1. Chapter 11 fiscal policy, deficits, and debt
ECON 201 Macroeconomics
Chapter 11
fiscal policy, deficits, and debt

2. Learning Objectives
The purposes, tools, and limitations of fiscal policy.
The role of built-in stabilizers in moderating business cycles.
How the standardized budget reveals the status of U.S. fiscal policy.
About the size, composition, and consequences of the U.S. public debt.

3. Review Inflation –rise in the general price levels.
Stagflation - period of inflation combined with stagnation (slow economic growth, rising unemployment, could include recession). Both inflation & stagnant business activity.
Recession - decline in a country's real gross domestic product (GDP).
Demand-Pull Inflation-Increases in the price level (inflation) resulting from an excess of demand over output at the existing price level (caused by an increase in aggregate demand).

4. Stabilize the Economy Please!
One major function of the government is to stabilize the economy (prevent unemployment or inflation).
Stabilization – achieved by manipulating the public budget—government spending and tax collections—to increase output and employment or to reduce inflation.

5. Fiscal Policy and the AD/AS Model
Discretionary (active) fiscal policy Deliberate manipulation of taxes and government spending by Congress to alter real domestic output and employment, control inflation, and stimulate economic growth.

6. Discretionary
Initiated by the President, on the advice of the Council of Economic Advisers (CEA).
“Discretionary” means the changes are at the option of the Federal government.

7. Council of Economic Advisers (CEA)
CEA - established by the Employment Act of 1946.
Provides President economic advice on domestic and international economic policy issues.
CEA - 3 members, appointed by the President, by and with the advice and consent of the Senate.

8. Council of Economic Advisers (CEA)
Visit their Website to learn more:

9. Fiscal Policy Choices (What to do?)
Expansionary Fiscal Policy
Used to combat a recession.
Increase in government spending.
Decrease in taxes.
Combination of increased spending and reduced taxes.
(If the budget was initially balanced,
expansionary fiscal policy creates a budget
deficit)

10. Expansionary Fiscal Policy Figure 11.1
Full $20 Billion
Increase in
Aggregate Demand
$5 Billion
Additional
Spending AS
Recessions
Decrease
Aggregate
Demand P1
Price Level
AD1
AD2
$490
$510
Real Domestic Output, GDP

11. Contractionary Fiscal Policy
Used to combat demand-pull inflation.
Decrease government spending
Increase in taxes will reduce income and then consumption.
Combined spending decrease and tax increase could have the same effect.
When the economy faces demand-pull inflation, fiscal policy should move toward a government budget surplus (tax revenues in excess of government spending.

12. Contractionary Fiscal Policy
Recessions
Decrease
Aggregate
Demand
$5 Billion
Initial Decrease
In Spending AS
Price Level
Full $20 Billion
Decrease in
Aggregate Demand P1
AD4
AD3
$510
$522
Real Domestic Output, GDP

13. Policy Options: G or T? Which to use ? (G) Government Spending Or
(T) Taxes
(Is the government too big or too small?)

14. Policy Options: G or T?
Economists who believe there are unmet social & infrastructure needs favor:
Higher Government spending during recessions.
Higher Taxes during inflationary times if they are concerned about unmet social needs or infrastructure. (both expand size of govt.)
Economists who think that the Govt. is too large and inefficient favor:
Lower Taxes for recessions.
Lower Government spending during inflationary periods when they think government is
too large and inefficient. (both restrain govt. size)

15. Built-In Stability Wouldn’t that be nice?
Built‑in stability - because net taxes (taxes minus transfers and subsidies) change with GDP.
(taxes reduce incomes and therefore, spending)
We Want -spending to rise when the economy is slumping and vice versa when the economy is becoming inflationary.

16. Built-In Stability
Taxes automatically rise with GDP because incomes rise and tax revenues fall when GDP falls.
Transfers and subsidies rise when GDP falls; when these government payments (welfare, unemployment, etc.) rise, net tax revenues fall along with GDP.
Transfer payments (“negative taxes”) behave in the opposite way from tax revenues:
Welfare goes down during economic expansion and up in economic contraction.

17. Automatic Stability?
Size of automatic stability depends on responsiveness of changes in taxes to changes in GDP: The more progressive the tax system, the greater the economy’s built‑in stability.

18. Automatic Stability
U.S. tax system reduces business fluctuations by as much as 8 to 10 percent of the change in GDP that would otherwise occur.
Automatic stability reduces instability, but does not eliminate economic instability.

19. Automatic or Built–In Stabilizers
A built-in stabilizer – anything that increases the government’s budget deficit (or reduces its budget surplus) during a recession and increases its budget surplus(or reduces its budget deficit) during an expansion without requiring explicit action by policymakers.
(U.S. tax system)
Govt. Budget Deficit- govt. spending in excess of tax revenues.

20. Built-In Stability Government Expenses, G and Tax Revenues, T Surplus
Deficit
GDP1
GDP2
GDP3
Real Domestic Output, GDP

21. Tax Progressivity How well do tax revenues respond to changes in GDP?
Progressive tax system
Proportional tax system
Regressive tax system
The more progressive a tax system, the greater the economy’s built-in stability.

22. Evaluating Fiscal Policy
How to determine if discretionary fiscal policy is expansionary, neutral, or contractionary?
Must adjust deficits & surpluses to eliminate automatic changes in tax revenues & compare the sizes of the adjusted budget deficits (or surpluses) to the levels of potential GDP.

23. Evaluating Fiscal Policy, cont.
Standardized (full employment)Budget.
Used to adjust Federal budget deficits & surpluses to eliminate the automatic changes in tax revenues.
Measures what the Federal budget deficit or surplus would be with existing tax rates and Gov spending levels if the economy had achieved its full-employment level of GDP each year.

24. What??? Standardized Budget
Compares actual government expenditures for each year with the tax revenues that would have occurred in that year if the economy had achieved full-employment GDP.
Make Believe “at full employment”

25. Evaluating Fiscal Policy
Government Expenses, G
and Tax Revenues, T b a
$500 G
$450 c
GDP2
GDP1
(Year 2)
(Year 1)
Real Domestic Output, GDP

26. Evaluating Fiscal Policyd
Government Expenses, G
and Tax Revenues, T
$500 G
$475 h
$450 f
$425 g
GDP4
GDP3
(Year 4)
(Year 3)
Real Domestic Output, GDP

27. Recent U.S. Fiscal Policy
Federal Deficits and Surpluses –
as a Percentage of Potential GDP
(1)
Year
(2)
Actual
Deficit (-) or
Surplus (+)
(3)
Standardized
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
-3.9%
-4.4%
-4.5%
-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%
-2.2%
-2.5%
-2.9%
-2.1%
-2.0%
-1.2%
-1.0%
-0.4%
+0.1%
+1.1%
-1.1%
-2.7%
-2.4%
-1.8%

28. Problems, Criticisms and Complications
Problems of timing
Recognition lag: time between the beginning of a recession or inflation and the certain awareness that it actually happening.
Administrative Lag: is the difficulty in changing policy once the problem has been recognized.
Operational lag: is the time elapsed between change in policy and its impact on the economy.

29. Problems, Criticisms and Complications
Political Considerations
Government has other goals besides economic stability, and these may conflict with stabilization policy. War?? Elections????
Gas prices are down.
A political business cycle may destabilize the economy: Election years have been characterized by more expansionary policies regardless of economic conditions.

30. Problems, Criticisms and Complications of Fiscal policy
Future Policy Reversals – lesson here is: tax-rate changes that households view as permanent are more likely to alter consumption and aggregate demand than tax changes they view as temporary.
Offsetting State & Local finance
Crowding-out Effect

31. The Crowding‑Out Effect
May be caused by fiscal policy and indicates that an expansionary fiscal policy may increase the interest rate and reduce investment spending.
occurs when the gov expands borrowing to finance increased expenditure, or cuts taxes (i.e. is engaged in deficit spending) crowding out private sector investment by way of higher interest rates.
Controversy on the subject, it is because of disagreements about how financial markets would react to more government borrowing.

32. The Public Debt
Total accumulation of the deficits(minus surpluses) the Federal government has incurred through time.
The public debt was $7.96 trillion in 2005.
What is it today?

33. Total Debt: $7.96 Trillion 2005 Debt Held Outside The Federal
Government
and Federal
Reserve (49%)
Debt Held by the
Federal Government
and Federal
Reserve (51%)
Other – Including
State and Local
Governments
U.S. Banks
And other
Financial
Institutions 8% 8% 9%
Federal
Reserve
25%
Foreign
Ownership
42%
U.S.
Government
Agencies 8%
U.S.
Individuals
Source: U.S. Treasury

34. Interest charges are the main burden imposed by the debt.
Interest on the debt was $184 billion in 2005.
Fourth largest item in the Federal budget.
Interest payments were 1.5 percent of GDP in The % is important b/c it represents the average tax rate necessary just to cover annual interest on the debt.

35. False Concerns
False concerns about the federal debt include several popular misconceptions:
Bankruptcy
Refinancing
Taxation
Burdening Future Generations

36. Substantive Issues Repayment of the debt affects income distribution.
Since interest must be paid out of government revenues, a large debt and high interest can increase tax burden and may decrease incentives to work, save, and invest for taxpayers.

37. More Substantive Issues
A higher proportion of the debt is owed to foreigners (about 18 percent) than in the past, and this can increase the burden since payments leave the country.
But Americans also own foreign bonds and this offsets the concern.

38. End CH 11