31
Fiscal Policy, Monetary
Policy, and Growth
Blessed are the young, for they shall
inherit the national debt.
HERBERT HOOVER
Contents
● Should the Budget Be Balanced? The Short
Run
● Surpluses and Deficits: The Long Run
● Deficits and Debt: Terminology and Facts
● Interpreting the Budget Deficit or Surplus
● Bogus Arguments About the Burden of the
Debt
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Contents (continued)
● Budget Deficits and Inflation
● Debt, Interest Rates, and Crowding Out
● The True Burden of the National Debt:
Slower Growth
● The Economics and Politics of the U.S.
Budget Deficit
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Should the Budget be
Balanced? The Short Run
● Not always.
♦ Attempts to achieve balance during a recession
or an inflationary episode would destabilize the
economy.
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Should the Budget be
Balanced? The Short Run
● The Importance of the Policy Mix
♦ The appropriate fiscal policy depends, among
other things, on the current monetary policy
stance.
♦ While a balanced budget may be appropriate
under one monetary policy, a deficit or a
surplus may be appropriate under another.
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31-1 The Interaction of
Monetary and Fiscal Policy
FIGURE
Potential GDP
Price Level
D0
Effect of
monetary
policy
S
D1
A
Effect of
fiscal policy
B
D0
S
D1
Y1
Y0
Real GDP
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Surpluses and Deficits: The
Long Run
● More expansionary fiscal policy and tighter
money supply should produce higher real
interest rates and therefore lower
investment, slowing economic growth.
● More restrictive fiscal policy and looser
monetary policy should reduce real interest
rates and hence increase investment and
spur economic growth.
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31-2 Growth and
Investment in 24 Countries
FIGURE
Average Annual Growth Rate of per
Capita Real GDP, 1970–1990
4%
Ireland
3
2
Portugal
Italy Iceland
Japan
Norway
Finland
Turkey
Canada Spain Austria
Belgium
Greece
Luxembourg
Germany
U.K.
France
Denmark Netherlands
U.S. Sweden
Australia
Switzerland
1
0
New Zealand
18
20
22
24
26
28
Average Investment as Percent of GDP,
1970–1990
30
32
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Deficits and Debt:
Terminology and Facts
● Budget Deficit = excess of a government’s
expenditures over its receipts in a period of
time
♦ A flow
● National Debt = total value of government
indebtedness at a moment in time
♦ A stock
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Deficits and Debt:
Terminology and Facts
● Some Facts about the National Debt
♦ In absolute terms the debt is large, but as a
proportion of GDP it is less than one half.
♦ Some, but not all, is backed by government
assets.
♦ Before the 1980s, most of the debt was
accumulated in times of war and recession.
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31-3 The U.S. National
Debt Relative to GDP, 1915-2001
FIGURE
1.00
Gross Domestic Product
Ratio of Public Debt to
1981–1982
Recession
World
War II
0.67
Great
Depression
1974–1975
Recession
0.50
World
War I
0.33
1915
1925
1935
1945
1955
Year
1965
1975
1981–1984
Tax cuts
1993 Budget
Agreement
1985
1995
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Interpreting the Budget
Deficit or Surplus
● Deficit rises in a recession and falls in a
boom even with no change in fiscal policy.
● Structural deficit (or surplus) = what the
deficit (or surplus) would be at full
employment
♦ Portion of the deficit unrelated to the business
cycle
♦ Shows how the deficit is related to government
policy
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31-4 Official Fiscal-Year
Budget Deficits, 1981-2001
FIGURE
$300
Federal Budget Deficit
250
200
150
100
50
0
–50
’98 ’99 ’00 ’01
’81 ’82 ’83 ’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97
Fiscal Year
–100
–150
–200
–250
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31-5 The Effect of the
Economy on the Budget
Spending and Tax Receipts
FIGURE
T = Taxes – Transfers
Surplus
A
G
Deficit
B
Y1
Y2
Gross Domestic Product
Y3
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Interpreting the Budget
Deficit or Surplus
● On-budget Versus Off-budget Surpluses
♦ Overall budget surplus = off-budget surplus +
on-budget surplus
♦ Off-budget surplus = revenues – expenditures
of off-budget items (primarily Social Security
taxes and payments)
♦ On-budget surplus = revenues – expenditures
of on-budget items (most other items)
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31-1 Alternative Budget
Concepts, 1981-2001
TABLE
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Bogus Arguments about the
Burden of the Debt
● Our children will be burdened by high
interest payments.
● Repayment of the debt will ruin the nation.
● A nation has a limited capacity to borrow.
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Budget Deficits and Inflation
● Deficits AD
♦ Can cause inflation if economy is strong, since
AS curves slope upward
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31-6 The Inflationary
Effects of Deficit Spending
FIGURE
D1
Aggregate supply
curve shifts
inward as wages rise
Potential
GDP
D0
S
112
Price Level
C
106
B
100
A
D1
S
D0
$5,000
$6,000
$7,000
Deficit spending
boosts aggregate
demand
$8,000
Real GDP
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Budget Deficits and Inflation
● The Monetization Issue
♦ If the Federal Reserve takes no countervailing
actions, an expansionary fiscal policy that
increases the budget deficit will tend to
■ real GDP and prices
■Cause outward shift of the demand curve for
money
■ interest rates
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31-7 Fiscal Expansion
and Interest Rates
FIGURE
M0
M1
S
Interest Rate
For given
Fed policy
B
Shift in money
demand caused
by rising Y and P
A
M
D0
D1
Quantity of Money
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Budget Deficits and Inflation
● The Monetization Issue
♦ If the Fed does not want interest rates to rise
■It can engage in expansionary open-market
operations, that is, purchase more government debt.
■The money supply will then increase.
■The portion of the deficit purchased by the Fed has
been monetized.
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31-8 Monetization and
Interest Rates
FIGURE
M1
M0
S0
Interest Rate
S1
B
A
Expansionary
Fed policy
C
M0
M1
D0
D1
Quantity of Money
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Monetized Deficit Spending
Expansionary
fiscal policy
Expansionary
D 2 monetary policy
D1
Price Level
D0
S
C
B
A
S
D2
D1
D0
Real GDP
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Debt, Interest Rates, and
Crowding Out
● Crowding out
♦ Occurs when unemployment is low
♦ deficit interest rates investment
+ capital stock
♦ Investment spending is thus crowded out by
government deficit.
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Debt, Interest Rates, and
Crowding Out
● Crowding in
♦ Occurs when unemployment is high
♦ deficit output savings +
capacity utilization
investment + capital stock
● Crowding-in is likely to dominate in the
short run, crowding-out in the long run.
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True Burden of the National
Debt: Slower Growth
● Much of the debt prior to the 1980s was
accrued during recessions, when crowdingin probably occurred.
● Since 1980, high deficits have often
persisted along with high employment,
leading one to think that crowding-out
predominated.
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True Burden of the National
Debt: Slower Growth
● The arguments that a large national debt
may lead the nation into bankruptcy, or
unduly burden future generations who have
to make onerous payments of interest and
principal, are mostly bogus.
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True Burden of the National
Debt: Slower Growth
● The national debt will be a burden if
♦ It is sold to foreigners.
♦ It is contracted in a fully employed, peacetime
economy.
♦ In the latter case, it will reduce the nation’s
capital stock.
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True Burden of the National
Debt: Slower Growth
● Under some circumstances, budget deficits
are appropriate for stabilization-policy
reasons.
● Until the 1980s, the public debt was mostly
contracted as a result of wars and
recessions.
♦ Precisely the circumstances under which the
valid burden-of-the-debt argument does not
apply
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True Burden of the National
Debt: Slower Growth
● However, the large deficits of the 1980s and
1990s were not mainly attributable to
recessions, and were therefore worrisome.
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?
Issue Revisited: Was Fiscal
Stimulus Warranted in 2001?
● Emergency spending and first phase of tax
cut after September 11th attacks stimulated
economy.
♦ Short-run effects: stimulate AD.
♦ Long-run effects: perhaps crowding out
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31-9 S-R Effect of Larger
Deficits or Smaller Surpluses
FIGURE
D1
D0
S
Price Level
?
B
A
S
D1
D0
Real GDP
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31-10 L-R Effect of Larger
Deficits or Smaller Surpluses
FIG.
Potential
GDP
S1
D
Price Level
?
S0
B
S1
A
S0
D
Y1
Y0
Real GDP
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The Economics and Politics
of the U.S. Budget Deficit
● The deficits of the early 1980s came during
recessions and hence crowding out was not
a serious problem.
● By 1987 the economy was approaching full
employment and hence crowding out was
becoming a problem.
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The Economics and Politics
of the U.S. Budget Deficit
● Deficit was eliminated by
♦ raising taxes and
♦ reducing spending;
♦ an expanding economy also produced more tax
revenues.
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