Fiscal Policy, Deficits, and Debt

Chapter 30

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

30-2

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

30-3

Fiscal Policy

• Council of Economic Advisers (CEA)

• Discretionary fiscal policy–Eliminate recessionary or

inflationary gap–Countercyclical

• Nondiscretionary fiscal policy–Passive or automatic

30-4

• Expansionary fiscal policy–Increased spending and/or lower

taxes–Budget deficit

• Contractionary fiscal policy–Lower spending and/or higher

taxes–Budget surplus

• Policy options?

Fiscal Policy

30-5

Expansionary Fiscal Policy

Real Domestic Output, GDP

Pri

ce L

evel

AD2

RecessionsDecreaseAggregateDemand

AD1

$5 Billion AdditionalSpending

Full $20 Billion Increase in

Aggregate Demand

AS

$490 $510

P1

30-6

Contractionary Fiscal Policy

Real Domestic Output, GDP

Pri

ce L

evel

AD3

Reduce Demand Pull

Inflation

AD4

$5 Billion Initial Decrease

In Spending

Full $20 Billion Decrease in

Aggregate Demand

AS

$510 $522

P1

30-7

Built-In Stability

• Automatic stabilizers–Taxes and transfers

• Economic importance

• Tax progressivity–Progressive tax system

–Proportional tax system

–Regressive tax system

30-8

Built-In Stability

G

T

Deficit

Surplus

GDP1 GDP2 GDP3

Real Domestic Output, GDP

Go

vern

men

t E

xpen

ses,

Gan

d T

ax R

even

ues

, T

30-9

Evaluating Fiscal Policy

• Standardized budget –Full-employment budget

• Cyclical deficit

• Recent U.S. fiscal policy

• Budget deficits and projections

• Social security considerations

30-10

Evaluating Fiscal Policy

G

T

GDP2 GDP1

Real Domestic Output, GDP

Go

vern

men

t E

xpen

ses,

Gan

d T

ax R

even

ues

, T

(Year 2) (Year 1)

$500

$450

ab

c

Cyclical deficitFiscal policy neutral

30-11

Evaluating Fiscal Policy

G

T1

GDP4 GDP3

Real Domestic Output, GDP

Go

vern

men

t E

xpen

ses,

Gan

d T

ax R

even

ues

, T

(Year 4) (Year 3)

$500

$450

de

f

$475

$425 g

T2

h

Standardized deficitExpansionary fiscal policy

30-12

(1)Year

(2)Actual

Deficit (-) orSurplus (+)

(3)StandardizedDeficit (-) orSurplus (+)

Budget Balances as % of GDP

1992199319941995199619971998199920002001200220032004200520062007

-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

30-13

Standardized Budget Balance

Percentage of Potential GDP, 2007

Source: Organization for Economic Cooperation and Development

Denmark

New Zealand

Ireland

Canada

Norway

France

United States

United Kingdom

Japan

-6 -4 -2 0 2 4 6Deficits Surpluses

30-14

Federal Budget BalanceActual and Projected, Fiscal 1994-2014

Source: Congressional Budget Office

$300

200

100

0

-100

-200

-300

-400

-500

Bu

dg

et D

efic

it (

-) o

r S

urp

lus,

Bill

ion

s

1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Actual Projected (as of March 2008)

30-15

• 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

Problems, Criticisms, and ComplicationsFiscal Policy Issues

30-16

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

30-17

Debt Held by theFederal Government

and FederalReserve (53%)

Debt Held OutsideThe FederalGovernmentand Federal

Reserve (47%)

FederalReserve

U.S.Government

AgenciesU.S.Individuals

ForeignOwnership

U.S. BanksAnd otherFinancial

Institutions

Other, IncludingState and LocalGovernments

Source: U.S. Treasury

9%

7%

25%

8% 7%

44%

The Public Debt

Total Debt: $9.01 trillion

30-18

Debt and GDP

Federal debt held by the public, percentage of GDP

Source: Economic Report of the President, 2006

Per

cen

t o

f G

DP

Year

50

45

40

35

30

25

20

15

10

5

01970 1975 1980 1985 1990 1995 2000 2005

30-19

Debt and GDPPublicly Held Debt: International Comparisons

As a Percentage of GDP, 2007

ItalyJapan

BelgiumHungaryGermany

United StatesUnited Kingdom

FranceNetherlands

CanadaSpain

Poland

0 20 40 60 80 100

Source: Organization for Economic Cooperation and Development

30-20

Debt and GDP

• Interest charges–Primary burden–1.7% of GDP 2007

• False concerns–Bankruptcy–Refinancing–Taxation–Burdening future generations

30-21

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

30-22

Crowding Out

5 10 15 20 25 30 35 400

2

4

6

8

10

12

14

16

Rea

l In

tere

st R

ate

(P

erce

nt)

Investment (Billions of Dollars)

ID1

ID2

a

b c

Interest RateRise WillDecrease

Investmenta to b

Crowding-Out Effect

A Large Public Debt to Finance Public Investment Will Cause…

If Public SpendingSpurs More Private

Investment WillIncrease to ID2

30-23

The Leading Indicators

1. Average workweek2. Initial claims for unemployment

insurance3. New orders for consumer goods4. Vendor performance5. New orders for capital goods6. Building permits for houses7. Stock prices8. Money supply9. Interest-rate spread10.Consumer expectations

Source: The Conference Board

30-24

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

30-25

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