1. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved ECON Designed by Amy McGuire, B-books, Ltd. McEachern 2010- 2011 13 CHAPTER Federal Budgets and Public Policy Macro

2. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 1 The Federal Budget Process  Federal budget –Outlays Government purchases Transfer payments –Revenues –Specific period  Federal government – shifted focus –From national defense –To redistribution

3. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 1 Defense’s Share of Federal Outlays Declined Since 1960 and Redistribution Increased Exhibit 1

4. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 1 Presidential and Congressional Roles  The President –Budget proposal Budget request from each agency “The budget of U.S. government” to Congress –Council of Economic Advisors “Economic report of the President”  House and Senate –Budget committees: Budget resolution

5. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 1 Presidential and Congressional Roles  Budget deficit: Outlays > Revenues –Stimulates AD in short run –Reduces national saving –Long run: hinder economic growth  Budget surplus: Revenues > Outlays –Dampens AD in short run –Boosts domestic saving –Long run: promote economic growth

6. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 1 Problems with Federal Budget Process  Continuing resolutions –Instead of budget decisions  Lengthy budget process  Uncontrollable budget items  No separate capital budget  Overly detailed budget

7. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 2 Fiscal Impact of the Federal Deficits  Rationale for deficits –Outlays that increase economy’s productivity  Budget philosophies and deficits –Annually balanced budget –Cyclically balanced budget –Functional finance

8. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 2 Fiscal Impact of the Federal Deficits  Federal deficits: since birth of the nation –1789-1930 –Deficit: 33% of years (war) –Since the Great Depression –Deficit: 85% of years –1980s relatively large deficits –Large tax cuts –High defense spending –1990s: improved economy –Decreasing deficits –By 1998: surplus

9. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 2 Fiscal Impact of the Federal Deficits  Federal deficits: since birth of the nation –2001 recession –Tax cuts –Higher federal spending –Deficits –Weak recovery –War against terrorism –2003, deficit 3.5% of GDP –2007 stronger economy –Rising stock market –Deficit 1.2% of GDP –2009 deficit of $1.8 trillion projected

10. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved After Decades of Federal Budget Deficits, Surpluses Appeared from 1998 to 2001, But Deficits Are Back LO 2 Exhibit 2

11. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 2 Fiscal Impact of the Federal Deficits  Why have deficits persisted? –Tax cuts –Spending increase –Federal officials Not required to balance the budget –Elected officials Big spending programs Small taxes Pork-barrel spending

12. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 2 Fiscal Impact of the Federal Deficits  Increase federal deficits –National saving – reduced –Interest rates – higher –Investment Discouraged (crowding out) Stimulated (crowding in)

13. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 2 Fiscal Impact of the Federal Deficits  The twin deficits –Finance huge deficits U.S. Treasury – sells IOUs High interest rates Greater demand for $ U.S. trade deficit increase Foreigners buy U.S. assets –Increase I –Decline S

14. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved During the 1990s, Federal Outlays Declined Relative to GDP and Revenues Increased, Turning Deficits into Surpluses, But Not for Long LO 2 Exhibit 3

15. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved The National Debt LO 3  National debt –Net accumulation of past deficits  Measuring the national debt –Gross debt U.S. Treasury notes – by federal agencies –Debt held by the public U.S. Treasury securities –Households; Firms –Banks (include the Fed) –Foreign entities

16. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Federal Debt Held by the Public as a Percentage of GDP Since 1940 LO 3 Exhibit 5

17. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Relative to GDP, U.S. Net Public Debt in 2008 Was Above Average for Major Economies LO 3 Exhibit 6

18. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved The National Debt LO 3  Interest on the national debt –Buyers of federal securities Individuals, $25 Institutions, $1 million Increasing interest rates 1 percentage point increase in nominal interest rate –Interest cost increase $58 billion per year

19. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved The National Debt LO 3  Who bears the burden of debt? –Billing future taxpayers For current spending –We owe it to ourselves Future generations –Service the debt –Receive the payments –Foreign ownership of debt Increase burden of debt –Future generations of Americans

20. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Foreign Holders of U.S. Treasury Securities LO 3 Exhibit 8

21. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved The National Debt LO 3  Crowding out and capital formation –Deficit spending, long run –Borrowed funds – invested in public capital Increased productivity Increased standard of living –Borrowed funds – current expenditures Less capital formation

22. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved The National Debt LO 3  Intergenerational view of deficits and debt –Welfare of generations Tied together –Parents now Consume less Save more Reduce the burden on next generation –Issues People with no children Informed of federal spending

23. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 3 Case Study An Intergenerational View of Deficits and Debt  Barro model  assumes parents are concerned about the welfare of their children, who, in turn,  are concerned about the welfare of their children  and so on for generations.

24. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 3 Case Study  Barro: Parents can reduce the burden of the federal debt on future generations by  consuming less  saving more An Intergenerational View of Deficits and Debt

25. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 3 Case Study  As governments substitute deficits for taxes, parents consume less/save more to increase gifts/bequests to their children.  If greater saving offsets federal deficits, deficit spending will not increase AD because the decline in consumption will negate the fiscal stimulus provided by deficits.  This offsets future burden of higher debt and neutralizes effect of deficit spending on AD, output, and employment. An Intergenerational View of Deficits and Debt

26. Chapter 13Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 3 Case Study  Critics:  The evidence fails to support his theory because large federal deficits coincided with lower, not higher, saving rates.  Those with no children may be less concerned about the welfare of future generations.  Theory assumes people are aware of federal spending and tax policies and about the future consequences of current policies. An Intergenerational View of Deficits and Debt