The Short Run: Countercyclical Fiscal Policy
• Fiscal policy
• In the short run
• Has demand-side effects on output and
employment
• Countercyclical fiscal policy
• A change in government purchases or net
taxes
• Designed to reverse or prevent a recession or
a boom
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The Short Run: Countercyclical Fiscal Policy
• Increase in government purchases
•
•
•
•
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Direct way to cure a recession
Aggregate expenditure line shifts upward
ΔGDP = Multiplier ˣ ΔG
ΔG = ΔGDP / Multiplier
Multiplier = 1/(1-MPC)
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Figure 1: Countercyclical Fiscal Policy
Real AE ($ billions)
Consumption
Function
B
45°
$9,000
(Recession
Output)
Initially, the economy’s
equilibrium is at full-employment
output of $10,000 billion (Point
A). Then a decrease in investment
AE1
spending shifts the aggregate
A
expenditure line down to AE2,
and the economy starts heading
AE2
toward point B—a recession.
The government could shift the
AE line back to its original
position by increasing its own
purchases, or by decreasing net
taxes with a change in tax or
transfer policies. If the change
were enacted quickly enough, the
government could prevent the
recession.
$10,000 Real GDP ($ billions)
(Full-Employment
Output)
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The Short Run: Countercyclical Fiscal Policy
• Cut net taxes (taxes – transfer payments)
•
•
•
•
•
•
Indirect way to cure a recession
Increase disposable income
Increase consumption spending
Aggregate expenditure line shifts upward
ΔGDP = Net tax multiplier ˣ Δ Net taxes
Net tax multiplier = - MPC ˣ Expenditure
multiplier = - MPC/(1-MPC)
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The Short Run: Countercyclical Fiscal Policy
• Problems with countercyclical fiscal policy
•
•
•
•
Timing problems
Irreversibility
Forward looking behavior
Reaction of the Federal Reserve
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Long Run: Deficits and the National Debt
• Budget deficit
• When government purchases exceed net tax
revenue
• National debt
• The total amount the federal government still
owes to the general public from past
borrowing
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Long Run: Deficits and the National Debt
• Government’s spending and its total debt
• Should be viewed in relation to the economy’s
total income
• Budget-related figures
• Such as government outlays, tax revenues, or
government debt
• Should be considered relative to a nation’s
total income—as percentages of GDP
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Long Run: Deficits and the National Debt
• Government outlays
• Total outflow of funds for:
• Government purchases
• Transfer payments
• Interest on the national debt
Budget surplus = Tax revenue - Outlays
Budget deficit = Outlays - Tax revenue
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Figure 2a: Federal outlays, revenue, and surplus or deficit, 1959–2009
In any given year, the deficit (relative to GDP) is the difference between federal revenue and
federal outlays as percentages of GDP. The deficit rises in recessions (shaded) and rises further
if fiscal policy is used to fight the recession, as in 2009.
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Figure 2b: Federal outlays, revenue, & surplus or deficit, 1959–2009
In any given year, the deficit (relative to GDP) is the difference between federal revenue
and federal outlays as percentages of GDP. The deficit rises in recessions (shaded) and
rises further if fiscal policy is used to fight the recession, as in 2009.
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Long Run: Deficits and the National Debt
• In a recession
• Transfers rise and tax revenue falls
• Budget deficit automatically increases
• Or the budget surplus decreases
• In an expansion
• Transfers decrease and tax revenue rises
• Budget deficit automatically decreases
• Or the budget surplus increases
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Long Run: Deficits and the National Debt
• Economic fluctuations automatically affect
• Transfer payments and tax revenues
• Budget deficits
• Add to the public’s holdings of federal
government bonds
• Add to the national debt
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Long Run: Deficits and the National Debt
• Budget surpluses
• Decrease the public’s bond holdings
• Subtract from the national debt
• Budget deficit or surplus
• Flow variable
• National debt
• Stock variable
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Figure 3: National Debt as a Percentage of GDP (1940–2009)
Debt as a percentage of GDP soared during World War II, then fell steadily for several
decades. It rose during the 1980s, fell in the 1990s, rose in the early 2000s, and then surged
in 2008–2009 due to recession and recession-fighting fiscal policies
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The National Debt: Myths and Realities
• The total national debt
• In mid-2009, it was approaching $12 trillion
• Amounts that government owes to the public
($7 trillion)
• It has macroeconomic impact
• Amounts that one government agency owes
to another ($5 trillion)
• No macroeconomic impact at all
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The National Debt: Myths and Realities
• Mythical concerns about the national debt
• “One day we’ll have to pay it all back”
• We don’t have to, ever
• As long as the debt grows by the same
percentage as nominal GDP
• The ratios of debt to GDP and interest payments
to GDP will remain constant
• The government can continue to pay interest on
its rising debt without increasing the average tax
rate in the economy
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The National Debt: Myths and Realities
• Genuine concerns about the national debt
• Interest payments on the debt, each year come out of current tax revenue
• Interest on foreign held public debt
• Transfer of purchasing power from U.S. residents to
foreign residents = reduce U.S. living standards
• Interest to U.S. residents who hold government
bonds
• Tax other U.S. residents
• Higher average tax rate - can lead to slower economic
growth
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The National Debt: Myths and Realities
• Three scenarios in which a nation’s debt
problem can become very costly
• A national debt that is growing too rapidly
• A debt approaching a national credit limit
• Failing to account for future obligations
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The National Debt: Myths and Realities
• A national debt that is growing too rapidly
• Debt that rises faster than nominal GDP
• Impose an opportunity cost in the future
• A permanently higher tax burden
• A period of inflation
• A period of reduced government outlays or higher
taxes relative to GDP
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The National Debt: Myths and Realities
• A debt approaching a national credit limit
• In recent years - debt has risen as a
percentage of GDP
• U.S. debt levels have not approached a credit
limit
• Based on loss of faith in the U.S. government’s
ability to pay interest on its debt
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The National Debt: Myths and Realities
• Failing to account for future obligations
• Social Security, Medicare, and Medicaid
benefits - projected to rise significantly
• From 8.3% of GDP in 2007
• To around 18.6% of GDP in 2050
• Federal government - should take these future
obligations into account in its planning
process
• Uncertainty over debt projections
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U.S. Fiscal policy during recession of 2008–2009
• Early 2009 - fiscal stimulus package
• The American Reinvestment and Recovery Act =
$787 billion over two years
• one-third was tax cuts
• one-third was greater government purchases
• One-third was increased transfer payments
• To help those most directly affected by the recession
• To state and local governments (to help them avoid
raising their own taxes or cutting their own outlays)
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U.S. Fiscal policy during recession of 2008–2009
• Short-run controversy: would the stimulus
work?
• Objections:
• Timing
• The likely reaction of the Federal Reserve
• Objections from economists:
• Stimulus too small.
• Stimulus not well designed
• Stimulus too large
• Opposition to any stimulus
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Figure 4: Estimated Impact of Fiscal Stimulus on GDP Gap
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U.S. Fiscal policy during recession of 2008–2009
• Long run controversy: what will happen later?
• Enlarging the deficit further – with stimulus package
• Along with other recession-fighting policies and the
long-term budget outlook
• Could bring the U.S. economy close to its credit limit
• Debt-to-GDP ratio
• Already risen substantially by the end of 2008
• Projected to rise even more rapidly than in the past
• For reasons having nothing to do with the recession
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Figure 5a: Current & projected deficits & federal debt relative to GDP
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Figure 5b: Current & projected deficits & federal debt relative to GDP
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U.S. Fiscal policy during recession of 2008–2009
• Beyond the fiscal stimulus: long-run budget
projections
• “Extended Baseline Scenario”
• Assumes that there will be no change in current
fiscal policies, other than the expiration of
temporary stimulus programs
• Debt ratio rises because of the aging of the
population, and increases in Social Security and
Medicare payments that will be required under
current law
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U.S. Fiscal policy during recession of 2008–2009
• Beyond the fiscal stimulus: long-run budget
projections
• “Alternative Fiscal Scenario”
• Assumes that Congress will make the
adjustments to taxes and transfers
• Adjustments to Medicare payments to reflect rising
medical costs per person, and periodic correction of
anomalies in the tax code
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Figure 6: Past and Future Debt: The Very Long Run
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