13e
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

• A fiscal stimulus package is designed to move the economy out of recession toward fullemployment GDP.
• Tax cuts or increased government spending, or a combination of the two, increases the size of the budget deficit.
• Borrowed funds to finance the stimulus must be paid for in the future by increased taxes or reduced spending, both fiscal restraint tools.
12-2

• 12-01. Know the origins of cyclical and structural debt.
• 12-02. Know how the national debt has accumulated.
• 12-03. Know how and when “crowding out” occurs.
• 12-04. Know what the real burden of the national debt is.
12-3

• Using fiscal policy to solve macro problems implies that federal expenditures and federal receipts won’t always be equal.
– In fiscal stimulus, G increases or T decreases.
– In fiscal restraint, G decreases or T increases.
• Budget deficit: amount by which G exceeds T in a given time period.
Budget deficit = Government spending – Tax revenues > 0
12-4

• Budget deficits are a routine by-product of fiscal policy, caused by a fiscal stimulus to increase AD.
• The goal of macro policy is not to balance the budget but to move the economy to fullemployment GDP.
• Keynes: Full employment first, then worry about the deficit.
12-5

• Discretionary spending: those elements of the budget not determined by past legislative or executive commitments.
• Automatic spending: those elements of the budget that are a result of decisions made in prior years; said to be “uncontrollable.”
• Make up of the budget:
– Automatic (uncontrollable): about 80 percent.
– Discretionary (controllable ): about 20 percent.
12-6

• The president and Congress can repudiate prior commitments and enact new legislation.
– Reduce Social Security benefits.
– Refuse to pay interest on the accumulated debt.
– Terminate projects approved in prior years.
– Reduce payouts for other social welfare programs.
• They would face political consequences in doing so.
12-7

• Automatic stabilizer: federal expenditure or revenue item that automatically responds countercyclically to changes in national income
(GDP).
– As a recession begins, unemployment compensation and welfare payments increase and income tax collections decrease, each stimulating economic growth in a small way.
– As economic growth returns, the opposite happens, which puts a small restraint on economic growth.
12-8

• Cyclical deficit: that portion of the budget deficit attributable to short-run changes in economic conditions.
• The cyclical deficit
– Widens when GDP growth slows or inflation increases.
– Shrinks when GDP growth accelerates or inflation decreases.
• As the economy slows
– Tax revenues decline.
– Unemployment benefits rise.
– Other transfer payments rise.
• As the economy grows
– Tax revenues rise.
– Unemployment benefits fall.
– Other transfer payments fall.
– Interest rates could rise, increasing debt payments.
12-9

• Structural deficit: federal revenues at full employment minus expenditures at full employment under prevailing fiscal policy.
• The structural deficit reflects fiscal policy decisions – that is, discretionary fiscal policy.
• Therefore, part of the deficit arises from cyclical changes in the economy; the rest is a result of discretionary fiscal policy.
12-10

• The impact of cyclical components
(automatic stabilizers) and policy initiatives affect the budget at the same time.
• According to the CBO, in 2009 the trilliondollar budget deficit increase was due in part to the recession ($278 billion) and the rest to discretionary fiscal policy ($675 billion).
12-11

• We must focus on changes in the structural deficit, not the total deficit.
– Fiscal stimulus is measured by an increase in the structural deficit (or shrinkage in the structural surplus).
– Fiscal restraint is measured by a decrease in the structural deficit (or increase in the structural surplus).
12-12

• Crowding out can occur, especially as the economy closes in on full employment.
– Increased government borrowing to finance a growing deficit reduces the availability of funds for private sector spending.
– Thus any increase in government expenditures will be offset by reductions in consumption and investment spending.
– Tax cuts will increase consumer spending, but near full employment may force cutbacks in investment or government services.
12-13

• Interest rate movements:
– An increase in demand for funds will cause the price of borrowing – the interest rate – to rise.
– Rising interest rates make it more costly for consumers or businesses to borrow, and they may cut back.
– Rising interest rates also increase the borrowing costs of government, leaving less room in government budgets for financing new projects.
12-14

• If the government runs a surplus – that is, tax revenues are greater than government expenditure - it is a leakage to the circular flow.
It is a drag on the economy.
• Potential uses for a budget surplus:
– Spend it on goods and services.
– Cut taxes.
– Increase income transfers.
– Pay off old debt (“save it”).
12-15

• Spending a surplus increases the size of the public sector.
• Cutting taxes or increasing income transfers puts money in the peoples’ hands and enlarges the private sector.
• Paying off some accumulated debt puts money in the hands of the debt holders:
– They buy more goods and services.
– Expands the private sector.
– Lowers the demand for funds and the interest rates.
12-16

• The national debt is the accumulation of many more years of running budget deficits than budget surpluses.
– The U.S. Treasury borrows by issuing Treasury bonds to lenders who want a safe investment paying out interest.
– When there is a deficit, the national debt increases.
– When there is a surplus, the national debt can be pared down.
12-17

• In 2011 the national debt was nearing $15 trillion.
• That is an average of more than $50,000 for every U.S. citizen.
• A better indicator is the debt-to-GDP ratio.
– Except for the Civil War, this ratio was about 10 percent from 1790 to 1917.
– During World War II, it rose to 130 percent.
– In 2000 it was about 35 percent.
– By 2012 it will rise above 100 percent.
12-18

• The national debt creates as much wealth for bondholders as it does liabilities for the U.S.
Treasury.
• Who are the bondholders (owners)?
– Federal agencies (such as the Federal Reserve and the Social Security Administration) hold 40 percent of all outstanding Treasury bonds.
– State and local governments hold 5 percent.
– The private sector holds 24 percent.
– Foreigners hold 31 percent.
12-19

• Relative to other investments:
– They are safe.
– There is no question of the debt being repaid.
– They pay interest.
– Dollar-denominated assets are generally acceptable in world trade.
12-20

• Refinancing: the issuance of new debt in payment of debt issued earlier.
– When a Treasury bond matures, new funds are borrowed to pay it off.
– So the debt remains debt. There is no addition to the debt. Only another deficit adds to the debt.
12-21

• Debt service: the interest required to be paid each year on outstanding debt.
– Increased interest payments use up funds that cannot be used for other government expenditures.
– Debt servicing is a redistribution of income from taxpayers to bondholders.
12-22

• Opportunity cost:
– The true burden of the debt is the opportunity cost of the activities financed by the debt.
– Funds spent on government expenditures cannot be used for other (public or private) expenditures.
– Resources consumed by a government expenditure cannot be used to produce other goods and services.
– The value placed on these forgone goods and services is the opportunity cost, however financed.
12-23

• Deficit spending changes the mix of output in the direction of more public sector goods.
• The burden of the debt is really the opportunity cost (crowding out) of deficitfinanced government activity.
12-24

• If deficit-financed government spending crowds out private investment, future generations will bear some of the debt burden.
– We will have smaller-than-anticipated productive capacity.
– There will be some question about achieving an optimal mix of output.
• The public sector grows at the expense of the private sector.
12-25

• If the U.S. Treasury pays off maturing bonds with taxes, it is a redistribution of income from taxpayers to bondholders.
– The heirs of current bondholders receive the payout.
– The taxpayers in the future are hit with the taxes to pay off the maturing bonds.
12-26

• Borrowing from foreigners eliminates crowding out.
– We get more public sector goods without cutting back on private sector production.
– Foreigners get the dollars by selling us more imports than they buy of our exports.
– We can consume an amount greater than the domestic-only PPC would allow us to consume.
• As long as foreigners are willing to hold U.S. debt, external financing imposes no real cost.
12-27

• If foreigners no longer want to hold U.S. debt, they will sell their bonds and hold dollars, which they can use to buy dollardenominated goods and services, mainly
U.S. exports.
• External debt will be repaid with exports of real goods and services.
12-28

• The only way to stop the growth of the debt is to eliminate budget deficits.
– One way is to balance the budget (G = T).
– A gradual way is to impose a debt ceiling that is decreased each year until it reaches zero.
• Debt ceiling: an explicit, legislated limit on the amount of outstanding national debt.
– This leads to compromises on how best to use budget deficits.
– Usually, when the debt ceiling is reached, Congress simply increases it.
12-29