1. Chapter 13 Fiscal Policy, Deficits, and Debt McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Objectives Purposes, tools, and limitations of fiscal policy
Built-in stabilizers and the business cycle
The standardized budget and U.S. fiscal policy
U.S. public debt
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3. This stabilization can be done by manipulating the public budget
Fiscal Policy
One major function of the government is to stabilize the economy by preventing unemployment or inflation
This stabilization can be done by manipulating the public budget
By adjusting the spending and tax collections of government, they can increase output and employment to reduce inflation
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4. Fiscal Policy
Discretionary fiscal policy refers to the deliberate manipulation of taxes and government spending by Congress to change domestic output and employment, control inflation and stimulate growth
“Discretionary” means the changes are at the option of the Federal government
Discretionary fiscal policy changes are often initiated by the President, on the advice of his economic advisors

5. These are called nondiscretionary policy changes
Fiscal Policy
There are some fiscal policy changes that do not result from congressional action
These are called nondiscretionary policy changes
They are passive or automatic and respond to legislation already enacted

6. Fiscal Policy
Expansionary fiscal policy is used to when the country is facing a recession because of increasing unemployment and decreasing GDP
The government can increase spending to help lower unemployment and/or lower taxes to encourage investment
If the Federal budget is balanced at the beginning (tax revenues = government spending), expansionary fiscal policy will create a budget deficit where spending exceeds tax revenues
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7. Expansionary Fiscal Policy
Suppose full-employment is at $510 billion
Price level is inflexible at P1
Aggregate demand moves to the left
Real GDP drops from $510 to $490 billion
A negative GDP of $20 billion occurs
Unemployment occurs

8. Expansionary Fiscal Policy
The government may increase spending
The recession causes the government to spend $5 billion on construction projects
This shifts the demand curve from AD2 to the dotted line just to its immediate right
However, because of the multiplier effect, the demand curve moves to AD1
Thus real output rises to $510 billion; up $20 billion from the recessionary level

9. Expansionary Fiscal Policy
Recessions
Decrease
Aggregate
Demand
$5 Billion
Additional
Spending AS
Price Level
Full $20 Billion
Increase in
Aggregate Demand P1
AD1
AD2
$490
$510
Real Domestic Output, GDP
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10. Tax reductions
You can get the same result by reducing taxes which will shift AD right from AD2 to AD1
Cutting personal income taxes by $6.67 billion will increase disposable income by the same amount
Consumption will rise by $5 billion; savings by $1.67 billion
The horizontal distance between AD2 and the dashed line represents only the $5 billion initial increase in consumption spending

11. Tax reduction
It is called the “initial” consumption spending because the multiplier process yields successive rounds of increased consumer spending
The AD curve eventually shifts rightward by four times the $5 billion initial increase in consumption produced by the tax cut
Real GDP rises by $20 billion, from $490 billion to $510 billion, showing a multiplier of 4
Note that a tax cut must be somewhat larger than the increase in government savings because part of the tax reduction increases savings

12. Contractionary fiscal policy
When demand-pull inflation occurs (prices rising), a restrictive or contractionary fiscal policy may be needed
In Fig. 13.2, full employment is at point a; intersection of AD 3 and AS with GDP of $510 billion
Price level is P1

13. Contractionary fiscal policy
Assume a $5 billion initial increase in investment and net exports shifts AD3 to AD4 (ignore dashed line)
With the upward-sloping AS, the GDP only rises by $12 billion to $522 billion
Some of the rightward move of AD causes demand-pull inflation instead of increased output
Price level rises from P1 to P2 at pt b

14. Contractionary fiscal policy
To eliminate the inflationary GDP gap, the government must either decrease government spending, raise taxes, or use a combination of the two policies
When the economy faces demand-pull inflation, fiscal policy should move toward a government budget surplus – tax revenues in excess of government spending to slow down investment and the economy in general
However, while increases in AD expand real output beyond full-employment level and the price level gets racheted up, decreases in the AD don’t seem to bring prices down very quickly
This must be taken into account by policy makers

15. Decreased government spending
Assume gov. is not aware of racheting effect
Gov. might assume problem could be solved by causing a $20 billion leftward shift of the AD from AD4 to AD3
It would do this by reducing gov. spending by $5 billion and allow multiplier of 4 to expand that initial decrease into a $20 billion decline in AD back to AD3

16. Contractionary fiscal policy
Looks like a good solution; economy is back at pt a with full-employment and GDP of $510 billion; price level back to P1
Doesn’t happen! Price level stuck at P2 so that P2 becomes supply line
Reduced gov. spending of $5 billion will actually cause a recession
New equilibrium will be at pt d, where AD3 crosses broken horizontal line
At point d, real GDP is only $502; $8 billion below full-employment level of $510 billion

17. Contractionary fiscal policy
With an immediate short-run supply curve, the multiplier is at full effect
With price level fixed, and AS horizontal, a $20 billion leftward shift of the AD causes a full $20 decline in GDP
As a result, GDP falls by the full $20 billion, from $522 billion to $502 billion, or $8 billion below potential output
By not understanding rachet effect, the gov. has replaced a $12 billion inflationary gap with an $8 billion recessionary GDP gap

18. Contractionary fiscal policy
How to avoid problem; gov determines inflationary GDP gap is $12 billion, that price level is fixed, that AS is horizontal, and that multiplier is in full effect
Thus, any decline in gov. spending will be multiplied by a factor of 4
Gov. spending should decline by only $3 billion and not $5 billion
This is because a decline of $3 billion times 4 (multiplier) = $12 billion which will exactly offset the $12 billion GDP gap

19. Contractionary fiscal policy
Back to Fig 13.2; the horizontal distance between AD 4 and the dashed line to its left represents the $3 billion decrease in gov. spending
Once multiplier is done, the spending cut will shift the AD leftward from AD4 to AD5
With price level fixed at P2, and AS horizontal as shown by dashed line, economy will come to equilibrium at pt c

20. Contractionary fiscal policy
Increased taxes will also get you to the same point
If the gov. raised taxes by $4 billion, savings would be reduced by $1 billion and consumption by $3 billion
This initial $3 billion decline in consumption will cause AD to shift leftward by $12 billion at each price level
Economy will move to point c, the inflationary GDP gap will be closed and the inflation will be stopped

21. Fiscal policy actons
Combined policies of tax increases and reducing spending will also work
Gov. could decrease spending by $1.5 billion and increase taxes by $2 billion to get same result (would need to calculate mpc and mps to go this)

22. Which is better; taxes or government spending?
Which policy option is better
If you think gov. is too big, go with tax cuts during recession and cut government spending during inflation
If you think gov has a very large social responsibility, go with increased spending during recession and tax increases during inflation
Sound like traditoinal “republican” and “democrat” policy positions?

23. Built-In Stability
Built-in stability arises because net taxes (taxes minus transfers and subsidies) changes with GDP
It is desirable that spending rises automatically when the economy is doing poorly and vice-versa when the economy is becoming inflationary
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24. Built-In Stabilizers
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 such as welfare and unemployment rise, net tax revenues fall along with GDP
The size of automatic stability depends upon how responsive the system is to changes in taxes compared to changes in GDP

25. Built-In Stabilizers
The size of automatic stability depends upon the responsiveness of changes in taxes to changes in GDP
Progressive tax: the average tax rate rises with GDP (tax revenue/GDP)
Proportional tax: the average tax rate remains constant as the GDP rises
Regressive tax: the average tax rate falls as GDP rises

26. Built-In Stabilizers
As shown in Fig. 13.3, tax revenues automatically increase as GDP rises during prosperity
Increased taxes reduce household and business spending and thus slow down the economic expansion
As the economy moves toward a higher GDP, tax revenues automatically rise and move the budget from deficit toward surplus
Note that the high inflationary income level GDP3 automatically generates a contractionary
budget surplus

27. Built-In Stabilizers
Conversely, as GDP falls during recession, tax revenues automatically decline, increasing spending and reducing the impact of the economic contraction
With a falling GDP, tax receipts decline and move the governments budget from surplus toward deficit
In Fig. 13.3, the low level of income GDP1 will automatically yield an expansionary budget deficit

28. Built-In Stabilizers
The U.S. tax system reduces business fluctuations by as much as 8 to 10 percent of the change in GDP that would otherwise occur
However, built-in stabilizers can only reduce, not eliminate, swings in real GDP
Discretionary fiscal policy such as changes in tax rates and gov. expenditures, along with monetary policy, are needed to correct any large recession or inflation

29. Federal Budget Balance
Actual and Projected, Fiscal
Actual
Projected
(as of March 2008)
$300
200
100
-100
-200
-300
-400
-500
Budget Deficit (-) or Surplus, Billions
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
Source: Congressional Budget Office
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30. Fiscal Policy Issues
Problems, Criticisms, and Complications
Recognition lag is the elapsed time between the beginning of recession or inflation and awareness of this occurrence
It may take several months to detect a recession or inflation
Even periods of moderate inflation have months of high inflation
Due to this recognition lag, the economic downslide or the inflation may become more serious than it would have if the situation had been identified and corrected sooner
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31. Fiscal Policy Issues Administrative lag Operational lag
Trying to get the house, senate, and the president to agree on a specific plan of attack may take months
In contrast, the Federal Reserve may act within weeks
Operational lag
Even once a policy is decided upon, it may require weeks to months to years (construction projects) to get underway
As a result, discretionary fiscal policy has increasingly relied on tax changes rather than on changes in spending as its main tool

32. Fiscal Policy Issues
Crowding out effect – when the government borrows money during a deficit and spends, its borrowing may increase the interest rate
This would reduce or crowd out private investors which overall, would weaken or cancel the stimulus of fiscal policy
This phenomenon may not occur during a recession when little borrowing or investment occurs
It is a much more serious problem during times when the economy is near full employment GDP

33. The Public Debt
The national debt is the total accumulation of the Federal government’s total deficits and surpluses that have occurred over time
The national debt was $9.01 trillion in and $14 trillion in 2011
Using the 2007 debt number, 47 percent of the debt was held by the public and 53 percent by the government, including the Federal Reserve
Foreign interests held about 25% of the public debt in 2007
The Federal debt held by the public was about 32% of the GDP in 2007
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34. The Public Debt Debt Held Outside The Federal Government
and Federal
Reserve (47%)
Debt Held by the
Federal Government
and Federal
Reserve (53%)
Other, Including
State and Local
Governments
U.S. Banks
And other
Financial
Institutions 8% 7% 9%
Federal
Reserve
25%
Foreign
Ownership
44% 7%
U.S.
Government
Agencies
U.S.
Individuals
Source: U.S. Treasury
Total Debt: $9.01 trillion
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35. Debt and GDP Federal debt held by the public, percentage of GDP
Percent of GDP
Year 50 45 40 35 30 25 20 15 10 5
1970
1975
1980
1985
1990
1995
2000
2005
Source: Economic Report of the President, 2006
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36. Debt and GDP Publicly Held Debt: International Comparisons
As a Percentage of GDP, 2007
Italy
Japan
Belgium
Hungary
Germany
United States
United Kingdom
France
Netherlands
Canada
Spain
Poland
Source: Organization for Economic Cooperation and Development
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37. Debt and GDP Interest charges are the main burden imposed by the debt
Interest on the debt was $237 billion in 2007 and is the fourth largest item in the Federal budget after income security, national defense, and health
Interest payments were 1.7% of the GDP in 2007
That percentage represents the average tax rate necessary just to cover annual interest on the debt
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38. Debt and GDP Substantive issues
Repayment of the debt affects income distribution; working taxpayers pay interest to wealthier groups who hold the bonds, probably increasing income inequality
Since interest is paid out of gov. revenues, a large debt and high interest rate can increase tax burdens and may decrease incentives to work and save for taxpayers
A higher proportion of debt is owed to foreigners than in the past, and this can increase the burden since payments leave the country
Some economists believe public borrowing crowds out private investment, especially when at full-employment
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39. Crowding Out
A Large Public Debt to Finance Public Investment Will Cause… 2 4 6 8 10 12 14 16 b c
Real Interest Rate (Percent) a
Interest Rate
Rise Will
Decrease
Investment
a to b
Crowding-
Out Effect
ID1 5 10 15 20 25 30 35 40
Investment (Billions of Dollars)
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40. The Leading Indicators indicating potential decline in GDP
Average workweek becomes shorter
Initial claims for unemployment insurance increase
New orders for consumer goods decrease
Vendor performance improves sowing less business demand
New orders for capital goods drops
Source: The Conference Board
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41. The Leading Indicators indicating potential decline in GDP
6. Building permits for houses decline
7. Stock prices decline
8. Money supply decreases
9. smaller interest rate spread in interest rates – restrictive monetary policies
10. Consumer expectations decline

42. Key Terms fiscal policy regressive tax system
Council of Economic Advisers (CEA)
expansionary fiscal policy
budget deficit
contractionary fiscal policy
budget surplus
built-in stabilizer
progressive tax system
proportional tax system
regressive tax system
standardized budget
cyclical deficit
political business cycle
crowding-out effect
public debt
U.S. securities
external public debt
public investments
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43. Next Chapter Preview…
Money and
Banking
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