External borrowing: Federal government borrows from non-U.S. citizens. Burden of the Debt: What is “bad” about deficits and debt? “When the government runs a deficit, we are placing a burden upon future generations of Americans who will have to repay the accumulated debt.” Question: Will external borrowing be a burden when the IOUs are repaid? Family analogy Answer: Yes Burden of the National Debt, Entitlements, and Inflation Targeting Internal borrowing: Federal government borrows from U.S. citizens. Question: Will internal borrowing be a burden when the IOUs are repaid? At first glance it appears that the answer should be no. The family analogy suggests that one American loses another one gains. The family analogy breaks down when we apply it to the U.S. as a whole, however.

Inflation rate (  ) up Expansionary fiscal policy  GDP = C + I + G At a given , GDP increases  AD curve shifts right Govt ConInvestInt RateInfl Rate PeriodGDPPurchDeficitPurch r (%)  (%) 02, , , , , , , , , ,  (%) GDP 2, AD 0 2,100 AD 1, 2,… Internal Borrowing and Crowding Out  Lab 13.1 AS 0,1 AS 2 AS 7… Taylor principle  Real interest rate (r) up  C and I down Borrowing is more costly  G increases

Budget deficits resulting from increased government purchases Possibility: The government could be financing infrastructure projects. This public investment would increase the productivity of American workers. Govt ConInvestInt RateInfl Rate PeriodGDPPurchDeficitPurch r (%)  (%) 02, , , , , , , , , , Internal Borrowing and Crowding Out  In the future, U.S. workers will have fewer tools, less modern factories, etc. and will be less productive Bottom Line  (Private ) Investment falls: Crowding Out  Real interest rate (r) increases In the long run:GDP = GDP P = 2,000

Changing Role of the Federal Government Question: What type of government outlays are now being financed by the deficits, infrastructure or current consumption? Answer: Mostly current consumption. Question: Why is the answer important? Burden of Internal Debt – A Summary Budget Deficits  Higher real interest rates (r)  Less private investment currently  Hurts U.S. workers in the future  Question: What is the current debt financing?  Public investment (Infrastructure)  Helps U.S. workers in the future  Current consumption  Does not help U.S. workers in the future Question: Why has the Federal government financing of current consumption increased? Claim: Mostly entitlements. Answer: Current consumption will not increase the productivity of workers in the future.

Defined Benefit Pension Plan John Doe and/or his employer contributes  to the firm’s fund Employer’s Pension Fund  John Doe  Employer’s legal obligation made at the “back end.” The employer is obliged to pay the employee a predetermined amount after the employee retires. Defined Contribution Pension Plan John Doe and/or his employer contributes  to his personal fund  John “own” fund balance John Doe  Employer’s legal obligation made at the “front end.” The employer contributes to the employee’s pension while the employee is working. The employer has no obligations after the employee retires. Pension Plans and Social Security John Doe’s Pension Fund On Detroit and Chapter 9: An Explainer Wall Street Journal – July 18, 2013 By Ashby Jones The beleaguered City of Detroit threw in the towel on Thursday, after having watched its middle- income tax base slowly shrink over a period of decades and, more recently, having reached an impasse with its largest creditors in negotiations.. The city will be able to begin in earnest its negotiations/fights with the two main creditor groups: both current and retired city employees on the one hand, and municipal bondholders on the other. Both types of plans have fund managers who purchase stocks, bonds, etc. to generate interest. Question: What happens when the employer of a defined benefit pension plan does not have the financial resources to fulfill its obligations.

Social Security: An Intergenerational Transfer or Pay-As-You-Go System Social security is not a pension plan. Workers (20-64) Social Security Trust Fund Retirees (65+) Social Security is an intergenerational transfer of income from those who are working to those who are retired. Social security benefits are then paid out of the trust fund (primarily) to retirees. Workers pay the Payroll Tax providing revenue to the trust fund. The Trust Fund was established to insulate the Social Security system from the ups and downs of the business cycle. Payroll Tax Benefits There are no Social Security Fund managers who purchase stocks, bonds, etc. Rationale Behind the Trust Fund During periods of recession, employment is low, and Payroll Tax revenues are low; consequently, during periods of recession, the trust fund shrinks. The rationale behind the trust fund is that it allows the Social Security Administration to build up a reserve in prosperous times to “tide it over” during recessions so that benefits can be continued to be provided at a steady rate. During periods of prosperity, employment is high, and Payroll Tax revenues are high; consequently, during periods of prosperity, the trust fund grows.   A Pay-As-You-Go System

SSMedicareSS+MedicarePercentPercent of Year(billions) of GDPElderly Receiving 1945 $ $ , Brief History of the Social Security Program 1935Old Age Insurance (OAI) 1939Survivors (OASI) 1954Disability (OASDI) 1965Medicare (OASDHI) 1972Supplemental Security Income (SSI) IncomeTax Rate for YearCeilingWorkerFirm 1935$3, % 19503, , , , , , , , , Payroll Tax“Unusual” Aspects Only labor income, “earned income,” is taxed; that is, income earned from savings accounts, CDs, bonds, stocks, etc. is not taxed. Earned income above the ceiling is not taxed. The legal incidence of the tax is divided equally between the worker and the firm.

Social Security Trust Fund Balances Three Social Security Trust Funds Old Age and Survivors Insurance (OASI). Medicare (HI). Disability Insurance (DI). We will focus on OASI, the largest of the funds. The ratio of trust fund balance to annual payments is on the vertical axis. This ratio has grown dramatically since the 1980’s. So why is there a problem? In 2010, the OASI fund could survive for about four additional years without additional payroll tax revenues. The ratio tells us how many years the trust fund could continue to pay benefits until its balance fell to 0 without any additional payroll tax revenue flowing into the fund. Ratio of Trust Fund Balance to Annual Payments In 1970, the OASI fund could survive for about one additional year without additional payroll tax revenues.

Social Security Trust Fund Balances After the end of World War II, the birth rate increased dramatically. Those who were born in 1946 turned 65 in Beginning in 2011, the baby boomers started to retire. no longer paying into the trust fund. The new retirees are now Workers (20-64) Social Security Trust Fund Retirees (65+) Payroll Tax Benefits   The ratio of workers per retiree will decline. Question: Why is this important? A Pay-As-You-Go System drawing benefits from the trust fund. The birth rate has fallen so the number of new workers entering the labor force is relatively smaller.

Back of the Envelope Calculations Benefits: $20,000 per retiree 10 workers per retiree: 20, = 2,000 5 workers per retiree: 20,000 5 = 4,000 2 workers per retiree: 20,000 2 = 10,000 Average Tax per Worker Workers (20-64) Social Security Trust Fund Retirees (65+) Payroll Tax Benefits   A Pay-As-You-Go System First, focus on OASI 2030: Ratio equals : Ratio equals 0. Question: What about DI and HI? Question: What are the consequences of the declining worker per retiree ratio? To keep the current benefits more funding must be found. If not, what will happen?

Inflation Targeting In 2012, the Fed adopted inflation targeting: In historic shift, Fed sets inflation target By Jonathan Spicer Wed Jan 25, :35 EST (Reuters) - The Federal Reserve took the historic step on Wednesday of setting an inflation target, a victory for Chairman Ben Bernanke that brings the Fed in line with many of the world's other major central banks. The U.S. central bank, in its first ever "longer-run goals and policy strategy" statement, said an inflation rate of 2 percent best aligned with its congressionally mandated goals of price stability and full employment. Inflation targeting uses autonomous monetary policies to achieve a predetermined inflation rate target: First, the Fed chooses a target inflation rate. Second, the Fed pursues autonomous monetary policies to meet the target. That is, the Fed shifts the Fed policy (FP) curve and therefore the aggregate demand (AD) curve to achieve its target inflation rate.

FP  (%) r (%) AD  (%) G&S AD Question: How many final goods and services would be purchased, if the inflation rate (  ) were _______ percent, given that all other factors relevant to demand remained the same? Review: Autonomous Monetary Policy: Shift of the Fed Policy (FP) curve FP Question: What would the real interest rate (r) equal, if the inflation rate (  ) were _______ percent, given that the Fed does not change its inflation policy? At a given inflation rate (  ) Households and firms purchase less Fewer goods and services purchased Aggregate demand (AD) curve shifts left  AD FP Fed increases the real interest rate (r) Loans become more costly  Autonomous Contractionary Monetary Policy Autonomous Expansionary Monetary Policy  Fed becomes tougher on inflation  Fed becomes easier on inflation FP curve shifts right  AD curve shifts left  Contractionary  Lab 10.1  Fed shifts the FP curve right  Fed shifts the FP curve left  At a given inflation rate (  ), the Fed increases the real interest rate (r).  At a given inflation rate (  ), the Fed decreases the real interest rate (r).

 Fed shifts the FP curve right  Borrowing costs up Households and firms purchases fewer goods  AD curve shifts right  GDP = C + I + G At a given r, GDP increases Govt ConInvestInt RateInfl Rate PeriodGDPPurchDeficitPurch r (%)  (%) 02, , , , , , , , , , AD 0, AD 1 Inflation Targeting:The Fed chooses a target inflation rate and then pursues autonomous monetary policies to meet the target.  (%) GDP 2, AD 0  Lab 19.1 SRAS 0,1 Contractionary autonomous monetary policy  Fed becomes tougher on inflation  C and I decrease  GDP = C + I + G At a given r, GDP decreases  AD curve shifts left Expansionary fiscal policy  G increases AD 1 2,080

Govt ConInvestInt RateInfl Rate PeriodGDPPurchDeficitPurch r (%)  (%) No Inflation Targeting (No auto. monetary policy) 02, , , , , , , , , , Inflation Targeting: 2.0% (Auto. monetary policy) 02, , , , , , , , , , In the long run, the Fed’s autonomous monetary policy: Has no effect on the “real” economy. Has no effect on real GDPConsumption purchases Interest rateInvestment purchases Government purchases Has an effect only on the inflation rate. This phenomenon has a fancy name: Classical dichotomy. Classical Dichotomy