PRINCIPLES OF MACROECONOMICSChapter 17 Government Budgets and Fiscal Policy

Modified by: Yun WangFall 2017, Florida International University

TREND OF GOVERNMENT SPENDING

Since 1960, total federal spending has ranged from about 18% to 22% of GDP, although it climbed above that level in 2009. The share spent on national defense has generally declined, while the share spent on Social Security and on healthcare expenses (mainly Medicare and Medicaid) has increased.

DISTRIBUTION OF GOVERNMENT SPENDING

About 71% of government spending goes to four major areas: national defense, Social Security, healthcare, and interest payments on national debt. This leaves about 29% of federal spending for all other functions of the U.S. government.

STATE AND LOCAL GOVERNMENT SPENDING

Spending by state and local government increased from about 10% of GDP in the early 1960s to 14–16% by the mid-1970s. It has remained at roughly that level since. The single biggest spending item is education, including both K–12 spending and support for public colleges and universities, which has been about 5–6% of GDP in recent decades.

TAX STRUCTURE

Federal tax revenues have been about 17–20% of GDP. The primary sources of federal taxes are individual income taxes and the payroll taxes that finance Social Security and Medicare. Corporate income taxes, excise taxes, and other taxes provide smaller shares of revenue.

STATE AND LOCAL TAX REVENUES

State and local tax revenues from about 8% to over 10% of the GDP. They have increased to match the rise in state and local spending.

FEDERAL GOVERNMENT DEFICIT

The federal government has run budget deficits for decades. The budget was briefly in surplus in the late 1990s, before heading into deficit again in the first decade of the 2000s—and especially deep deficits in the recession of 2008–2009.

FEDERAL GOVERNMENT DEFICIT

When government spending exceeds taxes, the gap is the budget deficit. When taxes exceed spending, the gap is a budget surplus. The recessionary period starting in late 2007 saw higher spending and lower taxes, combining to create a large deficit in 2009.

FEDERAL GOVERNMENT DEBT

During the 1960s and 1970s, the government often ran small deficits, but since the debt was growing more slowly than the economy, the debt/GDP ratio was declining over this time. In the 2008–2009 recession, the debt/GDP ratio rose sharply.

ILLUSTRATION OF A HEALTHY ECONOMY

In this well-functioning economy, each year AD AND AS rise so that the economy proceeds from equilibrium E0 to E1 to E2. Each year, the economy produces at potential GDP with only a small inflationary increase in the price level.

FISCAL POLICY

Fiscal Policy: The government’s spending and taxing policies to stabilize economic activity.

Discretionary Fiscal Policy: Changes in taxes or spending that are the result of deliberate changes in government policy by the government ad hoc judgment.

FISCAL POLICY

Expansionary Fiscal Policy: Increased government spending and/or reduced taxes to increased AD to help the economy grow faster.

Contractionary Fiscal Policy: decreased government spending and/or increased taxes to reduce the AD and reduce inflation.

EXPANSIONARY FISCAL POLICY

An expansionary fiscal policy shifts the AD to the right. The economy will recover from a recession to reach full employment equilibrium.

CONTRACTIONARY FISCAL POLICY

An contractionary fiscal policy shifts the AD to the left. The economy will recover from rapid inflation to reach full employment equilibrium.

THE CROWDING-OUT EFFECT

To pay for an expansionary fiscal policy, the government borrows money, increasing the demand for loanable funds and causing the rate of interest to rise, which is dicouraging for households and firms to borrow and spend.

Effectiveness of Stabilization Policy

Stabilization policy describes both monetary and fiscal policy, the goals of which are to smooth out fluctuations in output and employment and to keep prices as stable as possible.

Time lags: Delays in the economy’s response to stabilization policies.

Attempts to stabilize the economy can prove to be destabilizing because of time lags.

Recognition Lag: The time that takes for policy makers to recognize the existence of a boom or bust.

Implementation Lag: The time that takes to put the desired policy into effect once policy makers realize the economy is in a boom or bust.

TIME LAGS

Response Lag: The time that takes for the economy to adjust to the new conditions after a new policy is implemented; the lag that occurs because of the operation of the economy itself.

There is a long delay between the time a fiscal policy action is initiated and the time the full change in GDP is realized.

Until individuals or firms can revise their spending plans, extra government spending does not stimulate extra private spending.

TIME LAGS

Response Lags for Fiscal Policy:

Monetary policy works by changing interest rates, which then change planned investment and consumption spending on durable goods.

The response of consumption and investment to interest rate changes takes time.

TIME LAGS

Response Lags for Monetary Policy: