Lecture Essentials of economics (3/e): Chapter 13 - Brue, McConnell, Flynn

Chapter 13 - Fiscal policy, deficits, and debt. This chapter explores the tools of government stabilization policy in terms of the aggregate demand–aggregate supply (AD-AS) model. Next, this chapter examines fiscal policy measures that automatically adjust government expenditures and tax revenues when the economy moves through the business cycle phases.

Chapter 13 Fiscal Policy, Deficits, and Debt McGraw­Hill/Irwin Copyright © 2014 by The McGraw­Hill Companies, Inc. All rights reserved 13­1 1­1 Fiscal Policy • Deliberate changes in • Government spending • Taxes • Designed to • Achieve full employment • Control inflation • Encourage economic growth 13­2 Expansionary Fiscal Policy • Use during a recession • Increase government spending • Decrease taxes • Combination of both • Create a deficit 13­3 Expansionary Fiscal Policy Recessions decrease AD $5 billion increase in spending Price level AS Full $20 billion increase in aggregate demand P1 AD1 AD2 $490 $510 Real GDP (billions) 13­4 Contractionary Fiscal Policy • Use during demand-pull inflation • Decrease government spending • Increase taxes • Combination of both • Create a surplus LO1 13­5 Contractionary Fiscal Policy $3 billion initial decrease in spending Price level AS P2 P1 d c Full $12 billion decrease in aggregate demand b a AD4 AD AD3 $502 $510 $522 Real GDP (billions) 13­6 Built­in Stability • Automatic stabilizers • Taxes vary directly with GDP • Transfers vary inversely with GDP • Reduces severity of business fluctuations • Tax progressivity • Progressive tax system • Proportional tax system • Regressive tax system 13­7 Built­in Stability Government expenditures, G, and tax revenues, T T Surplus G Deficit GDP1 GDP2 GDP3 Real domestic output, GDP 13­8 Evaluating Fiscal Policy • Is the fiscal policy • Expansionary? • Neutral? • Contractionary? • Use the cyclically adjusted budget to evaluate 13­9 Recent U.S. Fiscal Policy Federal Deficits (-) and Surpluses (+) as Percentages of GDP, 2000– 2010 (1) Year (2) Actual Deficit – or Surplus + (3) Cyclically Adjusted Deficit – or Surplus +* 2000 +2.5 +1.0 2001 +1.3 +0.5 2002 -1.5 -1.3 2003 -3.4 -2.8 2004 -3.5 -3.3 2005 -2.6 -2.7 2006 -1.9 -2.2 2007 -1.2 -1.3 2008 -3.2 -2.9 2009 -9.4 -7.3 2010 -8.4 -6.1 •As a percentage of potential GDP Source: Congressional Budget Office, www.cbo.gov 13­10 Fiscal Policy: The Great  Recession • Financial market problems began in • • • 2007 Credit market freeze Pessimism spreads to the overall economy Recession officially began December 2007 and lasted 18 months 13­11 Budget Deficits and Projections Budget deficit (-) or surplus, billions $400 -400 -800 -1200 -1600 2014 2012 2010 2008 2006 2004 2002 2000 1998 1996 1994 Source: Congressional Budget Office, www.cbo.gov LO4 13­12 Problems, Criticisms, &  Complications • Problems of timing • Recognition lag • Administrative lag • Operational lag • Political considerations • Future policy reversals • Offsetting state and local finance • Crowding-out effect 13­13 Current Thinking on Fiscal Policy • Let the Federal Reserve handle short• • • term fluctuations Fiscal policy should be evaluated in terms of long-term effects Use tax cuts to enhance work effort, investment, and innovation Use government spending on public capital projects 13­14 The U.S. Public Debt • $13.6 trillion in 2010 • The accumulation of years of federal • deficits and surpluses Owed to the holders of U.S securities • Treasury bills • Treasury notes • Treasury bonds • U.S savings bonds 13­15 The U.S. Public Debt U.S Banks and Other Financial Institutions Other, including State and Local Gov’ts Federal Reserve 5% 13% Debt held outside the federal government and the Federal Reserve: 61% 6% U.S Government Agencies 33% Foreign Ownership 32% Debt held by the federal government and the Federal Reserve: 39% 11% U.S Individuals 13­16 The U.S. Public Debt 13­17 Global Snapshot Public Sector Debt as Percentage of GDP, 2010 20 40 60 80 100 120 Japan Greece Italy Belgium United States Hungary France United Kingdom Germany Spain Netherlands Canada Source: Organization for Economic Cooperation and Development, OECD 13­18 The U.S. Public Debt • Interest charges on debt • Largest burden of the debt • 1.4 percent of GDP in 2010 • False Concerns • Bankruptcy • Refinancing • Taxation • Burdening future generations 13­19 Substantive Issues • Income distribution • Incentives • Foreign-owned public debt • Crowding-out effect revisited • Future generations • Public investment 13­20 Crowding­Out Effect Real interest rate (percent) 16 14 12 b 10 c Increase in investment demand a Crowding-out effect ID1 10 15 20 25 30 35 Investment (billions of dollars) ID2 40 13­21 Social Security Shortfalls • More Americans will be receiving • benefits as they age Social Security shortfalls • Income during retirement • Funds will be depleted by 2036 13­22 Social Security Shortfalls 13­23 Social Security Shortfalls • Possible options “to fix” include • Increasing the retirement age • Increasing the portion of earnings subject to the Social Security tax • Disqualifying wealthy individuals • Redirecting low-skilled immigrants to higher-skilled, higher-paying work • Defined contribution plans owned by individuals 13­24 ... +1.0 2001 +1.3 +0.5 2002 -1 .5 -1 .3 2003 -3 .4 -2 .8 2004 -3 .5 -3 .3 2005 -2 .6 -2 .7 2006 -1 .9 -2 .2 2007 -1 .2 -1 .3 2008 -3 .2 -2 .9 2009 -9 .4 -7 .3 2010 -8 .4 -6 .1 •As a percentage of potential GDP Source:... months 13 11 Budget Deficits and Projections Budget deficit (-) or surplus, billions $400 -4 00 -8 00 -1 200 -1 600 2014 2012 2010 2008 2006 2004 2002 2000 1998 1996 1994 Source: Congressional Budget Office, www.cbo.gov... finance • Crowding-out effect 13 13 Current Thinking on Fiscal Policy • Let the Federal Reserve handle short• • • term fluctuations Fiscal policy should be evaluated in terms of long-term effects