1. PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University 1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Budget Deficits in the Short and Long Run Blessed are the young, for they shall inherit the national debt. HERBERT HOOVER

2. Balanced Budget? Short Run Should the budget always be balanced? The short run Balancing the government budget –Fiscal policy: focus on balancing aggregate supply and aggregate demand –Desired budget deficits, when Private demand [C+I+G+(X-IM)] is weak –Desired budget surpluses, when Private demand [C+I+G+(X-IM)] is strong 2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3. Balanced Budget? Short Run Balancing the government budget –Balanced budget When C+I+G+(X-IM) approximately equals potential GDP Balancing the budget –During recessions: will prolong and deepen slumps –During booms: may lead to inappropriate fiscal policy 3 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4. The Importance of the Policy Mix Government – can influence aggregate demand –Through fiscal policy –Through monetary policy The appropriate fiscal policy –Depends, among other things, on the current stance of monetary policy 4 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5. The Importance of the Policy Mix Balanced budget –May be appropriate under one monetary policy –A deficit or a surplus may be appropriate under another Given target for aggregate demand –Any change in monetary policy will alter the appropriate fiscal policy –Any change in fiscal policy will alter the appropriate monetary policy 5 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6. Figure 1 The Interaction of Monetary and Fiscal Policy 6 Real GDP Price Level S S D0D0 D0D0 Potential GDP Y0Y0 A D1D1 D1D1 Y1Y1 Effect of fiscal policy Effect of Monetary policy B © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7. The Importance of the Policy Mix Deficit is too large or too small? –Strength of private-sector aggregate demand –Stance of monetary policy –Desired composition of GDP Monetary policy –Affects interest rates 7 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

8. The Importance of the Policy Mix Fiscal policy – affects interest rates –Increases in government spending or tax cuts Push interest rates up –Restrictive fiscal policies Pull interest rates down 8 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

9. Figure 2 The Effect of Expansionary Fiscal Policy on the Market for Bank Reserves 9 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Bank Reserves Interest Rate S S D0D0 D0D0 E0E0 D1D1 D1D1 Effect of a higher Y or P E1E1

10. The Importance of the Policy Mix Reasons why the oversimplified formula overstates the multiplier 1.It ignores variable imports 2.It ignores price-level changes 3.It ignores the income tax 4.It ignores the rising interest rates that accompany any autonomous increase in spending 10 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

11. The Importance of the Policy Mix Lower budget deficits –Should lead to higher levels of private investment spending –Contractionary fiscal policy Reduce spending or raise taxes Reduce real interest rates Spur investment Higher budget deficits –Should lead to less private investment 11 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

12. The Importance of the Policy Mix Aggregate demand – unchanged –And real GDP – unchanged –Combinations of fiscal and monetary policy –E.g. Government – raise taxes –Reduce aggregate demand The Fed – cut interest rates –Increase aggregate demand 12 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13. The Importance of the Policy Mix More expansionary fiscal policy and tight monetary policy –Higher interest rates –Lower investment – less capital formation –Slower growth of potential GDP 13 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

14. The Importance of the Policy Mix Tighter budget (fiscal policy) and looser monetary policy –Lower interest rates –Higher investment –Faster growth of potential GDP 14 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

15. The Importance of the Policy Mix Composition of aggregate demand –Major determinant Rate of economic growth –Larger fraction of GDP – investment Capital stock - grow faster Aggregate supply schedule –Shift more quickly to right Accelerated growth 15 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

16. Figure 3 Growth and Investment in 24 Countries 16 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

17. Deficits and Debt Deficits and debt: terminology and facts Budget deficit –Amount by which the government’s expenditures –Exceed its receipts During a specified period of time, usually a year 17 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

18. Deficits and Debt Budget surplus –Amount by which the government’s receipts –Exceed its expenditures During a specified period of time, usually a year 2010, the federal government –Budget deficit: $1.3 trillion Receipts: $2.2 trillion Expenditures: $3.5 trillion 18 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

19. Deficits and Debt National debt (public debt) –The federal government’s total indebtedness at a moment in time –The result of previous budget deficits –End of 2010: $13.5 trillion Government accumulates debt –By running deficits Government reduces its debt –By running surpluses 19 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

20. Deficits and Debt Some facts about the national debt –How large a public debt do we have? –How did we get it? –Who owes it? –Is it growing or shrinking? 20 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

21. Deficits and Debt How large a public debt do we have? –Enormous, $13.5 trillion $43,000 per person –Net national debt: $9 trillion Because one-third of the national debt: one branch of the government owed it to another –Net national debt relative to GDP 60% of GDP 21 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22. Figure 4 The U.S. National Debt Relative to GDP, 1915–2010 22 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

23. Deficits and Debt How did we get it? –Until about 1983, from Financing wars or from the loss of tax revenues that accompany recessions –1983 - 1993, it grew faster No wars, only one recession –2001, Large tax cuts –Great Recession Huge losses of tax Dramatic fiscal policy efforts to fight it 23 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

24. Interpreting Deficit or Surplus Interpreting the budget deficit or surplus Deficit = G + Transfers – Taxes = = G – (Taxes – Transfers) = = G – T No change in fiscal policy, deficit –Rises in a recession –Falls in a boom 24 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

25. Figure 5 (a) Official Fiscal-Year Budget Deficits, 1981–2010 25 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

26. Figure 5 (b) Official Fiscal-Year Budget Deficits, 1981–2010 26 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

27. Surplus Deficit Figure 6 The Effect of the Economy on the Budget 27 Gross Domestic Product Spending and Tax Receipts G T =Taxes - Transfers Y1Y1 Y2Y2 Y3Y3 A B © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

28. Interpreting Deficit or Surplus Structural budget deficit or surplus –The hypothetical deficit or surplus we would have under current fiscal policies –If the economy were operating near full employment –Doesn’t depend on state of economy –Changes Only when policy changes Not when GDP changes 28 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

29. Table 1 Alternative Budget Concepts, 1981–2009 29 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

30. Interpreting Deficit or Surplus Overall budget deficit = On-budget deficit + Off-budget deficit Off-budget –Social Security expenditures –Payroll tax receipts - finance them 30 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

31. Interpreting Deficit or Surplus What happened to the deficit? –Early 1980s - large Reagan tax cuts From $79 billion to $212 billion – structural –Late 1980s, started rising again Even though Social Security began to run small surpluses –1991, $269 billion, then began to shrink Social Security surplus Strong economy 31 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

32. Interpreting Deficit or Surplus What happened to the deficit? –The Clinton years: tax increases and expenditure restraint Got the budget under control – The George W. Bush administration Large tax cuts, a burst of spending, and weaker economic growth New record high: $378 billion in 2003 32 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

33. Interpreting Deficit or Surplus What happened to the deficit? –Recession, late 2007 Depressed economy plus the government’s massive anti-recession measures Colossal $1.4 trillion deficit 33 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

34. National Debt - a Burden? Why is the national debt considered a burden? National debt owned by domestic citizens –Future interest payments Transfer funds from one group of Americans to another National debt owned by foreigners –Burden on the nation as a whole 34 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

35. National Debt - a Burden? Fundamental difference –Nations that borrow in their own currency Don’t default on their debt The U.S. –Nations that borrow in some other currency Might have to default on their debts Often, the U.S. dollar 35 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

36. Budget Deficits and Inflation Deficit spending –Increase aggregate demand Higher real GDP Higher price level Budget deficits - inflationary –Slope of aggregate supply curve –Degree of resource utilization –Policy mix 36 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

37. Figure 7 The Inflationary Effects of Deficit Spending 37 Price Level $5,0000 $6,000 Real GDP $8,000 $7,000 D1D1 D1D1 S S D0D0 D0D0 Potential GDP 100 112 A C 106 B Deficit spending boosts aggregate demand Aggregate supply curve shifts inward as wages rise © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

38. Budget Deficits and Inflation Monetize the deficit –Central bank –Purchases bonds issued by government Deficit spending –Higher GDP and price level –Increase demand for bank reserves –Fed – no action Interest rates – increase 38 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

39. Budget Deficits and Inflation Deficit spending –Higher GDP and price level –Increase demand for bank reserves –Fed – expansionary monetary policy Purchase government debt Increase supply of bank reserves No increase in interest rates Increase money supply 39 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

40. Figure 8 Monetization and Interest Rates 40 Interest Rate Quantity of Bank Reserves D1D1 D1D1 S0S0 S0S0 D0D0 D0D0 A B Expansionary Fed policy S1S1 S1S1 C © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

41. Debt, Interest Rates, Crowding Out Large budget deficit and no Fed monetization –Higher interest rate –Lower investment –Future Less capital Smaller potential GDP –Burden future generations 41 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

42. Debt, Interest Rates, Crowding Out Crowding out –When deficit spending by government Higher interest rates –Forces private investment spending to contract –Dominates in the long run 42 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

43. Debt, Interest Rates, Crowding Out Crowding in –When government spending By raising real GDP –Induces increases in private investment spending –More powerful – short run 43 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

44. Debt, Interest Rates, Crowding Out The bottom line –Unless the economy produces enough additional saving, more government borrowing Will force out some private borrowers - discouraged by the higher interest rates Reduce investment spending Cancel out some of the expansionary effects of higher government spending 44 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

45. Debt, Interest Rates, Crowding Out The bottom line –Crowding out is rarely strong enough to cancel out the entire expansionary thrust of government spending –If deficit spending induces substantial GDP growth The crowding-in effect: more income and more saving 45 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

46. Debt, Interest Rates, Crowding Out The bottom line –The crowding-out effect dominates In the long run Or when the economy is operating near full employment –The crowding-in effect dominates In the short run, especially when the economy has a great deal of slack 46 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

47. Slower Growth The main burden of the national debt: slower growth Government budget deficits –For: high-employment economy –Crowding-out effect – dominates Less investment –Smaller capital stock, lower potential GDP To future generations –Burden 47 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

48. Slower Growth Government budget deficits –For: high unemployment economy –More investment –Crowding-in effect dominates –Higher growth –Blessing 48 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

49. Figure 9 The Short-Run Effect of Larger Deficits or Smaller Surpluses 49 Price Level Real GDP D1D1 D1D1 S S D0D0 D0D0 A B © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

50. Figure 10 The Long-Run Effect of Larger Deficits or Smaller Surpluses 50 Price Level Real GDP S0S0 S0S0 D D Potential GDP Y0Y0 A S1S1 S1S1 Potential GDP Y1Y1 B © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

51. Economics and Politics The economics and politics of the U.S. budget deficit 1. Have the deficits of the 1980s, 1990s, and 2000s been a problem? –Recessions: 1981–1982, 1990–1991, 2001, since late 2007, weak economy –Crowding out - more serious issue as the economy recovered –Rising structural deficit: 1980s, 2002 -2004 51 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

52. Economics and Politics 2. How did we get rid of the deficit in the 1990s? –Raising taxes and reducing spending Contentious but bipartisan budget agreement in 1990 Highly partisan deficit reduction package in 1993 Smaller bipartisan budget deal in 1997 –Well coordinated fiscal and monetary policies 52 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

53. Economics and Politics 2. How did we get rid of the deficit in the 1990s? –Contractionary fiscal policy –Expansionary monetary policy –Surprisingly rapid economic growth in the late 1990s Generated much more tax revenue –Increasing: the off-budget surplus 53 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

54. Economics and Politics 3. How did the surplus give way to such large deficits so rapidly in the 2000s? –Under President George W. Bush Recession, Tax cuts Higher levels of spending –National defense, homeland security, and Medicare –Under President Obama The economy deteriorated Extraordinary measures 54 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

55. Economics and Politics 4. What are the future prospects for the federal budget deficit? –Not good –Beginning in 2011, baby boomers Eligible for Medicare and full Social Security benefits –Sharp rise in federal spending –No new tax increases –No cut in promised benefits 55 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.