1. KRUGMAN'S MACROECONOMICS for AP* 30 Margaret Ray and David Anderson Module Long-run Implications of Fiscal Policy: Deficits and the Public Debt

2. What you will learn in this Module : Why governments calculate the cyclically adjusted budget balance Why a large public debt may be a cause for concern Why implicit liabilities of the government are also a cause for concern

3. Deficits Surpluses Good? Bad? The Budget Balance

4. The Budget Balance as a Measure of Fiscal Policy The Budget Balance as a Measure of Fiscal Policy The Budget Balance is … Savings by the government S gov = T – G – TR T = value of tax revenues G = government purchases of g/s TR = value of government transfers Budget Surplus = positive budget balance Budget Deficit = negative budget balance

5. The Budget Balance as a Measure of Fiscal Policy The Budget Balance as a Measure of Fiscal Policy How does this relate to fiscal policy? 1.Recessionary Gap 1.Expansionary Fiscal Policy 1.Cut taxes 2.Increase transfers 3.Increase government spending 2.AD increases and reverses the recession 1.Budget balance with decrease 1.Smaller surplus OR 2.Bigger deficit

6. The Budget Balance as a Measure of Fiscal Policy The Budget Balance as a Measure of Fiscal Policy How does this relate to fiscal policy? 1.Inflationary Gap 1.Contractionary Fiscal Policy 1.Increase taxes 2.Decrease transfers 3.Decrease government spending 2.AD decreases and reverses the inflation 1.Budget balance will increase 1.Bigger surplus OR 2.Smaller deficit

7. The Business Cycle and the Cyclically Adjusted Budget Balance The Business Cycle and the Cyclically Adjusted Budget Balance 1.The Budget Deficit almost always … 1.Rises when U% rises 2.Falls when U% falls Is this due to changes in fiscal policy? Maybe, Maybe not!

8. The Business Cycle and the Cyclically Adjusted Budget Balance The Business Cycle and the Cyclically Adjusted Budget Balance 1.Automatic Stabilizers ( we talked about these before) 1.Heading into a recession ( budget balance happenings) 1.Tax revenue declines 1.Incomes and profits declining 2.Transfer Payments (like welfare) rise 1.Unemployment rises

9. The Business Cycle and the Cyclically Adjusted Budget Balance The Business Cycle and the Cyclically Adjusted Budget Balance 1.Automatic Stabilizers ( we talked about these before) 1.Heading into an inflationary period ( budget balance happenings) 1.Tax revenue rises 1.Incomes and profits rising 2.Transfer Payments (like welfare) fall 1.Unemployment decreasing

10. The Business Cycle and the Cyclically Adjusted Budget Balance Strong relationship between budget balance and business cycle

11. The Business Cycle and the Cyclically Adjusted Budget Balance The Business Cycle and the Cyclically Adjusted Budget Balance 1.We need a way to separate the two effects on the budget balance. 1.Effect One – impact due to changes in fiscal policy 2.Effect Two – impact due to current state of the business cycle

12. The Business Cycle and the Cyclically Adjusted Budget Balance The Business Cycle and the Cyclically Adjusted Budget Balance Cyclically Adjusted Budget Balance is … 1.An estimate of what the budget balance WOULD BE IF 1.No recessionary gap OR 2.Inflationary gap 2.CABB takes into account … 1.Extra tax revenue + transfer IF recessionary gap eliminated 2.Lost Revenue + extra transfers IF inflationary Gap eliminated

13. Cyc The Business Cycle and the Cyclically Adjusted Budget Balance (Continued)

14. Should the Budget Be Balanced? Should the Budget Be Balanced? Political motivation for running deficits or balancing the budget Economists argue against balanced budget rule in favor of cyclically balanced budget Limits on deficits as a compromise

15. Deficits, Surpluses, and Debt Deficits, Surpluses, and Debt When spending exceeds tax revenue, government borrows National Debt = accumulation of al past deficits – all past surpluses Public Debt = government debt help by individuals and institutions outside the government

16. Problems Posed by Rising Government Debt Problems Posed by Rising Government Debt Two reasons to be concerned when a government runs persistent budget deficits 1.G borrows funds in financial markets 1.Competes with firm borrowing for investment 2.Crowding Out effect 3.Interest Rates Increase 4.Reducing economy long-run growth rate 2.Today’s deficits – increasing G debt 1.Financial pressure on future budgets 2.Interest paid in the future 3.$$$ goes here rather than 1.Education, military, space exploration, + others

17. Problems Posed by Rising Government Debt Problems Posed by Rising Government Debt How can a government pay off its debt? 1.Borrowing $$$$$ 1.Like getting a new credit card to pay off the old one. BANCKRUPTCY 2. Increase taxes or cut spending. POLICICALLY UNPOPULAR 3. Print Money FAST TRACK TO SERIOUS INFLATION

18. Deficits and Debt in Practice Deficits and Debt in Practice Debt-GDP Ratio = G debt as a % of GDP

19. Implicit Liabilities Implicit Liabilities Implicit Liabilities – spending promises made by the government (debt not included in the usual debt stats) Demographics – aging population = increase in Social Security Medicare Medicaid