1. Fiscal Policy, Deficits, and Debt 13 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 30-2 Chapter Objectives Purposes, Tools, and Limitations of Fiscal Policy Role of Built-In Stabilizers in Moderating Business Cycles How the Standardized Budget Reveals the Status of U.S. Fiscal Policy The Size, Composition, and Consequences of the U.S. Public Debt

3. 30-3 Fiscal Policy Council of Economic Advisers (CEA) Discretionary fiscal policy –Eliminate recessionary or inflationary gap –Countercyclical Nondiscretionary fiscal policy –Passive or automatic

4. 30-4 Fiscal Policy and the AD-AS Model or AE Model Expansionary Fiscal Policy –Increased Government Spending –Tax Reductions –Some Combination of the Two –Political considerations Budget Deficit

5. 30-5 Expansionary Fiscal Policy Real Domestic Output, GDP Price Level AD 2 Recessions Decrease Aggregate Demand AD 1 $5 Billion Additional Spending Full $20 Billion Increase in Aggregate Demand AS $490$510 P1P1

6. 30-6 Equilibrium Versus Full-Employment GDP Recessionary Expenditure Gap Real GDP (billions of dollars) Aggregate Expenditures (billions of dollars) 550 530 510 490 470 45° 490 510 530 AE 0 AE 1 Full Employment Recessionary Expenditure Gap = $5 Billion $5 Billion Gap Yields $20 Billion GDP Change

7. 30-7 Fiscal Policy and the AD-AS Model Contractionary Fiscal Policy –Decreased Government Spending –Increased Taxes –Some Combination of the Two Budget Surplus Policy Options: G or T? Political considerations G 11.1

8. 30-8 Contractionary Fiscal Policy Real Domestic Output, GDP Price Level AD 3 Reduce Demand Pull Inflation AD 4 $5 Billion Initial Decrease In Spending Full $20 Billion Decrease in Aggregate Demand AS $510$522 P1P1

9. 30-9 Equilibrium Versus Full-Employment GDP Inflationary Expenditure Gap Real GDP (billions of dollars) Aggregate Expenditures (billions of dollars) 550 530 510 490 470 45° 490 510 530 AE 0 AE 2 Full Employment Inflationary Expenditure Gap = $5 Billion $5 Billion Gap Yields $20 Billion GDP Change

10. 30-10 Built-In Stability Automatic stabilizers –Taxes and transfers Economic importance Tax progressivity –Progressive tax system –Proportional tax system –Regressive tax system

11. 30-11 Built-In Stability G T Deficit Surplus GDP 1 GDP 2 GDP 3 Real Domestic Output, GDP Government Expenses, G and Tax Revenues, T

12. 30-12 Evaluating Fiscal Policy Standardized budget –Full-employment budget Cyclical deficit Recent U.S. fiscal policy Budget deficits and projections Social security considerations

13. Evaluating Fiscal Policy Is the fiscal policy… Expansionary? Neutral? Contractionary? Use the cyclically adjusted budget to evaluate LO3 13-13

14. 30-14 Evaluating Fiscal Policy G T GDP 2 GDP 1 Real Domestic Output, GDP Government Expenses, G and Tax Revenues, T (Year 2)(Year 1) $500 $450 a b c Cyclical deficit Fiscal policy neutral

15. 30-15 Evaluating Fiscal Policy G T1T1 GDP 4 GDP 3 Real Domestic Output, GDP Government Expenses, G and Tax Revenues, T (Year 4)(Year 3) $500 $450 d e f $475 $425 g T2T2 h Standardized deficit Expansionary fiscal policy

16. 30-16 (1) Year (2) Actual Deficit (-) or Surplus (+) (3) Standardized Deficit (-) or Surplus (+) Budget Balances as % of GDP 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 -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% -1.9% -1.3% -2.9% -2.1% -2.0% -1.2% -1.0% -0.4% +0.1% +1.1% +1.0% -1.2% -2.5% -2.4% -1.9% -1.8% -1.4% Source: Congressional Budget Office

17. Recent U.S. Fiscal Policy Federal Deficits (-) and Surpluses (+) as Percentages of GDP, 2000-2009 (1) Year (2) Actual Deficit – or Surplus + (3) Cyclically Adjusted Deficit – or Surplus +* 2000+2.4+1.1 2001+1.3+0.5 2002-1.5-1.3 2003-3.4-2.7 2004-3.5-3.2 2005-2.6-2.5 2006-1.9-2.0 2007-1.2 2008-3.2-2.8 2009-9.9-7.3 As a percentage of potential GDP Source: Congressional Budget Office, http://www.cbo.gov.http://www.cbo.gov LO3 13-17

18. Fiscal Policy: The Great Recession Financial market problems began in 2007 Credit market freeze Pessimism spreads to the overall economy Recession officially began December 2007 and lasted 18 months LO4 13-18

19. Global Perspective LO4 13-19

20. Budget Deficits and Projections Source: Congressional Budget Office, http://www.cbo.gov.http://www.cbo.gov $200 0 -200 -400 -600 -800 -1000 -1200 -1400 -1600 Budget Deficit (-) or Surplus, Billions 19941996199820002002200420062008201020122014 Actual Projected (as of March 2010) LO4 13-20

21. 30-21 Problems of timing –Recognition lag –Administrative lag –Operational lag Political considerations –Political Business Cycle –Annual balanced budgets –Cyclically balanced budgets Future policy reversals Offsetting state and local finance Crowding-out effect Problems, Criticisms, and Complications Fiscal Policy Issues

22. Current Thinking on Fiscal Policy Let the Federal Reserve handle short- term fluctuations Fiscal policy should be evaluated in terms of long-term effects Use tax cuts to enhance work effort, investment, and innovation Use government spending on public capital projects LO4 13-22

23. The U.S. Public Debt $11.9 trillion in 2009 ($9.01 Trillion 2007 and $7.96 Trillion in 2005) The accumulation of years of federal deficits and surpluses Owed to the holders of U.S. securities Treasury bills Treasury notes Treasury bonds U.S. savings bonds LO4 13-23

24. The U.S. Public Debt LO4 Debt held outside the Federal government and the Federal Reserve: 57% Debt held by the Federal government and the Federal Reserve: 43% 13-24

25. The U.S. Public Debt LO4 13-25

26. Global Perspective Public Sector Debt as Percentage of GDP, 2009 Italy Japan Greece Belgium France United States France Germany United Kingdom Spain Netherlands Canada 0 20 40 60 80 100 Source: Organization for Economic Cooperation and Development, OECD LO4 13-26

27. The U.S. Public Debt Interest charges on debt Largest burden of the debt 1.3% of GDP in 2009 False Concerns Bankruptcy Refinancing Taxation Burdening future generations LO4 13-27

28. 30-28 Debt and GDP Substantive issues –Income distribution –Incentives –Foreign-owned public debt Crowding-out effect revisited –Burden on future generations –Public investment as an offset –Graphically

29. 30-29 Crowding Out 5101520253035400 2 4 6 8 10 12 14 16 Real Interest Rate (Percent) Investment (Billions of Dollars) ID 1 ID 2 a bc Interest Rate Rise Will Decrease Investment a to b Crowding- Out Effect A Large Public Debt to Finance Public Investment Will Cause… If Public Spending Spurs More Private Investment Will Increase to ID 2

30. 30-30 The Leading Indicators 1.Average workweek 2.Initial claims for unemployment insurance 3.New orders for consumer goods 4.Vendor performance 5.New orders for capital goods 6.Building permits for houses 7.Stock prices 8.Money supply 9.Interest-rate spread 10.Consumer expectations Source: The Conference Board

31. Social Security, Medicare Shortfalls More Americans will be receiving benefits as they age Social security shortfalls Income during retirement Funds will be depleted by 2037 Medicare shortfalls Medical care during retirement Funds will be depleted by 2017 13-31

32. Social Security, Medicare Shortfalls Possible options “to fix” include: Increasing the retirement age Increasing the portion of earnings subject to the social security tax Disqualifying wealthy individuals Redirecting low-skilled immigrants to higher-skilled, higher paying work Defined contribution plans owned by individuals 13-32

33. 30-33 Key Terms fiscal policy 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