Long-Run Implications of Fiscal Policy: Deficits and the Public DebtModule 30

May 2015

The Budget Balance

The budget balance as a measure of fiscal policy is defined by:

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 CycleRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 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 RateRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

Figure 30.3 The Actual Budget Deficit Versus the Cyclically Adjusted Budget DeficitRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 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 DebtRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 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 debt-GDP 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 low-income families

The next chart shows why we may be in trouble!!

Figure 30.6 Future Demands on the Federal BudgetRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers