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Calculating the Multiplier Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. Step-by-Step Working of the Multiplier When MPC is.5 $1, $ $ $ $ $ $ $ $ $ etc. $ etc. $2, It is surely much easier to use the multiplier of 2 (2 X $1,000 = $2000) than to go through this process and add up all the figures

12-18 Calculating the Multiplier (Continued) The MPC is.75 - Find the multiplier Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

12-19 Calculating the Multiplier (Continued) The MPC is.75 - Find the multiplier Multiplier = = = = MPC 1 – Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Applications of the Multiplier The Multiplier is used to calculate the effect of changes in C, I, or G on GDP GDP = 2,500; Multiplier = 3; C rises by 10 What is the new level of GDP GDP New = GDP Initial + (Change in spending X Multiplier) GDP New = ( 10 x 3) GDP New = ( 30) GDP New = 2530 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Applications of the Multiplier The Multiplier is used to calculate the effect of changes in C, I, or G on GDP GDP = X; Multiplier = 3; C rises by 10 What happens to GDP GDP New = GDP Initial + (Change in spending X Multiplier) GDP New = X + ( 10 x 3) GDP New = X + ( 30) GDP increases by 30 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Applications of the Multiplier The Multiplier is used to calculate the effect of changes in C, I, or G on GDP GDP = X; Multiplier = 7; G falls by 5 What happens to GDP GDP New = GDP Initial + (Change in spending X Multiplier) GDP New = X + ( -5 x 7) GDP New = X + ( -35) GDP decreases by 35 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Applications of the Multiplier How big is the multiplier (M)? Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. M = distance between the equilibrium GDP and the full- employment GDP / by the gap M = 2 / 2 = 1

Applications of the Multiplier How big is the multiplier (M)? Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. M = distance between the equilibrium GDP and the full- employment GDP / by the gap M = 500 / 200 = 2.5

Removing the Deflationary Gap Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. To remove the deflationary gap we raise aggregate demand from C+I+G+X n to C 1 +I 1 +G 1 +Xn 1 This pushes equilibrium GDP to $7 trillion and removes the deflationary gap

Removing the Inflationary Gap Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. To remove the inflationary gap we lower aggregate demand from C+I+G+X n to C 1 +I 1 +G 1 +X n 1 This pushes equilibrium GDP down to 1,000 and removes the inflationary gap

The Automatic Stabilizers The automatic stabilizers protect us from the extremes of the business cycle –Personal Income and Payroll Taxes During recessions, tax receipts decline During inflations, tax receipts rise –Personal Savings During recessions, saving declines During prosperity, saving rises Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Automatic Stabilizers The automatic stabilizers protect us from the extremes of the business cycle –Credit Availability Credit availability helps get us through recessions –Unemployment Compensation During recessions more people collect unemployment benefits Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Automatic Stabilizers The automatic stabilizers protect us from the extremes of the business cycle –The Corporate Profits Tax During recessions, corporations pay much less corporate income taxes –Other Transfer Payments Welfare (or public assistance) payments, Medicaid payments, and food stamps rise during recessions Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Discretionary Fiscal Policy Making the Automatic Stabilizers More Effective –Public Works The main fiscal policy to end the Depression was public works –Transfer Payments The government could extend the benefit period for unemployment compensation and increase welfare payments, Social Security, and veterans’ pensions Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Without the automatic stabilizers, real GDP would fluctuate much more widely. But you will note that, while the stabilizers do smooth out the cycle, they do not eliminate it. Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved

Discretionary Fiscal Policy Making the Automatic Stabilizers More Effective –Changes in Tax Rates To fight inflation, the government can raise taxes To fight recession, the government can cut taxes Corporate incomes taxes can be raised during periods of inflation and lowered when recessions occur –Using tax rate changes as a counter cyclical policy tool provides a quick fix, however, temporary tax cuts carried out during recessions should not become permanent Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Discretionary Fiscal Policy Making the Automatic Stabilizers More Effective –Changes in Government Spending The government increases spending and cuts taxes to fight recessions The government decreases spending and raises taxes to fight inflation In brief, we fight recessions with budget deficits and inflation with budget surpluses Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Who Makes Fiscal Policy? The President and Congress make fiscal policy –This is complicated and can be time consuming, especially when one political party controls Congress while the president belongs to the other party –No one seems to be in charge of making fiscal policy Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Deficit Dilemma Deficits, Surpluses, and the Balanced Budget –When government spending is greater than tax revenue, we have a federal budget deficit The government borrows to make up the difference Deficits are prescribed to fight recession Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Deficit Dilemma Deficits, Surpluses, and the Balanced Budget –When the budget is in a surplus position, tax revenue is greater than government spending Budget surpluses are prescribed to fight inflation Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Deficit Dilemma Deficits, Surpluses, and the Balanced Budget –We have a balanced budget when government expenditures are equal to tax revenue We’ve never had an exactly balanced budget We’re dealing with a budget of nearly $4 trillion in taxes and spending Perhaps, if the deficit or surplus were less than $20 billion, we’d call that a balanced budget Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Deficit Dilemma Deficits and Surpluses: The Record Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. The Federal Budget Deficit, Fiscal Years Economic Report of the President and Economic Indicators

The Deficit Dilemma – How does our deficit compare with those of other nations? Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. The Surplus or Deficit as a Percentage of GDP, Selected Countries, 2006 The Economist, December 17, 2005, p 93

Why Are Large Deficits So Bad? Large deficits raise interest rates The federal government has become increasingly dependent on foreign savers to finance the deficit The deficit sops up more large amounts of personal savings in this country, making much less available to large corporate borrowers seeking funds for new plant and equipment Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Must We Balance the Budget Every Year? In a word, “no!” –We couldn’t, even if we tried –During recessions, the budget will automatically go into deficit –Events beyond our control can force the federal government to spend great sums of money However, some believe that barring national emergencies and possibly recessions, the government should be legally bound to balance its budget every year. –During the 1990s, several attempts were made to pass a constitutional amendment requiring this –None were successful Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Public Debt Differentiating between the Deficit and the Debt –The deficit occurs when federal government spending is greater than tax revenue –The debt is the cumulative total of all the federal budget deficits less any surpluses Suppose that our deficit declined one year from $200 billion to $150 billion The national debt would still go up by $150 billion So every year that we have a deficit – even a declining one – the national debt will go up Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Public Debt Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. National Debt, Economic Report of the President, 2006

Holders of National Debt Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. January,

The Public Debt Who holds the national debt? –Private American citizens hold a little about one quarter of the national debt –Foreigners hold a little over one half –The rest is held by banks, other business firms, and U.S. government agencies (mainly the social security trust fund and the Federal Reserve) Is the national debt a burden that will have to borne by future generations? –To the degree that we owe it to foreigners, our children and grandchildren will have to pay them hundreds of billions of dollars a year in interest –This appears that it will be a great burden and a disgraceful legacy to leave our children and grandchildren Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Percentage of Outstanding Debt Held by Foreigners, Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. Before the 1970s, foreigners held no more than 5 percent of the outstanding debt; today they hold over 50 percent

The Public Debt When do we have to pay off the debt? –We don’t. All we have to do is roll it over, or refinance it, as it falls due –Each year more than three trillion dollars worth of federal securities fall due By selling new ones, the Treasury keeps us going –In the future, even if we never pay back one penny of the debt, our children and our grandchildren will have to pay hundreds of billions of dollars in interest At least to that degree, the public debt will be a burden to future generations Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Current Issue: Deficits as Far as the Eye Can See The Baby Boom Catastrophe –Baby boomers will begin retiring in the second and third decades of this century –When they do the Government will have to shell out hundreds of billions more than they are now in Social Security and Medicare benefits If you think the federal budget deficits are’ large now – you ain’t seen nothing yet! In January 2006 the budget deficit was over $8 trillion on which we paid $370 billion interest It is expected this will run over $400 billion a year the rest of the decade In 2011 the we be adding at least $600 billion to the debt in interest payments alone A higher debt will meant higher interest rates Higher interest rages will cause the U.S. Treasury to borrow more and more which will drive interest rates up still further The future will be a vicious cycle of rising debt and deficits each feeding off the other –A one trillion dollar annual deficit in years is looking more and more probable Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.