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2. Government Budgets and Fiscal Policy and The Impacts of Government Borrowing
Module Overview

3. Principles of Macroeconomics
Acknowledgments
This presentation is based on and includes content derived from the following OER resource:
Principles of Macroeconomics
An OpenStax book used for this course may be downloaded for free at:

4. Government Spending, Part 1
Fiscal policy is the set of policies that relate to federal government spending, taxation, and borrowing.
In recent decades, the level of federal government spending and taxes, expressed as a share of GDP, has not changed much, typically fluctuating between about 18% to 22% of GDP.
However, the level of state spending and taxes, as a share of GDP, has risen from about 12-13% to about 20% of GDP over the last four decades.

5. Government Spending, Part 2
The four main areas of federal spending are national defense, Social Security, healthcare, and interest payments, which together account for about 70% of all federal spending.
When a government spends more than it collects in taxes, it is said to have a budget deficit. When a government collects more in taxes than it spends, it is said to have a budget surplus. If government spending and taxes are equal, the government is said to have a balanced budget. 
The sum of all past deficits and surpluses make up the government debt.

6. Taxation
A progressive tax is one like the federal income tax, where those with higher incomes pay a higher share of taxes out of their income than those with lower incomes.
A proportional tax is one like the payroll tax for Medicare, where everyone pays the same share of taxes regardless of their income levels. 
A regressive tax is one like the payroll tax (above a certain threshold) that supports Social Security, where those with high incomes pay a lower share of their income in taxes than those with lower incomes. 

7. Federal Deficits and the National Debt
For most of the twentieth century, the U.S. government took on debt during wartime and then paid down that debt slowly in peacetime.
However, it took on substantial debts in peacetime in the 1980s and early 1990s, before a brief period of budget surpluses from 1998 to This was followed by a return to annual budget deficits since 2002, with very large deficits in the recession of 2008 and 2009. 
A budget deficit or budget surplus is measured annually. Total government debt or national debt is the sum of budget deficits and budget surpluses over time.

8. Expansionary Fiscal Policy Graph
(Image: Principles of Macroeconomics. OpenStax. Fig 17.11)

9. Expansionary Fiscal Policy
On the previous slide, the original equilibrium (E0) represents a recession, occurring at a quantity of output (Y0) below potential GDP. 
However, a shift of aggregate demand from AD0 to AD1, enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of E1 at the level of potential GDP, which the LRAS curve shows.
Since the economy was originally producing below potential GDP, any inflationary increase in the price level from P0 to P1 that results should be relatively small.

10. Contractionary Fiscal Policy Graph
(Image: Principles of Macroeconomics. OpenStax. Fig 17.12)

11. Contractionary Fiscal Policy
The economy starts at the equilibrium quantity of output Y0, which is above potential GDP.
The extremely high level of aggregate demand will generate inflationary increases in the price level.
A contractionary fiscal policy can shift aggregate demand down from AD0 to AD1, leading to a new equilibrium output E1, which occurs at potential GDP, where AD1 intersects the LRAS curve.

12. Automatic Stabilizers, Part 1
Automatic stabilizers are tax and spending rules that have the effect of slowing down the rate of decrease in aggregate demand when the economy slows down and restraining aggregate demand when the economy speeds up, without any additional change in legislation.
Automatic stabilizers occur quickly.
Lower wages means that a lower amount of taxes is withheld from paychecks right away. Higher unemployment or poverty means that government spending in those areas rises as quickly as people apply for benefits.

13. Automatic Stabilizers, Part 2
Although automatic stabilizers offset part of the shifts in aggregate demand, they do not offset all or even most of it. Historically, automatic stabilizers on the tax and spending side offset about 10% of any initial movement in the level of output. This offset may not seem enormous, but it is still useful. 
Automatic stabilizers, like shock absorbers in a car, can be useful if they reduce the impact of the worst bumps, even if they do not eliminate the bumps altogether.

14. Practical Problems with Discretionary Fiscal Policy
Since fiscal policy affects the quantity of money that the government borrows, it not only affects aggregate demand; it can also affect interest rates. 
If an expansionary fiscal policy also causes higher interest rates, then firms and households are discouraged from borrowing and spending, reducing aggregate demand in a situation called crowding out.
Given the uncertainties over interest rate effects, time lags (implementation, legislative, and recognition lags), temporary and permanent policies, and unpredictable political behavior, many economists and policymakers have concluded that discretionary fiscal policy is a blunt instrument and better used only in extreme situations.

15. A Balanced Budget
A balanced budget occurs when government spending and taxes are equal. Balanced budget amendments are a popular political idea, but the economic merits behind such proposals are questionable.
Most economists accept that fiscal policy needs to be flexible enough to accommodate unforeseen expenditures, such as wars or recessions. While persistent large budget deficits can indeed be a problem, a balanced budget amendment prevents even small, temporary deficits that might, in some cases, be necessary.

16. Total savings = Private savings (S) + Public savings (T – G)
National Saving and Investment Identity, Part 1
The national saving and investment identity shows the relationships between the sources of demand and supply in financial capital markets. The identity begins with a statement that must always hold true: the quantity of financial capital supplied in the market must equal the quantity of financial capital demanded.
The U.S. economy has two main sources for financial capital: private savings from inside the U.S. economy and public savings.
Total savings = Private savings (S) + Public savings (T – G)
These include the inflow of foreign financial capital from abroad. The inflow of savings from abroad is, by definition, equal to the trade deficit.

17. National Saving and Investment Identity, Part 2
We can write this inflow of foreign investment capital as imports (M) minus exports (X). There are also two main sources of demand for financial capital: private sector investment (I) and government borrowing. Government borrowing in any given year is equal to the budget deficit, which we can write as the difference between government spending (G) and net taxes (T).
Quantity supplied of financial capital = Quantity demanded of financial capital
Private savings + Inflow of foreign savings = Private investment + Government budget deficit
S + (M – X) = I + (G –T)

18. Twin Deficits Graph
(Image: Principles of Macroeconomics. OpenStax. Fig 18.4)

19. Twin Deficits
In the 1980s, the budget deficit and the trade deficit declined at the same time. However, since then, the deficits have stopped being twins.
The trade deficit grew smaller in the early 1990s as the budget deficit increased, and then the trade deficit grew larger in the late 1990s as the budget deficit turned into a surplus.
In the first half of the 2000s, both budget and trade deficits increased. However, in 2009, the trade deficit declined as the budget deficit increased.

20. Budget Deficits and Exchange Rates Graph
(Image: Principles of Macroeconomics. OpenStax. Fig 18.5)

21. Budget Deficits and Exchange Rates
Imagine that the U.S. government increases its borrowing and the funds come from European financial investors.
To purchase U.S. government bonds, the investors will need to demand more U.S. dollars on foreign exchange markets. As the previous slide shows, this causes the demand for U.S. dollars to shift to the right from D0 to D1 . 
European financial investors as a group will also be less likely to supply U.S. dollars to the foreign exchange markets, causing the supply of U.S. dollars to shift from S0 to S1.
As a result, the equilibrium exchange rate strengthens from 0.9 euro/ dollar at E0 to 1.05 euros/dollar at E1. 

22. Ricardian Equivalence Graph
(Image: Principles of Macroeconomics. OpenStax. Fig 18.6)

23. Ricardian Equivalence
The theory of Ricardian equivalence suggests that additional private saving will offset any increase in government borrowing, while reduced private saving will offset any decrease in government borrowing.
Thus, greater private saving will offset higher budget deficits, while greater private borrowing will offset larger budget surpluses.
Sometimes this theory holds true, and sometimes it does not.
If the theory holds true, then changes in government borrowing or saving would have no effect on private investment in physical capital or on the trade balance. However, empirical evidence suggests that the theory holds true only partially.

24. Budget Deficits and Interest Rates Graph
(Image: Principles of Macroeconomics. OpenStax. Fig 18.8)

25. Budget Deficits and Interest Rates
As the previous slide shows, in the financial market, an increase in government borrowing can shift the demand curve for financial capital to the right from D0 to D1. 
As the equilibrium interest rate shifts from E0 to E1, the interest rate rises from 5% to 6% in this example.
The higher interest rate is one economic mechanism by which government borrowing can crowd out private investment.

26. Public and Private Sectors in a Market Economy
(Image: Principles of Macroeconomics. OpenStax. Table 18.2)

27. How to Study this Module
Read the syllabus or schedule of assignments regularly.
Understand key terms; look up and define all unfamiliar words and terms.
Take notes on your readings, assigned media, and lectures.
As appropriate, work all questions and/or problems assigned and as many additional questions and/or problems as possible.
Discuss topics with classmates.
Frequently review your notes. Make flow charts and outlines from your notes to help you study for assessments.
Complete all course assessments.

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