1. Long-Run Implications of Fiscal Policy: Deficits and the Public Debt
Module 30
May 2015

2. The Budget Balance
The budget balance as a measure of fiscal policy is defined by:
𝑆 𝑔𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 =𝑇−𝐺−𝑇𝑅
T is the value of tax revenues
G is government purchases of goods and services
TR is the value of government transfers
Other things being equal, expansionary fiscal policies reduce the budget balance for that year, creating a deficit. Conversely, contractionary fiscal policies increase the budget, creating a surplus.
Two different changes in fiscal policy that have equal-size effects on the budget balance may have quite unequal effects on that economy (gov spending has a larger effect than gov transfers.
Changes in the budget balance are themselves the result, not the cause, of fluctuations in the economy.

3. The business cycle and the cyclically adjusted budget balance
The budget deficit as a percentage of the GDP tends to rise during recessions (indicated by shaded areas) and fall during expansions in the slide that follows

4. Figure The U.S. Federal Budget Deficit and the Business Cycle Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

5. Cyclically adjusted budget balance
There is a close relationship between the budget balance and the business cycle: a recession moves the budget balance toward deficit, but an expansion moves it toward surplus. In the next slide, the unemployment rate serves as an indicator of the business cycle, and we should expect to see a higher unemployment rate associated with a higher budget deficit. This is confirmed by the figure: the budget deficit as a percentage of GDP moves closely in tandem with the unemployment rate
Cyclically adjusted budget balance – is an estaimte of what the budget balance would be in real GDP were exactly equal to potential output

6. Figure The U.S. Federal Budget Deficit and the Unemployment Rate Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

7. Figure The Actual Budget Deficit Versus the Cyclically Adjusted Budget Deficit Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

8. The actual budget deficit versus the cyclically adjusted budget deficit
The cyclically adjusted budget deficit is an estimate of what the budget deficit would be if the economy were at potential output. It fluctuates less than the actual budget deficit, because years of large budget deficits also tend to be years when the economy has a large recessionary gap.

9. Long run effects
Fiscal year – for the U.S. government the fiscal year begins on October 1st and ends on September 30th.
For deficit spending, the government borrows money. A lot of money is owed to Social Security and China.
Public debt – government debt held by individuals and institutions outside the government
Two reasons to be concerned about persistent deficit – when the government borrows funds in the financial markets, it is competing with firms that plan to borrow funds for investment spending and may crowd out private investment spending. Another reason is it places financial pressure on future budgets, namely the interest it must set aside to pay off the debt.

10. Figure U.S. Federal Deficits and Debt Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

11. Deficits and Debts
Debt-GDP ration is the government’s debt as a percentage of GDP
In the graph, you saw how the debt-GDP ratio fell for 30 years after WWII, that is because the GDP grew faster than the debt. Therefore the debt- GDP factor can fall even with debt is rising as long as GDP grows faster than debt.

12. Other factors
Implicit liabilities – spending promises made by governments that are effectively a debt despite the fact that they are not included in the usual debt statistics (Social Security, Medicare…Medicaid, benefits to low- income families
The next chart shows why we may be in trouble!!

14. Figure Future Demands on the Federal Budget Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers