Fiscal Policy, Deficits, and Debt 30 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Fiscal Policy Deliberate changes in: Either Government spending or Taxes Designed to: Achieve full-employment Control inflation Encourage economic growth LO1 30-3

Expansionary Fiscal Policy Use during a recession Increase government spending Decrease taxes Combination of both Create a deficit LO1 30-4

Expansionary Fiscal Policy Real GDP (billions) Price level AD 2 AD 1 $5 billion increase in spending Full $20 billion increase in aggregate demand AS $490$510 P1P1 LO1 Recessions Decrease AD 30-5

Contractionary Fiscal Policy Use during demand-pull inflation Decrease government spending Increase taxes Combination of both Create a surplus LO1 30-6

Contractionary Fiscal Policy Real GDP (billions) Price level AD 3 AD 4 $3 billion initial decrease in spending Full $12 billion decrease in aggregate demand AS $502 $ 522 P2P2 AD 5 $ 510 d b a P1P1 c LO1 30-7

Policy Options: G or T? To expand the size of government If recession, then increase government spending If inflation, then increase taxes To reduce the size of government If recession, then decrease taxes If inflation, then decrease government spending LO1 30-8

Built-In Stability Automatic stabilizers Taxes vary directly with GDP Transfers vary inversely with GDP Will reduce severity of business fluctuations Tax progressivity Progressive tax system Proportional tax system Regressive tax system LO2 30-9

Built-In Stability G T Deficit Surplus GDP 1 GDP 2 GDP 3 Real domestic output, GDP Government expenditures, G, and tax revenues, T LO

Evaluating Fiscal Policy Is the fiscal policy… Expansionary? Neutral? Contractionary? Use the cyclically adjusted budget to evaluate LO

Recent U.S. Fiscal Policy Federal Deficits (-) and Surpluses (+) as Percentages of GDP, (1) Year (2) Actual Deficit – or Surplus + (3) Cyclically Adjusted Deficit – or Surplus +* As a percentage of potential GDP Source: Congressional Budget Office, LO

Fiscal Policy: The Great Recession Financial market problems began in 2007 Recession officially began December 2007 and lasted 18 months Current outlook: Current outlookCurrent outlook LO

Budget Deficits and Projections Source: Congressional Budget Office, $ Budget Deficit (-) or Surplus, Billions Actual Projected (as of March 2010) LO

Problems, Criticisms, & Complications Problems of Timing Recognition lag Administrative lag Operational lag Crowding-out effect LO

The U.S. Public Debt National debt clock The accumulation of years of federal deficits and surpluses Financing: –Treasury bonds -promissory notes (IOUs) issued by the U.S. Treasury. US Debt/GDP ratio 103% of GDP (relative to 165% in Greece, 204% in Japan, 81% in Germany) LO

Ownership of Debt Foreigners Foreigners 25% State and local governments 7% Public Sector Social Security 21% Federal agencies 24% Federal Reserve 9% Private Sector Internal debt 14%

The U.S. Public Debt LO

The U.S. Public Debt Interest charges on debt are the largest burden of the debt LO Interest Expense Fiscal Year 2014 June$97,565,768, May$32,081,384, April$31,099,852, March$26,269,559, February$21,293,863, January$19,498,592, December$88,275,817, November$22,327,099, October$16,451,313, Fiscal Year Total $354,863,251,628.78

Managing the Public Debt Debt video

Crowding Out: –Reduced private sector investment due to increase government borrowing –Limits private sector output Consequence of Deficits

Crowding-Out Effect LO