29-1 Economics: Theory Through Applications

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29-3 Chapter 29 Balancing the Budget

29-4 Learning Objectives What is the difference between the deficit and the debt? What are the links between the deficit and the debt? What are the budget constraints faced by the government? How does fiscal policy affect the budget deficit? How does the state of the economy affect the budget deficit? How do we determine if a budget deficit is because of fiscal policy or the state of the economy?

Learning Objectives When do countries run government budget deficits? Why might a country incur a government budget deficit? What is the crowding out effect? When is crowding out effect of government deficits large? What is the Ricardian theory about the effects of deficits on interest rates and real GDP? What is the evidence on the Ricardian theory? 29-5

Budget Deficit: Definition 29-6

Table Calculating the Deficit 29-7

Figure The Government Sector in the Circular Flow 29-8

Table Recent Experience of Deficits and Surpluses (Billions of Dollars) 29-9

Table On-Budget, Off-Budget, and Total Surplus, 2010 (Billions of Dollars) 29-10

Table Federal Outlays, 2010 (Billions of Dollars) 29-11

The Intertemporal Government Budget Constraint 29-12

Linking the Debt and the Deficit 29-13

Table Deficit and Debt 29-14

Figure US Surplus and Debt, 1962–

Figure US Surplus and Debt as a Fraction of GDP, 1962–

Table Foreign Holdings of U.S. Treasury Securities as of August 2008 (Billions of Dollars) 29-17

Who Holds the Debt? 29-18

Figure Government Spending 29-19

Taxation 29-20

Figure The Tax Function 29-21

Table Tax Receipts and Income 29-22

Table Deficit and Income 29-23

Figure Government Spending and Tax Receipts 29-24

Figure Deficit/Surplus and GDP 29-25

Figure Expansionary Fiscal Policy 29-26

Figure The Cyclically Adjusted Budget Deficit 29-27

Figure Cyclical Deficit 29-28

Figure Structural Deficit 29-29

Figure Balanced-Budget Requirement 29-30

Figure – Recession with a Balanced-Budget Amendment 29-31

Figure Ratio of US Debt to GDP, 1791–

Table Budget Deficits Around the World, 2005* 29-33

Figure The Financial Sector in the Circular Flow 29-34

The Credit Market 29-35

Figure The Credit Market 29-36

Figure Crowding Out 29-37

Crowding Out 29-38

Table Investment, Savings, and Net Exports (Billions of Dollars) 29-39

The Household’s Lifetime Budget Constraint 29-40

Figure Ricardian Equivalence 29-41

Figure U.S. Surplus/GDP Ratio and Real Interest Rate, 1965–

Figure U.S. Government and Private Savings Rates 29-43

Figure Government and Private Savings Rates in Spain and Greece 29-44

Figure Government and Private Savings Rates in France and Ireland 29-45

Key Terms Government deficit: The difference between government outlays and revenues Government outlays: Government outlays equal government purchases of goods and services plus transfers Government revenues: Money that flows into the government sector from households and firms, largely through taxation, is called government revenues Government purchases: Government purchases equals spending by the government on goods and services 29-46

Key Terms Transfers: Transfers are cash payments from the government to individuals and firms – Examples are unemployment insurance and Medicaid payments Government surplus: The government surplus is equal to total tax revenues collected by the governments less its purchases of goods and services and transfers to households Government budget constraint: The government budget constraint says that the deficit must be financed by issuing government debt Government debt: The stock of government debt is the total outstanding obligations of a government at a point in time 29-47

Key Terms Intertemporal budget constraint: According to the government’s intertemporal budget constraint, the discounted present value of outlays, excluding interest on the debt, minus the discounted present value of taxes must equal the current stock of debt outstanding Primary deficit: The primary deficit is the difference between government outlays excluding interest payments and government revenues Primary surplus: The primary surplus is the negative of the primary deficit 29-48

Key Terms Fiscal policy: Fiscal policy refers to changes in taxation and the level of government purchases, typically under the control of a country’s lawmakers Exogenous variable: An exogenous variable is determined outside the model and is not explained in the analysis Expansionary fiscal policy: Increases in government purchases or reductions in tax rates are called expansionary fiscal policy Contractionary fiscal policy: Decreases in government purchases or increases in tax rates are called contractionary fiscal policy 29-49

Key Terms Cyclically adjusted budget deficit: The cyclically adjusted budget deficit is the difference between outlays and revenues calculated under the assumption that the economy is operating at potential GDP Potential output: Potential output is the amount of real GDP the economy produces when the labor market is in equilibrium and capital goods are not lying idle 29-50

Key Terms Cyclical deficit: A cyclical deficit occurs when a government budget is in deficit because of the low level of real GDP Standardized deficit: A standardized deficit occurs when a government budget is in deficit because of expansionary fiscal policy Tax smoothing: To reduce the distortionary effects of taxes, a government will finance some current spending by issuing debt to spread the tax burden over time Credit market: The credit market brings together suppliers of credit, such as households who are saving, and demanders of credit, such as businesses and households who need to borrow 29-51

Key Terms Real interest rate: The rate of return specified in terms of goods not money National savings: The sum of private and government saving Crowding out: Crowding out occurs when an increase in the government deficit leads to an increase in the real interest rate and to a decrease in spending through reductions in investment and exports Appreciation: An appreciation is an increase in the price of a currency Ricardian equivalence: Ricardian equivalence occurs when a decrease in taxes leads to an equal increase in private saving and thus no change in either the real interest rate or investment 29-52

Key Takeaways The deficit is the difference between government outlays and government revenues – It is a flow – The debt is a measure of the stock of outstanding obligations of the government at a point in time The change in the debt between two dates is equal to the deficit incured during the time between those two dates 29-53

Key Takeaways The government faces a single-year constraint that its deficit must be financed by issuing new debt – The government also faces an intertemport budget constraint that it debt at a point in time must equal the discounted present value of future primary surpluses At a given level of GDP, an expansionary fiscal policy will increase the budget deficit and a contractionary fiscal policy will decrease the budget deficit As the level of economic activity increases, tax revenues will increase, transfers will fall and the budget deficit will fall 29-54

Key Takeaways By looking at the cyclically adjusted budget deficit, it is possible to evaluate how much of the budget deficit is due to the state of the economy and how much is due to the stance of fiscal policy Countries run government budget deficits when faced with large expenditures, such as a war By running a deficit, a government is able to spread distortionary taxes over time – Also, a deficit allows a government to allocate tax obligations across generations of citizens who all benefit from some form of government spending – Finally, stabilization policy often requires the government to run a deficit 29-55

Key Takeaways Crowding out occurs when government deficits lead to higher real interest rates and lower investment – The high interest rates can also cause the domestic currency to appreciate and exports to fall The crowding out effect is large when spending by households on durables and investment spending is sensitive to variations in the real interest rate and when exports are sensitive to changes in the exchange rate 29-56

Key Takeaways According to Ricardian theory, a government deficit will be offset by an increase in household saving leaving real interest rates and the level of economic activity unchanged – The key to the theory is the anticipation of households of future taxes when the government runs a deficit There is some evidence that interest rates are high when deficits are high, contrary to the prediction of the Ricardian view – But, during some periods of large deficits, the household saving rate is high as well – The evidence on Ricardian equivalence is not conclusive 29-57