Long-Run Implications of
Fiscal Policy: Deficits and the
Public Debt
Module 30
May 2015
The Budget Balance
 The budget balance as a measure of fiscal policy is defined by:
 𝑆𝑔𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 = 𝑇 − 𝐺 − 𝑇𝑅
 T is the value of tax revenues
 G is government purchases of goods and services
 TR is the value of government transfers
 Other things being equal, expansionary fiscal policies reduce the budget
balance for that year, creating a deficit. Conversely, contractionary fiscal
policies increase the budget, creating a surplus.
 Two different changes in fiscal policy that have equal-size effects on the budget
balance may have quite unequal effects on that economy (gov spending has
a larger effect than gov transfers.
 Changes in the budget balance are themselves the result, not the cause, of
fluctuations in the economy.
The business cycle and the cyclically
adjusted budget balance
 The budget deficit as a percentage of the GDP tends to rise during
recessions (indicated by shaded areas) and fall during expansions in the
slide that follows
Figure 30.1 The U.S. Federal Budget Deficit and the Business Cycle
Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition
Copyright © 2011 by Worth Publishers
Cyclically adjusted budget balance
 There is a close relationship between the budget balance and the business
cycle: a recession moves the budget balance toward deficit, but an
expansion moves it toward surplus. In the next slide, the unemployment rate
serves as an indicator of the business cycle, and we should expect to see a
higher unemployment rate associated with a higher budget deficit. This is
confirmed by the figure: the budget deficit as a percentage of GDP moves
closely in tandem with the unemployment rate
 Cyclically adjusted budget balance – is an estaimte of what the budget
balance would be in real GDP were exactly equal to potential output
Figure 30.2 The U.S. Federal Budget Deficit and the Unemployment Rate
Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition
Copyright © 2011 by Worth Publishers
Figure 30.3 The Actual Budget Deficit Versus the Cyclically Adjusted Budget Deficit
Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition
Copyright © 2011 by Worth Publishers
The actual budget deficit versus the
cyclically adjusted budget deficit
 The cyclically adjusted budget deficit is an estimate of what the budget
deficit would be if the economy were at potential output. It fluctuates less
than the actual budget deficit, because years of large budget deficits also
tend to be years when the economy has a large recessionary gap.
Long run effects
 Fiscal year – for the U.S. government the fiscal year begins on October 1st
and ends on September 30th.
 For deficit spending, the government borrows money. A lot of money is
owed to Social Security and China.
 Public debt – government debt held by individuals and institutions outside
the government
 Two reasons to be concerned about persistent deficit – when the
government borrows funds in the financial markets, it is competing with
firms that plan to borrow funds for investment spending and may crowd out
private investment spending. Another reason is it places financial pressure
on future budgets, namely the interest it must set aside to pay off the debt.
Figure 30.4 U.S. Federal Deficits and Debt
Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition
Copyright © 2011 by Worth Publishers
Deficits and Debts
 Debt-GDP ration is the government’s debt as a percentage of GDP
 In the graph, you saw how the debt-GDP ratio fell for 30 years after WWII,
that is because the GDP grew faster than the debt. Therefore the debtGDP factor can fall even with debt is rising as long as GDP grows faster than
debt.
Other factors
 Implicit liabilities – spending promises made by governments that are
effectively a debt despite the fact that they are not included in the usual
debt statistics (Social Security, Medicare…Medicaid, benefits to lowincome families
 The next chart shows why we may be in trouble!!
Figure 30.6 Future Demands on the Federal Budget
Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition
Copyright © 2011 by Worth Publishers