Macroeconomics ECO 110/1, AAU
Lecture 8
DEFICITS, SURPLUSES AND
DEBT
Eva Hromádková, 12.4 2010
Budget Effects of Fiscal Policy
2

Keynesian theory highlights the potential of fiscal
policy to solve macro problems.
 Fiscal
Policy is the use of government taxes and
spending to alter macroeconomic outcomes.
Budget Deficits and Surpluses
Definitions
3


Budget deficit is the amount by which government
spending exceeds government revenue in a given
time period.
Budget surplus is an excess of government revenues
over government expenditures in a given time period.
Budget deficit / surplus =
gvt spending – tax revenues > /< 0
Budget Deficits and Surpluses
Real world example - USA
4
US Budget Totals (billions of dollars)
Revenues
Outlays
Surplus (deficit)
Revenues
Outlays
Surplus (deficit)
2000
2001
2002
2003
2,025
1,991
1,853
1,782
-1,789 -1,864 -2,011 -2,157
236
127
-158
2004
2005
2006
1,880
2,154
2,407
-2,293 -2,472 -2,654
-413
-318
-247
-375
US budget deficits 1970-2008
5
Keynesian View
6


LO1
Budget deficits and surpluses are a routine feature
of counter-cyclical fiscal policy.
The goal of macro policy is not to balance the
budget but to balance the economy at fullemployment.
Discretionary vs. Automatic Spending
7

At the beginning of each fiscal year, the government
and parliament (Czech Republic) or President and
Congress (US) put together a budget blueprint
(proposal) for next fiscal year.
 Fiscal
year (FY) is the twelve-month period used for
accounting purposes
 In
the Czech Rep, the same as calendar year
 In US, begins on October 1 for the federal government.
 After
approval it is published as a bill (law)
Discretionary vs. Automatic Spending
8



LO1
To a large extent, current revenues and expenditures
are the result of decisions made in prior years past
legislative or executive commitments.
Q: Examples?
Roughly 80 percent of the budget is given by
previous commitments, so that only about 20 percent
represents discretionary fiscal spending.

Left to or regulated by gvt's own discretion or judgment.

Available for use as needed or desired
Discretionary vs. Automatic Spending
9
Since most of the budget is uncontrollable, fiscal
restraint or fiscal stimulus is less effective.
Remember?
 Fiscal restraint – tax hikes or spending cuts intended to
reduce (shift) aggregate demand.
 Fiscal stimulus – tax cuts or spending hikes intended to
increase (shift) aggregate demand.

LO1
Automatic Stabilizers
Automatic budget fluctuations w.r.t. business cycle
10



LO1
Some items on the budget actually change with economic
conditions, irrespectively of government plans.
Expenditure side:
 Unemployment insurance benefits
 Welfare benefits
Revenue side:
 Income taxes (progressive even more)
 Corporate taxes
Stabilizing effect = countercyclical response to changes in
national income (inject/withdraw spending power)
Automatic Transfers
11

These income transfers act as automatic stabilizers.
Income transfers are payments to
individuals for which no current
goods or services are exchanged,
such as social security, welfare,
unemployment benefits.
LO1
Automatic Transfers
12

Automatic stabilizers are federal expenditure or
revenue items that automatically respond countercyclically to changes in national income.
Automatic Transfers
13

Automatic stabilizers also exist on the revenue side
of the budget.
Income taxes move up and down with
the value of spending and output.
Being progressive, personal taxes
siphon off increasing proportions of
purchasing power as incomes rise.
Cyclical Deficits
14


LO1
The size of the federal deficit or surplus is sensitive
to expansion and contraction of the macro economy.
Actual budget deficits and surpluses may arise from
economic conditions as well as policy.
Cyclical Deficits
15

The cyclical deficit is that portion of the budget
deficit attributable to unemployment or inflation.
The cyclical deficit widens when GDP
growth slows or inflation decreases.
The cyclical deficit shrinks when GDP
growth accelerates or inflation
increases.
LO1
Structural Deficits
16

To isolate effects of fiscal policy, the deficit is
broken down into cyclical and structural components.
Total budget
deficit
LO1
=
Cyclical
deficit
+
Structural
deficit
Structural Deficits
17

LO1
The structural deficit is federal revenues at fullemployment minus expenditures at full employment
under prevailing fiscal policy.
Structural Deficits
18

Part of the deficit arises from cyclical changes in the
economy.
The rest is the result of discretionary
fiscal policy.
Only changes in the structural deficit
measure the thrust of fiscal policy.
LO1
Structural Deficits
19

Fiscal policy is categorized as follows:
Fiscal stimulus is measured by the
increase in the structural deficit (or
shrinkage in the structural surplus).
Fiscal restraint is gauged by the
decrease in the structural deficit (or
increase in the structural surplus).
LO1
Economic Effects of Deficits
20

There are a number of consequences of budget
deficits.
 Crowding
out.
 Opportunity cost.
 Interest-rate movements.
Crowding Out
21


LO2
Crowding-out is the reduction in private-sector
borrowing (and spending) caused by increased
government borrowing.
Crowding out implies less private-sector output.
Crowding Out
Public-sector output (quantity per year)
22
g2
g1
b
Increase in
government spending . . .
a
c
Crowds out private spending
h2
h1
Private-sector output (quantity per year)
LO2
Opportunity Cost
23

Crowding out reminds us that there is an opportunity
cost to government spending.
 Opportunity
cost is the most desired goods or services
that are forgone in order to obtain something else.
Interest-Rate Movements
24

Rising interest rates are both a symptom and a
cause of crowding out.
Economic Effects of Surpluses
25

The economic effects of budget surpluses are the
mirror image of those for deficits.
Crowding In
26

There are four potential uses for a budget surplus:
 Spend
it on goods and services.
 Cut taxes.
 Increase income transfers.
 Pay off old debt (“save it”).
LO2
Crowding In
27

LO2
Crowding in is the increase in private sector
borrowing (and spending) caused by decreased
government borrowing.
Cyclical Sensitivity
28


LO2
Crowding in depends on the state of the economy.
In a recession, a decline in interest rates is not likely
to stimulate much spending if consumer and investor
confidence is low.
The Accumulation of Debt
29


The United States has accumulated a large national
debt.
The national debt is the accumulated debt of the
federal government.
Debt Creation
30



When the Treasury borrows funds it issues treasury
bonds.
Treasury bonds are promissory notes (IOUs) issued
by the U.S. Treasury.
The national debt is a stock of IOUs created by
annual deficit flows.
Early History, 1776-1900
31

By 1783, the United States had borrowed over $8
million from France and $250,000 from Spain to
finance the Revolutionary War.
Early History, 1776-1900
32

During the period 1790-1812 the U.S. often
incurred debt but typically repaid it quickly.
The War of 1812 caused a massive
increase in national debt and, by
1816, the national debt was over
$129 million.
Early History, 1776-1900
33

1835-36: Debt Free! – The U.S. was completely out
of debt by 1835.
The Mexican-American War (1846-48)
caused a four-fold increase in the
debt.
Early History, 1776-1900
34

By the end of the Civil War (1861-65), the North
owed over $2.6 billion, nearly half of its national
income.
After the South lost, Confederate
currency and bonds had no value.
The Twentieth Century
35


The Spanish-American War (1898) also increased
the national debt.
World War I raised the debt from 3% to 41% of
the national income.
The Twentieth Century
36

National debt declined during the 1920’s but rose
again during the Great Depression.
World War II
37

The greatest increase in national debt occurred
during World War II.
 Rather
than raise taxes, the government rationed
consumer goods.
 U.S. War Bond purchases raised the debt from 45% of
GDP to over 125% in 1946.
The 1980s
38


During the 1980s, the national debt rose by nearly
$2 trillion.
The increase was not war-related but as a result of
recessions, a military buildup, and massive tax cuts.
The 1990s
39


The early 1990s continued the same trend.
Discretionary federal spending increased sharply in
the first two years of the Bush administration.
The 1990s
40

The 1988-92 period saw the national debt
increased by another trillion dollars.
There was some success in reducing
the structural deficit in 1993.
Budget deficits for 1993-96 have
pushed the national debt to over $5
trillion.
2000 41


By 2002, the accumulated debt was $5.6 trillion.
By 2007, the debt approximated $9 trillion, which
works out to nearly $30,000 of debt for every U.S.
citizen.
Historical View of the Debt/GDP Ratio
42
World War II
1990-91
recession
Great
Depression
Civil War
Bush
tax cuts
World War I
1990-91
recession
Who Owns the Debt?
43

Who can ever expect to pay off a debt measured
in the trillions of dollars?
Liabilities = Assets
44

National debt represents an asset as well as a
liability in the form of bonds.
 Liability
– An obligation to make future payment; debt.
 Asset – Anything having exchange value in the
marketplace; wealth.
Liabilities = Assets
45

The national debt creates as much wealth (for
bondholders) as liabilities (for the U.S. Treasury).
Ownership of Debt
46



Federal agencies hold roughly 50 percent of the
outstanding Treasury bonds.
State and local governments hold 7 percent of the
national debt.
U.S. households hold nearly 20% of the national
debt, either directly or indirectly.
Ownership of Debt
47

Internal debt is the U.S. government debt (Treasury
bonds) held by U.S. households and institutions.
The external debt is U.S.
government debt (Treasury bonds)
held by foreign households and
institutions.
Ownership of Debt
Public Sector
Federal Reserve 9%
Federal
agencies Social
Security
24%
21%
State and local
governments 7%
Foreigners
25%
Foreigners
Internal
debt
14%
Private Sector
Burden of the Debt
49

The burden of the debt is not so evident:
 Refinancing.
 Debt
service.
 Opportunity cost.
LO3
Refinancing
50


LO3
The debt has historically been refinanced by issuing
new bonds to replace old bonds that have become
due.
Refinancing is the issuance of new debt in payment
of debt issued earlier.
Debt Service
51


LO3
Debt service is the interest required to be paid each
year on outstanding debt.
Interest payments restrict the government’s ability to
balance the budget or fund other public sector
activities.
Debt Service
52

Most debt servicing is simply a redistribution of
income from taxpayers to bondholders.
Interest payments themselves have
virtually no direct opportunity cost.
LO3
Opportunity Costs
53


LO3
Opportunity costs are incurred only when real
resources (factors of production) are used.
The true burden of the debt is the opportunity costs
of the activities financed by the debt.
Government Purchases
54

LO3
The true burden of the debt is the opportunity cost
of the activities financed by the debt.
Transfer Payments
55

LO3
The only direct cost of transfer payments are the
resources involved in the administrative process of
making the transfer.
The Real Trade-Offs
56


LO3
Deficit financing tends to change the mix of output
in the direction of more public-sector goods.
The burden of the debt is the opportunity costs
(crowding out) of deficit-financed government
activity.
The Real Trade-Offs
57

The primary burden of the debt is incurred when the
debt-financed activity takes place.
The real burden of the debt cannot
be passed on to future generations.
LO3
Economic Growth
58


LO3
Future generations will bear some of the debt
burden if debt-financed government spending
crowds out private investment.
The whole debate about the burden of debt is
really an argument over the optimal mix of output.
Repayment
59

LO3
Future interest payments entail a redistribution of
income among taxpayers and bondholders living in
the future.
External Debt
60

LO3
External debt presents some special opportunities
and problems.
No Crowding Out
61


LO3
External financing allows us to get more publicsector goods without cutting back on private-sector
production.
As long as foreigners are willing to hold U.S. bonds,
external financing imposes no real cost.
External Financing
Public-sector Output (units per year)
62
g2
b
d
a
g1
h2
Extra output
(imports)
financed with
external debt
h1
Private-sector Output (units per year)
LO3
Repayment
63


LO3
Foreigners may not be willing to hold bonds forever.
External debt must be paid with exports of real
goods and services.
Deficit and Debt Limits
64

LO3
The key policy question is whether and how to limit
or reduce the national debt.
Deficit Ceilings
65


The only way to stop the growth of the national
debt is to eliminate the budget deficit that created
it.
Deficit ceilings are an explicit, legislated limitation
on the size of the budget deficit.
Deficit Ceilings
66

The Balanced Budget and Emergency Deficit Control
Act of 1985 (Gramm-Rudman-Hollings Act) was the
first explicit attempt to force the federal budget
into balance.
Gramm-Rudman-Hollings Act
67


It set a lower ceiling on each year’s deficit until
budget balance was achieved.
It called for automatic cutbacks in spending if
Congress failed to keep the budget below the
ceiling.
Debt Ceilings
68


A debt ceiling is an explicit, legislated limit on the
amount of outstanding national debt.
Like deficit ceilings, debt ceilings are just political
mechanisms for forging political compromises on
how to best use budget surpluses or deficits.
Dipping into Social Security
69

The Social Security Trust Fund has been a major
source of funding for the federal government for
over 20 years.
Aging Baby Boomers
70

Persistent surpluses in the Trust Fund largely result
from Baby Boomers paying lots more payroll taxes
than are paid out in benefits to the retired.
Social Security Deficits
71


The Trust Fund balance shifts from surplus to deficit
soon after 2014.
To pay back Social Security loans, Congress will
have to significantly raise future taxes or
substantially cut other programs.
Changing Worker-Retiree Ratios
72
Year
Workers per
Beneficiary
Year
Worker per
Beneficiary
1950
16.5
2000
3.4
1960
5.1
2015
2.7
1970
3.7
2030
2.0
DEFICITS, SURPLUSES, AND
DEBT
End of Chapter 12