Chapter 30 Fiscal Policy, Deficits, and Debt McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Objectives • Purposes, tools, and limitations of fiscal policy • Built-in stabilizers and the business cycle • The standardized budget and U.S. fiscal policy • U.S. public debt 30-2 Fiscal Policy • Council of Economic Advisers (CEA) • Discretionary fiscal policy –Eliminate recessionary or inflationary gap –Countercyclical • Nondiscretionary fiscal policy –Passive or automatic 30-3 Fiscal Policy • Expansionary fiscal policy –Increased spending and/or lower taxes –Budget deficit • Contractionary fiscal policy –Lower spending and/or higher taxes –Budget surplus • Policy options? 30-4 Expansionary Fiscal Policy Recessions Decrease Aggregate Demand Price Level $5 Billion Additional Spending AS Full $20 Billion Increase in Aggregate Demand P1 AD1 AD2 $490 $510 Real Domestic Output, GDP 30-5 Contractionary Fiscal Policy Reduce Demand Pull Inflation $5 Billion Initial Decrease In Spending Price Level AS Full $20 Billion Decrease in Aggregate Demand P1 AD4 AD3 $510 $522 Real Domestic Output, GDP 30-6 Built-In Stability • Automatic stabilizers –Taxes and transfers • Economic importance • Tax progressivity –Progressive tax system –Proportional tax system –Regressive tax system 30-7 Built-In Stability Government Expenses, G and Tax Revenues, T T Surplus G Deficit GDP1 GDP2 GDP3 Real Domestic Output, GDP 30-8 Evaluating Fiscal Policy • Standardized budget –Full-employment budget • • • • Cyclical deficit Recent U.S. fiscal policy Budget deficits and projections Social security considerations 30-9 Government Expenses, G and Tax Revenues, T Evaluating Fiscal Policy T Cyclical deficit Fiscal policy neutral $500 $450 a b G c GDP2 GDP1 (Year 2) (Year 1) Real Domestic Output, GDP 30-10 Government Expenses, G and Tax Revenues, T Evaluating Fiscal Policy Standardized deficit Expansionary fiscal policy $500 d e $475 $450 $425 T1 T2 G h f g GDP4 GDP3 (Year 4) (Year 3) Real Domestic Output, GDP 30-11 Budget Balances as % of GDP (1) Year (2) Actual Deficit (-) or Surplus (+) (3) Standardized Deficit (-) or Surplus (+) 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% -2.9% -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 30-12 Standardized Budget Balance Percentage of Potential GDP, 2007 -6 Deficits -4 -2 0 Surpluses 2 4 6 Denmark New Zealand Ireland Canada Norway France United States United Kingdom Japan Source: Organization for Economic Cooperation and Development 30-13 Federal Budget Balance Actual and Projected, Fiscal 1994-2014 Actual Projected (as of March 2008) Budget Deficit (-) or Surplus, Billions $300 200 100 0 -100 -200 -300 -400 -500 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Source: Congressional Budget Office 30-14 Fiscal Policy Issues Problems, Criticisms, and Complications • Problems of timing –Recognition lag –Administrative lag • • • • • –Operational lag Political considerations Future policy reversals Offsetting state and local finance Crowding-out effect Current thinking on fiscal policy 30-15 The Public Debt • National or public debt $9.01 trillion • Ownership –U.S. securities –53% owned by federal government and Federal Reserve –47% held outside the federal government and Federal Reserve 30-16 The Public Debt Debt Held Outside The Federal Government and Federal Reserve (47%) Other, Including State and Local Governments U.S. Banks And other Financial Institutions 8% Debt Held by the Federal Government and Federal Reserve (53%) 7% 9% Federal Reserve 25% Foreign Ownership 7% 44% U.S. Government Agencies U.S. Individuals Total Debt: $9.01 trillion Source: U.S. Treasury 30-17 Debt and GDP Federal debt held by the public, percentage of GDP 50 45 Percent of GDP 40 35 30 25 20 15 10 5 0 1970 1975 1980 1985 1990 Year 1995 2000 2005 Source: Economic Report of the President, 2006 30-18 Debt and GDP Publicly Held Debt: International Comparisons As a Percentage of GDP, 2007 0 20 40 60 80 100 Italy Japan Belgium Hungary Germany United States United Kingdom France Netherlands Canada Spain Poland Source: Organization for Economic Cooperation and Development 30-19 Debt and GDP • Interest charges –Primary burden –1.7% of GDP 2007 • False concerns –Bankruptcy –Refinancing –Taxation –Burdening future generations 30-20 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 30-21 Crowding Out A Large Public Debt to Finance Public Investment Will Cause… 16 If Public Spending Spurs More Private Investment Will Increase to ID2 Real Interest Rate (Percent) 14 12 b 10 c 8 a 6 Interest Rate Rise Will 4 Decrease 2 Investment a to b 0 5 10 CrowdingOut Effect ID2 ID1 15 20 25 30 35 40 Investment (Billions of Dollars) 30-22 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 30-23 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 30-24 Next Chapter Preview… Money and Banking 30-25